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While the umbrella group for Canada's provincial securities commissions ponders whether to make new rules to manage the booming mortgage investment fund sector, the Ontario Securities Commission has decided to act on its own to clamp down on the industry.

The OSC has issued a notice saying it will no longer allow closed-end mortgage funds to be registered in the category of investment funds, arguing their active management strategy is not appropriate for what was intended to be a passive investment model.

The intent is clearly to tell closed-end mortgage funds that they must now be registered as regular public companies, but the OSC has not said that bluntly. The staff notice issued late last week simply says funds will no longer be allowed to file an initial prospectus using the investment fund form.

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Rhonda Goldberg, director of investment funds at the OSC, said the notice was not intended to cause immediate changes for existing issuers, but puts the industry on notice about how OSC staff will view subsequent fund offerings.

"The notice was intended to give issuers a heads-up, so to speak, of our approach in reviewing these types of offerings going forward," Ms. Goldberg said in an e-mailed statement. "It sets out what OSC staff will be looking for when reviewing prospectuses and the types of questions that staff will be asking.... The notice wasn't intended to cause immediate changes to existing issuers, but OSC staff will examine subsequent offerings of existing issuers through this lens."

Mortgage investment corporations lend money at higher rates of interest to borrowers who do not have ready access to lower-interest bank loans, including real estate developers. The industry model typically sees a management company provide the mortgages using funds raised in the public market by an affiliated closed-end mortgage fund.

Retail investors seeking higher returns in a low-interest-rate environment have gobbled up the units. At least eight funds trade publicly on the Toronto Stock Exchange, and a majority of them are structured as closed-end investment funds, which means their units trade on the exchange but they are not redeemable on a daily basis at a net asset value like mutual fund units are.

In its latest staff notice, the OSC says it has seen an increase in the number of prospectus filings from mortgage investment funds, and said the typical model "is contrary to the spirit and intent of the definition of a non-redeemable investment fund" which is supposed to be a passive investment vehicle. The OSC said it appears the mortgage funds are an extension of the mortgage originator's business, which is "inconsistent with the nature of an investment fund and is, in essence, an operating business."

In other words, the OSC says the mortgage investment fund may appear to be simply a pool of outstanding mortgages, but what the fund is really selling to investors is the money-lending expertise of the management company.

The OSC said this model may look similar to other sorts of investment funds that hold debt or equity securities, but said they are typically purchased as passive holdings on the secondary market. The OSC said its concern is with mortgage investment entities that essentially originate their own loans, which makes them "more akin to a lending business than an investment fund, which generally invests in a portfolio of securities."

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The Canadian Securities Administrators, which is an umbrella group of provincial and territorial securities commissions, has raised similar questions about mortgage funds. It issued a sweeping position paper on investment fund reforms in March, seeking public comment on numerous questions about fund regulation, including whether mortgage investment corporations should be allowed to continue under their existing model.

But the CSA proposal is at the early stages. The March publication asked for public comment by late August on whether or how it should regulate the sector at all. The next step would be to propose specific new rules. And if or when they are published, there would be another comment period for the industry to comment on the specific proposals before anything would become a new rule.

The OSC has essentially stepped outside of the CSA process to move more quickly with a staff notice on mortgage funds. A staff notice advises the industry about how OSC staff will interpret the existing rules. As such, it doesn't require the same notice and comment period, so allows the Ontario regulator to move more quickly.

Timbercreek Asset Management has already received approval from shareholders to convert two of its mortgage investment corporations into regular public companies to comply with anticipated new rules from regulators. Executive director Peter Hawkings said Timbercreek assumes the OSC notice means it could not raise any new money under its current investment fund structure.

"We obviously believe mortgage investment entities that are investment funds will eventually have to either divest their non-guaranteed mortgages or change their structure," he said. "That's why we proposed the transition of Timbercreek Mortgage Investment Corporation and Timbercreek Senior Mortgage Investment Corporation into regular issuers and not investment funds…. Under our new structure, we're able to continue our existing investment strategy and there's no limits to raising capital."

(Janet McFarland is a Globe and Mail Business Reporter.)

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About the Author
Real Estate Reporter

Janet McFarland is the real estate reporter for The Globe and Mail’s Report on Business, with a focus on residential real estate trends. She joined Report on Business in 1995, and has specialized in reporting on corporate governance, executive compensation, pension policy, business law, securities regulation and enforcement of white-collar crime. More


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