New rules to make risky funds more transparent

Date: Wednesday, June 18, 2008
Author: Ellen Roseman, www.thestar.com

In one of Canada's biggest investment scandals, regulators pulled the plug on Portus Alternative Asset Management Inc. in early 2005.

The now-bankrupt Toronto company was selling risky hedge funds to ordinary investors, using a complex structure that avoided mandatory disclosure in a prospectus.

Luckily, the 26,000 people who invested more than $700 million in Portus products didn't lose everything.

Clients of Manulife Financial Corp. were reimbursed in full – with a payout of $246 million by the insurer. Other Portus investors recouped most of their money through receivers last year.

A few months later in 2005, Norshield Financial Group of Montreal closed down. It, too, was selling hedge funds to unsophisticated investors.

Norshield investors were owed more than $400 million, but recovered almost nothing in the bankruptcy.

Both companies used a "principal-protected note" to get around normal hedge fund requirements.

Investors bought bank notes issued by a licensed commercial bank, usually with maturity dates of five to seven years. The bank guaranteed the principal. Any additional return was linked to the performance of a hedge fund or fund-of-funds, marketed with the note.

In 2006, the Canadian Securities Regulators alerted principal-protected note, or PPN, investors to the risks and said they should ask about the security backing the guarantee.

"At present, there are few rules that dictate what PPN managers must tell investors," the regulators admitted in their warning.

Starting July 1, such notes will be transformed into something more transparent.

Investors can thank Ottawa for beefing up the disclosure rules, albeit three years after the traumatic Portus and Norshield losses.

The federal government took action because it's responsible for regulating the banks that guarantee principal-protected notes.

Here's what you can expect of the new disclosure regime, according to the regulations published in the Canada Gazette last Wednesday:

Clear and simple language that is not misleading.

Written and verbal information from a financial institution at least two days before you agree to buy a principal-protected note.

Information about the term of the note, how and when the principal is to be repaid and the interest, if any, is to be paid.

A warning about any risks associated with the note, including the risk that no interest may accrue.

An explanation of the difference between principal-protected notes and fixed-rate investments.

If a PPN relates to a deposit that is not eligible for coverage by the Canada Deposit Insurance Corp., the fact should be clearly mentioned.

Information about whether the note can be redeemed before maturity and, if so, that early redemption may result in the investor's receiving less than the principal amount.

Even after the purchase, banks still have disclosure obligations. They must tell investors "without delay" about the value of their PPN on any given day and how that value relates to the interest payable.

Also, they must tell investors who ask to cash in a PPN early about any penalties and their effect on the amount that would be received at maturity.

The new disclosure system may seem cumbersome. But it's only because principal-protected notes are so darned murky.

Ottawa says its principle-based approach to regulation is flexible enough to adapt to fast and frequent changes in the marketplace.

I'm sure the investment industry has many more complex products up its sleeve. Let's hope regulators can act more quickly next time.

You can reach Ellen Roseman by writing Business c/o Toronto Star, 1 Yonge St., Toronto M5E 1E6; by phone at 416-945-8687; by fax at 416-865-3630; or at eroseman@thestar.ca by email