The Ontario Securities Commission, AMF and MSC have now released notices reminding derivatives market participants of the imminent requirement to identify counterparties to a transaction by a Legal Entity Identifier (LEI). The OSC further advises that “non-reporting counterparties should provide all relevant information to reporting counterparties under OSC Rule 91-507, including their LEI, to assist reporting counterparties in complying with their obligations”. The obligations in Quebec and Manitoba are similar.
As we've recently discussed, trade reporting rules in Ontario Manitoba and Quebec will require reporting beginning October 31. The requirement to identify counterparties by an LEI will apply to all transactions for which the reporting counterparty is a derivatives dealer or recognized or exempt clearing agency.
The OSC, AMF and MSC also state that reporting counterparties faced with legal barriers to reporting counterparty-identifying information in their jurisdiction should apply for exemptive relief. Meanwhile, while derivatives market participants may face operation challenges not related to legal impediments to obtaining counterparty LEIs by October 31, the notices advise that best efforts should be used to obtain counterparty LEIs as soon as possible.
The Manitoba Securities Commission yesterday released changes to its derivatives trade reporting rule that will, among other things, address the issue of clearing agency reporting where the clearing agency is not recognized or exempt in Manitoba (by adding a concept similar to Quebec of a “reporting clearing agency”) and which will permit the reporting obligation to be assigned by written agreement (thereby allowing adoption of the ISDA reporting methodology and giving effect to other forms of delegation agreement). Also, similar to the Quebec rule, the Manitoba rule will require Canadian financial institutions (that are not otherwise caught as dealers) to report transactions with non-dealer local counterparties (as opposed to dual reporting in that situation).
Notably, however, the Manitoba amendments diverge from those in Ontario and Quebec insofar as the amended rule requires that, in certain circumstances involving two local non-dealers, each local counterparty submit to the MSC within 5 days of the trade a document identifying both the unique transaction identifier assigned to the transaction by the trade repository to which it reported the transaction, as well as the unique transaction identifier assigned to the transaction by the trade repository to which the other local counterparty reported the transaction.
The amendments come into force on October 31, 2014. As the amendments are being adopted without a consultation period, the MSC is also accepting comments on whether to make the amendments permanent, until January 5, 2015. For more information, see MSC Rule 2014-19.
Earlier this week, the Ontario Securities Commission (OSC) and Quebec's Autorité des marchés financiers (AMF) issued parallel orders designating the Chicago Mercantile Exchange Inc., DTCC Data Repository (U.S.) LLC and ICE Trade Vault, LLC as trade repositories in each province. The Manitoba Securities Commission also confirmed today that it had received corresponding applications for designation as trade repository from those three entities and that it would coordinate with the OSC and the AMF in reviewing and finalizing the designations. The orders are expected to be similar in nature to those issued by the OSC and the AMF.
As we've previously discussed, under each province's respective Rule 91-507, over-the-counter derivatives transactions involving counterparties in the province must be reported to a designated trade repository. Each of the three trade repositories applied for designation this past summer. The first phase of reporting obligations becomes effective on October 31.
Earlier this week, Alberta Securities Commission staff proposed replacing ASC Blanket Order 91-505 Over-the-Counter Derivatives Transactions, with a new blanket order aimed at conforming the prospectus and dealer registration exemptions available under the existing order to pending amendments to the Securities Act.
The pending amendments will, among other things, exclude “futures contracts” from the definition of “security” while introducing the concept of “derivatives” (which will exclude any products that have attributes of a derivative but are also a security, referred to as “derivative-like securities”) and exclude derivatives from the prospectus requirement entirely. As a result, the new blanket order will no longer provide a prospectus exemption for derivatives.
However, in order to maintain the scope of the current prospectus and registration exemptions of the existing Blanket Order, the new blanket order will ensure that a prospectus exemption will also be available for over-the-counter trades in derivative-like securities and that a dealer registration exemption will continue to be available for over-the-counter trades in derivatives and derivative-like securities, in each case if (i) at the time of the trade each counterparty was a qualified party; or (ii) the trade was in a physical commodity contract.
Further, under the new blanket order, the definition of "qualified party" is proposed to be more closely aligned with the definition of “accredited investor” in NI 45-106 Prospectus and Registration Exemptions.
The new blanket order is proposed to come into effect concurrently with the amendments to Alberta's Securities Act expected to come into force on October 31, 2014, and is intended only as a stop-gap measure until the Canadian Securities Administrators can harmonize the regulation of OTC-traded derivatives.
In light of the proposed new blanket order, parties should ensure that their representations to qualified party status are drafted broadly enough so as to capture the breadth of qualified parties contemplated by the replacement blanket order.
The ASC is accepting comments on the proposal until October 17, 2014. For more information, see ASC Staff Notice 91-706.
Earlier this week, the Bank of Canada and securities regulators in Alberta, Quebec, B.C., Manitoba and Ontario released a list of Canadian central counterparties that can be considered qualifying central counterparties (QCCP) under the applicable Basel standard.
Specifically, the Basel standard defines a QCCP as
…an entity that is licensed to operate as a CCP (including a license granted by way of confirming an exemption), and is permitted by the appropriate regulator/overseer to operate as such with respect to the products offered. This is subject to the provision that the CCP is based and prudentially supervised in a jurisdiction where the relevant regulator/overseer has established, and publicly indicated that it applies to the CCP on an ongoing basis, domestic rules and regulations that are consistent with the CPSS-IOSCO Principles for Financial Market Infrastructures (PFMIs).
In Canada, CDS Clearing and Depository Services Inc., Canadian Derivatives Clearing Corporation, ICE Clear Canada, Inc., and Natural Gas Exchange Inc. have been designated or recognized by at least one of the regulators above.
For more information, see CSA Multilateral Staff Notice 24-311.
The Canadian Securities Administrators yesterday released an update on the proposed local rules designed to set out certain requirements in relation to the application process for seeking recognition as a clearing agency (or an exemption from the recognition requirement), which were published in December 2013.
As we discussed late last year, the proposed rules were published in substantially the same form by the Ontario Securities Commission, Quebec's Autorité des marchés financiers and the Manitoba Securities Commission, while the securities regulators in British Columbia, Alberta, Saskatchewan, New Brunswick and Nova Scotia announced an intention to develop a materially similar multilateral rule in the future.
According to the update provided yesterday, however, the CSA now intend to develop a proposed national instrument that takes into consideration the comments received in response to the earlier local proposals, and that applies across all Canadian jurisdictions to facilitate uniform, consistent and transparent requirements for clearing agencies across the country. The new regulatory framework is also intended to facilitate ongoing compliance by recognized clearing agencies with international minimum standards applicable to financial market infrastructures (FMIs).
The CSA note that the proposed national instrument would further facilitate the efforts of Canadian CCPs to meet the “qualifying CCP” (QCCP) status under the Basel III and Canadian banking guidelines. The notice reminds market participants that Canadian and foreign banks that have certain counterparty exposures to Canadian CCPs would be subject to higher capital requirements if these CCPs do not meet the QCCP status.
The CSA also state that, as with the earlier proposed companion policies, the companion policy to the proposed national instrument will include supplementary guidance jointly developed by the CSA and the Bank of Canada for domestic clearing agencies that are regulated by CSA jurisdictions and the Bank of Canada. The CSA and the Bank of Canada intend to publish for comment further joint supplementary guidance on other standards.
The CSA note that the Bank of Canada has published the Joint Supplementary Guidance related to liquidity risk on its website for a 30-day comment period and state their intention to republish the guidance related to liquidity risk later this fall with the proposed national instrument and related companion policy. The notice encourages prospective commenters to provide their views, if any, during the Bank of Canada’s comment period, which expires on August 4, 2014 so that any feedback can be incorporated in the next round of proposals.
For more information, see CSA Staff Notice 24-310.
On July 3, Quebec’s Autorité des marchés financiers (AMF) published for comment the Draft Regulation to amend Regulation 91-507 respecting Trade Repositories and Derivatives Data Reporting (the “Draft Regulation”). Regulation 91-507, which requires that all over-the-counter (OTC) derivatives transactions involving a local counterparty be reported to a recognized trade repository, came into force in Quebec on December 31, 2013, with reporting obligations becoming effective for the various market participants over the course of 2014 and 2015. The AMF is proposing the Draft Regulation in furtherance of its previously stated intent to make consequential amendments to Regulation 91-507 “to maintain a harmonized national oversight and reporting regime for OTC derivatives markets”.
As part of the changes proposed in the Draft Regulation, section 25 of Regulation 91-507, which imposes the reporting requirement on the dealer, would be amended to explicitly add Canadian financial institutions to the determination of the reporting counterparty. The reason for the addition is that Canadian financial institutions engaging in derivatives trading on their own behalf might not need to be registered as derivatives dealers under the Quebec Derivatives Act. For purposes of transaction reporting under Regulation 91-507, a Canadian financial institution would be the most technologically sophisticated counterparty.
The Draft Regulation is not, however, intended to cover the implementation in Quebec of the International Swaps and Derivatives Association (ISDA) Canadian methodology to determine the reporting counterparty for a transaction. (The ISDA methodology was recently introduced in Ontario through amendments to OSC Rule 91-507 Trade Repositories and Derivatives Data Reporting that permit parties to agree to sign up to it for purposes of reporting counterparty determination.)
The amended Regulation 91-507 would also match the terms of the AMF blanket exemption decision published on May 15 by extending the date for the commencement of OTC derivatives trade reporting obligations under Regulation 91-507 to October 31, 2014 for dealers, clearing agencies and Canadian financial institutions, and to June 30, 2015 for all other OTC derivatives market participants. In addition, the requirement for trade repositories to make transaction level data available to the public would be delayed to April 30, 2015.
The AMF will be accepting comments on the proposed amendments until August 2, 2014.
The OSC announced the anticipated further amendments to OSC Rule 91-507 Trade Repositories and Derivatives Data Reporting (the TR Rule) to incorporate reporting in accordance with the Canadian Transaction Reporting Requirements issued by ISDA April 4, 2014 where transactions are between two dealers or two non-dealers, thus avoiding (hopefully) double reporting. In order to rely on the ISDA methodology: (i) each party to the transaction must agree to a multilateral agreement administered by and delivered to IDSA and under which the process set out in the ISDA methodology is required to be followed; (ii) the ISDA methodology process must be followed in determining the reporting counterparty in respect of that transaction; and (iii) each party to the transaction must consent to the release to the OSC by ISDA of information relevant in determining the applicability of the first two conditions.
As we discussed in April, amendments were also recently announced to delay the effective date of reporting obligations under the rule and to lessen the burden on local end-user counterparties.
The amendments announced today also designate the U.S. as a jurisdiction that will satisfy the substituted compliance condition in section 26(5) when reporting pursuant to CFTC data reporting rules. Recall that this substituted compliance rule only applies if the only local counterparty is a party that is a local counterparty because they are registered as a derivatives dealer in the jurisdiction (but are not otherwise located in the jurisdiction) or are an affiliate who liabilities are assumed by a party located in the jurisdiction.
In terms of data to be reported it amends the local counterparty identification data field to require market participants to specify the provinces in which the parties are local counterparties, thus facilitating the filing of one transaction report for multiple jurisdictions. In addition, a few fields that were not consistent with requirements in other jurisdictions were removed (ie. those labelled “Reporting counterparty derivatives dealer or non-derivatives dealer”, “Clearing timestamp: and “Valuation type”
Assuming Ministerial approval, these amendments will come into effect on September 9, 2014.
The Ontario Securities Commission today released its Statement of Priorities for the 2014-2015 financial year. The OSC notice also addresses stakeholder comments received in response to a draft version released earlier this year.
Ultimately, the OSC provides five broad regulatory goals for the upcoming year, namely (i) delivering strong investor protection, including by considering the best interest duty to investors, completing research in regards to embedded fees in mutual funds and publishing final rules to introduce pre-sale delivery of Fund Facts for mutual funds; (ii) delivering responsive regulation by, among other things, publishing proposals to update the order protection rule, developing proposals for streamlining the existing rights offering exemption, and moving forward on proposed rules regarding board gender diversity; (iii) delivering effective enforcement and compliance; (iv) supporting and promoting financial stability, including by developing rules for the clearing of OTC derivatives and implementing trade reporting rules, as well as by working with B.C., Ontario and the federal government to implement a cooperative securities regulator to deliver "more efficient and effective regulation of the capital markets" and oversee sources of systemic risk; and (v) running a modern, accountable and efficient organization.
For more information, see OSC Notice 11-770.
As we've discussed in numerous posts on our structured finance blog, new derivative trade reporting rules were recently enacted that will see the staggered implementation of reporting requirements over the course of the next year.
The International Swaps and Derivatives Association (ISDA), meanwhile, has developed a number of useful tools for end-users in the Canadian OTC derivatives markets, including a Canadian Representation Letter.
Join me at ISDA's conference on transaction reporting on June 19, where I'll be discussing the contents of the Canadian Representation Letter and its application to reporting requirements. This will be a good conference for not only representatives of derivatives dealers that want to know more about data reporting, but also for those in the end-user community that need to know more about how reporting will affect them and what they have to do to ensure that their dealers can report on their behalf.
As a follow-up to our post of April 17, the AMF issued its blanket exemption decision on May 15 to extend the date for the commencement of over-the-counter (OTC) derivatives trade reporting under AMF Regulation 91-507 respecting Trade Repositories and Derivatives Data Reporting until October 31, 2014 for clearing houses and dealers, and until June 30, 2015 for all other OTC derivatives market participants.
In the accompanying notice, the AMF confirms its intention to make consequential amendments to Regulation 91-507 “to maintain a harmonized national oversight and reporting regime for OTC derivatives markets”. These amendments are expected to be broadly consistent with the amendments to the Ontario and Manitoba TR Rules released on April 17 and discussed in our April post. Both the blanket decision and the accompanying notice are currently available in French only.
Last week, Nova Scotia introduced amendments to its Securities Act intended to further facilitate the harmonization of derivatives regulation across Canada. Specifically, the amendments would provide the Nova Scotia Securities Commission with the authority to, among other things, recognize clearing agencies, derivatives trading facilities and trade repositories and regulate the trading of derivatives through such facilities. Nova Scotia's proposed amendments follow Alberta's recent adoption of amendments to its Securities Act and New Brunswick's similar amendments, also intended to create frameworks for the regulation of over-the-counter derivatives in those provinces.
The amendments to both Alberta's and Nova Scotia's securities legislation also expand on the definition of "special relationship" in the context of insider trading, similar to changes made in Ontario last year, to include those considering or evaluating whether to make a take-over bid.
As we have discussed in recent months, Manitoba and Ontario also recently enacted legislation to provide for the regulation of derivatives, while substantive regulation has been adopted by those two provinces as well as Quebec.
Changes to Nova Scotia's statute have yet to be enacted, while Alberta's amendments come into force on proclamation. Changes to New Brunswick's legislation, meanwhile, are currently in force.
The Ontario Securities Commission, among other regulators, released amendments today to OSC Rule 91-507 Trade Repositories and Derivatives Data Reporting (the TR Rule). The amendments are intended to lessen the burden on local end-user counterparties, while also delaying the effective date of reporting obligations under the rule.
As we discussed last week, the CSA recently announced a delay in implementation of reporting obligations. Specifically, clearing agencies and dealers will now have to begin trade reporting on October 31, 2014, while all other OTC derivatives market participants will be required to report beginning on June 30, 2015. The requirement for trade repositories to make transaction-level reports publicly available will also be delayed to April 30, 2015.
The amendments also repeal provisions of the rules that established a fall-back mechanism requiring local non-dealer counterparties to monitor the transaction reporting of foreign dealer reporting counterparties. The amendment is intended to relieve a significant burden on local end-user counterparties.
Meanwhile, Quebec’s AMF today stated that it intends to formalize the delay in implementation dates by publishing a blanket exemption to be effective as of July 2, 2014. Further, it also intends to propose amendments to the TR Rule in order to “maintain a harmonized national oversight and reporting regime for OTC derivatives markets”, in the near future. The AMF advises that it therefore seeks to specify that reporting counterparties that are dealers, clearing houses or financial institutions will be required to report derivatives data pursuant to Part 3 of the TR Rule as of October 31, 2014.
As we've recently discussed on our structured finance blog, the OSC, MSC and AMF recently adopted derivatives rules in respect of product determination, trade repositories and derivatives data reporting.
Under the new rules, any entity engaging in over-the-counter derivatives transactions must obtain a legal entity identifier and may have to make certain status representations to its counterparties to facilitate trade reporting. Reporting requirements begin July 2.
Join me as I participate in ISDA's webinar on preparing for the new reporting requirements on April 3 to learn more.
Last week, Quebec's Autorité des marchés financiers published a webinar and related slide presentation summarizing recently adopted derivatives reporting requirements. As our structured finance blog discussed last year, final versions of Rule 91-507 came into force in Quebec, Ontario and Manitoba at the end of last year, with staggered implementation scheduled over the course of 2014.
Ultimately, the online presentation outlines the objectives of reporting, the circumstances that trigger reporting, the use of unique transaction identifiers (legal entity identifiers), data dissemination and access, and the effective dates associated with the various obligations.
While the global legal entity identifier (LEI) system is not yet operational, market participants can request a pre-LEI from an approved local operating unit.
As previously noted in our structured finance blog post of January 24, the Canadian Securities Administrators have published for comment proposed amendments to National Instrument 45-106 Prospectus and Registration Exemptions. These amendments represent a significant retreat from the more comprehensive set of amendments that were originally proposed by the CSA in 2011. Insofar as both the public and private term markets are concerned, status quo is the happy result. This is a sensible and welcome result and credit to the CSA for taking into consideration the feedback received from the industry consultation on the 2011 proposals.
Given that the only troubling issues in the asset-backed securities market during the financial crisis occurred in the asset-backed commercial paper (ABCP) market (albeit in the non-bank sponsored portion of the market), it is not surprising to see the CSA retain some semblance of heightened regulation over this sector. Consistent with the approach taken in 2011, the CSA have (thankfully) chosen not to impose some of the more substantive (and controversial) requirements on transactions that are being implemented in other jurisdictions (such as mandatory risk retention) but instead have chosen to impose additional requirements (that are largely disclosure-based) on ABCP conduit issuers in order for them to be able to access the prospectus-exempt market.
At first blush, the revised proposals appear to be responsive to much of the commentary received from the industry on the ABCP market in 2011. That being said, there look to be some issues that we expect will draw the interest of (and create some consternation for) ABCP conduit sponsors.
In brief, the main substantive requirements for ABCP to be issued on a prospectus-exempt basis are as follows: (i) the ABCP must be rated by at least two of the specified rating agencies in the highest short-term rating category (which is R-1 (high)(sf) in the case of DBRS); (ii) a “global style” liquidity facility must be provided by a deposit-taking institution that is regulated by OSFI or by another federal or provincial authority that regulates deposit-taking institutions and that has certain specified minimum ratings from two of the specified rating agencies (which is A(low) in the case of DBRS); (iii) the ABCP must be the highest rated “class” issued by the conduit; and (iv) the asset pool of the conduit is limited to a prescribed list of asset types (bond, mortgage, lease, loan, receivable, royalty or a security issued by another conduit that is backed by one of these asset types).
Rating and liquidity requirements
The rating and liquidity requirements are simply codifying the current state of the ABCP market and should not raise any real concern. While ABCP rated less than R-1 (high) was never a large part of the market, it formally ends the possibility of any type of rebirth or renewal of this sector. The reference to “classes” of debt throughout the proposed amendments is an interesting change in terminology. The 2011 proposals repeatedly used the concept of “series” to distinguish between different categories of debt issued by conduits and this is consistent with the commonly used terminology in the conduit market in the sense that series of debt are typically “siloed” or “ring-fenced” from other series and each series is secured by a separate asset pool (or a separate asset interest in a common asset pool). Typically, multiple series of debt wouldn’t rank with or as against one another or have an interest in the same collateral (whereas classes within a series would).
It isn’t clear from these proposed amendments whether the CSA is trying to distinguish between classes of debt within the same series or whether they are using the concepts of “series” (as used by the market) and “class” interchangeably. Consequently, in some cases the purpose of the amendments is uncertain and will hopefully be clarified.
Prescribed list of assets
The use of a prescribed list of assets to determine what may form part of an asset pool of a conduit is somewhat unfortunate. While it may on its face appear to be sufficiently broad to cover the lion’s share of asset classes that are presently securitized in the Canadian market, this prescriptive approach could stifle innovation in the future as new asset classes or financial products develop or evolve.
While we understand the concern over riskier assets such as highly leveraged credit default swaps, which introduce a significant degree of market risk (over and above the credit risk), query whether the other substantive requirements that are being codified (including multiple ratings and global style liquidity) aren’t sufficient to police this issue (anecdotal evidence would suggest this is the case). At a minimum, the preferred approach would be to create a broader definition of financial assets that would permit new asset classes to fit within its parameters and to prescribe certain assets that are prohibited rather than prescribe what is permissible.
The greatest area of concern raised by the proposed amendments relates to the substance of the disclosures that are required in the prescribed form of information memorandum (IM), the form of monthly report and the timely disclosure report. The IM is required to disclose, among other things, the identity of persons originating assets in an asset pool of the conduit. Anonymity has long been a hallmark of the ABCP conduit market and something that has been important to many originators; this may lead some (of those that are left) to withdraw from the ABCP market.
The IM is also required to disclose certain matters that are typically determined (and will vary) from transaction to transaction depending upon the quality and characteristics of the particular originator and its assets (such as investment guidelines and underwriting criteria (typically embodied in transaction-specific eligibility criteria), the amount and nature of credit enhancements, portfolio performance tests, a description of the terms of each material agreement and the basic structure and cash flows of each transaction). Given that these matters are transaction-specific and will change periodically this type of information would seem to be more appropriately dealt with in the monthly disclosure reports.
In addition to the required content in the IM, the conduits are also required to provide monthly disclosure reports containing transaction-specific disclosure. These are intended to provide information with respect to new transactions entered into by the conduit as well as an update to information previously disclosed in the IM or prior monthly disclosure reports. As with the form of IM, the level of detail required (including specific disclosure with respect to originators and their assets) is significant and in some cases goes beyond what is currently provided in the market. Whether or not these requirements will deter either sponsors from maintaining a conduit or originators from selling to conduits (for confidentiality and competitive reasons) will be subject to debate.
In addition to the IM and the monthly report, conduits are also required to provide a timely disclosure report within two days of becoming aware of any change to the information provided in the most recently required monthly disclosure report or any event that the conduit would reasonably expect to significantly affect either a payment on the securitized product or the performance of the assets in the asset pool. Given that sponsors already require a minimum of 30 days (or perhaps longer) to compile monthly portfolio reports from their sellers in order to prepare the conduit’s monthly report, it is unlikely that this type of information can be disseminated more effectively or efficiently than through the monthly reporting process. Nonetheless, this reporting requirement would appear to put a greater onus on the conduits to report information that isn’t entirely within their control (at least not on a timely basis).
Given the vast amount of regulatory change and the turbulent economic conditions in recent years, the ABCP market in Canada isn’t nearly as robust as it used to be. Hopefully these proposals won’t inflict greater damage or render it extinct.
Specifically, the fall session of Alberta's legislature ended prior to adoption of Bill 42, which would have amended the province's Securities Act to provide the ASC with the authority to make rules dealing with OTC derivatives. The amendments would also have sought to harmonize Alberta's derivatives regulations with those of other Canadian jurisdictions. Accordingly, until such time that similar legislation is reintroduced, the regulation of OTC derivatives in Alberta will continue under current rules.
As we've previously discussed, amendments related to providing securities regulators with rule-making authority, and rules emanating from the regulators themselves, have recently come into force in Ontario, Quebec and Manitoba.
For more information, see ASC Staff Notice 91-704.
As of December 31, 2013, certain derivatives-related amendments to the Ontario Securities Act (OSA) primarily relating to the rule-making authority of the Ontario Securities Commission have come into force.
Among other things, the OSC now has the authority to make rules in respect of prescribing registration requirements in respect of persons or companies trading in derivatives, prescribing classes of derivatives that are deemed to be securities for the purposes of prescribed provisions of the OSA, prescribing requirements for investment funds in respect of derivatives and prescribing requirements relating to derivatives, including disclosure and record keeping requirements.
As previously discussed, these amendments can be found in Ontario’s Bill 135, the Helping Ontario Families Managing Responsibility Act 2010, which received Royal Assent on December 8, 2010. Despite these recent amendments to the OSA, a number of amendments remain unproclaimed.
The Ontario Securities Commission announced last week that OSC Rule 91-506 Derivatives: Product Determination and OSC Rule 91-507 Trade Repositories and Derivatives Data Reporting have received Ministerial approval.
As we previously discussed, the final versions of the rules were published in November and came into force beginning on December 31, 2013. The implementation of some requirements, meanwhile, will be staggered over the next year.
Canadian regulators have published for comment proposed rules dealing with clearing agencies and financial market infrastructure and mandatory central counterparty clearing (CCP) of specified OTC derivatives. This most recent round of rulemaking follows the publication of final rules on trade repositories and derivatives trade data reporting which come into effect on December 31, 2013 in certain Canadian jurisdictions, subject to staggered implementation of reporting obligations over the course of 2014.
Taken together, these proposals are key building blocks in the regulatory architecture currently being developed by the Canadian Securities Administrators (CSA) Derivatives Committee to establish a comprehensive regulatory framework for the trading of derivatives in Canada as part of Canada’s G-20 commitments.
The CSA yesterday published for comment the CSA Staff Notice 91-303 Proposed Model Provincial Rule on Mandatory Central Counterparty Clearing of Derivatives (the Proposed CCP Model Rule).
The Proposed CCP Model Rule sets out requirements for central counterparty (CCP) clearing of OTC derivatives transactions. The purpose of the rule is to enhance market transparency and the overall mitigation of risks in OTC derivatives markets through the introduction of requirements for CCP clearing of previously bilaterally cleared or uncleared derivatives transactions.
The CSA Derivatives Committee, in its Consultation Paper 91-406 Derivatives OTC Central Counterparty Clearing published in June 2012, had sought public comment on a number of recommendations relating to the clearing of eligible OTC derivatives which have been incorporated into the Proposed CCP Model Rule.
The Proposed CCP Model Rule is divided into two rule-making areas, namely (i) the determination of derivatives subject to the CCP clearing requirement (the concept of a “clearable derivative”), and (ii) the requirement to submit a “clearable derivative” to a CCP for clearing, subject to proposed end-user and intragroup exemptions.
Rule 91-506 Derivatives: Product Determination which, as noted in our earlier posts, is scheduled to come into force in Ontario, Quebec and Manitoba on December 31, 2013 in conjunction with local Rule 91-507 Trade Repositories and Derivatives Data Reporting would be made applicable to the CCP clearing rule.
The comment period on these proposals ends on March 19, 2014.
The publication yesterday of the Proposed CCP Model Rule follows the publication by certain members of the CSA of draft Rule 24-503 relating to clearing agency requirements. The CSA are also expected to release Model Provincial Model Rule 91-304 Derivatives Customer Clearing and Protection of Customer Positions and Collateral. The CSA invite industry stakeholders to consider these three publications comprehensively since they each relate to CCP clearing.
Canadian regulators propose adopting international standards for clearing agencies, central securities depositories and settlement systems
The Ontario Securities Commission (OSC), Quebec's Autorité des marchés financiers (AMF) and the Manitoba Securities Commission earlier this week published for comment proposed local rules that would set out certain requirements in relation to the application process for seeking recognition as a clearing agency (or an exemption from the recognition requirement) under local rules, as well as the ongoing requirements for recognized clearing agencies that act as central counterparties, central securities depositories or securities settlement systems.
The requirements under proposed Rule 24-503 Clearing Agency Requirements in Ontario and Manitoba and Regulation 24-503 respecting Clearing House, Central Securities Depository and Settlement System Requirements in Quebec are generally based on the Principles for Financial Market Infrastructures (PFMI) developed by the Committee on Payment and Settlement Systems (CPSS) of the Bank for International Settlements and the Board of the International Organization of Securities Commissions (IOSCO). The PFMI set out in the April 2012 CPSS/IOSCO consultative report are considered to be minimum international standards for payment, clearing and settlement systems which must be implemented globally to strengthen core financial infrastructures and markets (including derivatives markets) and critical market infrastructures, and to limit systemic risks.
The Canadian regulators note that implementation of the principles is an integral part of their efforts to develop a comprehensive regulatory framework for the trading of derivatives in Canada and is crucial to satisfying Canada’s G20 commitments for OTC derivatives market regulatory reforms.
To that end, the proposed rules incorporate the PFMI "to the extent possible" and include requirements in respect of, among other things, (i) governance; (ii) credit risk; (iii) collateral; (iv) margin; (v) liquidity risk; (vi) settlement finality; (vii) money settlements; (viii) physical deliveries; (ix) central securities depositories; (x) participant default rules and procedures; (xi) segregation and portability; (xii) general business risk; (xiii) custody and investment risks; (xiv) operational risks; (xv) access, participation and due process requirements; (xvi) efficiency and effectiveness; and (xvii) transparency.
The proposals include additional guidance provided by the PFMI Coordinating Group made up of staff of the OSC, the AMF, the British Columbia Securities Commission and the Bank of Canada on the application of the PFMI in the Canadian market context.
The securities regulators in British Columbia, Alberta, Saskatchewan, New Brunswick and Nova Scotia intend to develop a materially similar multilateral rule in the future.
The proposals are open for comments until March 19, 2014, with a planned adoption of the rules by June 30, 2014.
The regulators further intend to implement specific requirements over the next two years, with all requirements expected to come into force by January 1, 2016.
Quebec approves final derivatives determination and trade repositories and derivatives trade data reporting rules
The Quebec government has approved, effective December 6, 2013, Regulation 91-506 respecting Derivatives Determination and Regulation 91-507 respecting Trade Repositories and Derivatives Data Reporting which come into force on December 31, 2013, except for the provisions contained in Parts 3 and 5 of Regulation 91-507.
The rules governing derivatives data reporting provide for their staggered implementation over the course of 2014. For more information on these regulations (or equivalent rules in Ontario and Manitoba), please see our earlier post on our Structured Finance Law blog.
Amendments to the Manitoba Securities Act providing the Manitoba Securities Commission with authority to regulate over-the-counter derivatives come into force on December 31, 2013. As we described in a post last month, the MSC recently published final rules in respect of product determination, trade repositories and derivatives data reporting that are also expected to come into force on December 31.
Yesterday, the MSC, among other regulators, also published for comment proposed rules to regulate clearing agencies. Until such a rule comes into effect, the MSC has issued a blanket order exempting clearing agencies from the new requirement to be recognized.
For more information, see MSC Notice 2013-49.
The British Columbia Securities Commission recently proposed amendments to the conditions of registration for investment dealers that maintain an office in B.C. and trade in U.S. over-the-counter markets. Specifically, the amendments would prohibit investment dealers from engaging in account activity with a financial institution's office if the office was in a jurisdiction outside Canada or the U.S. where the regulator in that jurisdiction was not a signatory to the IOSCO Multilateral Memorandum of Understanding. "Account activity" would include deposits, transfers and trades.
As we discussed last year, the BCSC proposed initial changes in August 2012 to expand reporting requirements. Those proposals have not been adopted at this time. For more information, see BC Notice 2013/09.
As we discussed earlier this month, the Ontario Securities Commission recently published final rules dealing with the regulation of trade repositories, derivatives data reporting requirements and the scope of derivatives that will be subject to such reporting requirements.
Our colleagues Margaret Grottenthaler and William A. Scott have now published a more comprehensive analysis of the new rules on their structured finance law blog.
The Ontario Securities Commission today published final versions of harmonized derivatives rules in respect of product determination, trade repositories and derivatives data reporting. Quebec's Autorité des marchés financiers and the Manitoba Securities Commission also published final rules.
As we discussed in June, Ontario, Quebec and Manitoba each published draft harmonized rules on the subject earlier this year, while the CSA released draft rules in December 2012.
The final rules released today by the OSC make non-material revisions to the earlier drafts to address comments received from stakeholders. Assuming Ministerial approval, the requirements come into force beginning on December 31, 2013 with the implementation of some requirements staggered over the next year. For example, data reporting obligations for reporting counterparties involving a local counterparty come into effect on July 2, 2014, while obligations regarding the public dissemination of transaction level data by designated trade repositories will come into effect on December 31, 2014. Where both counterparties are non-dealers, no reporting will be required until September 30, 2014.
For more information, see OSC Rule 91-506 and OSC Rule 91-507.
On October 10, 2013 the Ontario Securities Commission issued Staff Notice 21-707 Swap Execution Facilities to notify that it provided exemptive relief in respect of a number of “Swap Execution Facilities” or “SEFs” regulated by the U.S. Commodity Futures Trading Commission (the CFTC) from the requirement to be recognized as an exchange in Ontario.
Background – CFTC regulation of SEFs
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) certain amendments were made to the Commodity Exchange Act (U.S.) (the CEA) to establish a new regulatory framework for swaps. Among other changes to the CEA, the Dodd-Frank Act established SEFs as a new regulated market category, and required that the execution of certain swaps occur on a designated contract market or SEF.
The Dodd-Frank Act defines an SEF as “a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility that: (A) facilitates the execution of swaps between persons; and (B) is not a designated contract market.” The CFTC’s final SEF Rule, adopted on May 16, 2013 (the SEF Rule), formalizes this definition and establishes registration requirements for SEFs as well as core principles to govern the operation of SEFs.
The SEF Rule had an effective date of August 5, 2013 with general compliance required as of October 2, 2013. The CFTC granted temporary registration to a number of SEFs in advance of the October 2 deadline to be effective until the CFTC has fully reviewed each SEF application for full compliance with the applicable requirements under the CEA and the SEF Rule.
While securities legislation in Ontario does not define the term “exchange”, the Companion Policy to National Instrument 21-101 Marketplace Operation provides that Canadian Securities regulators would generally consider a “marketplace” to be an exchange where it, among other things, sets requirements governing the conduct of its participants and disciplines marketplace participants by means other than exclusion from trading. While a comprehensive framework for the regulation of derivatives in Ontario has yet to be enacted, effective December 8, 2010, the definition of “marketplace” under the Securities Act (Ontario) was expanded from its application to securities only to apply to any person or company that “constitutes, maintains or provides a market or facility for bringing together buyers and sellers of securities or derivatives”.
In order to comply with the SEF Rule, one of the many obligations of a regulated SEF is to have requirements governing the conduct of its participants, to monitor compliance with those requirements and to discipline participants, including by means other than exclusion from the marketplace.
Accordingly, OSC staff state in the Staff Notice that “[b]ecause SEFs have self-regulatory responsibilities, they are considered “exchanges” under Ontario securities law. If an SEF provides access to participants in Ontario, it is considered to be doing business in Ontario and must be recognized as an exchange or obtain an exemption from recognition.” Consequently, the OSC granted temporary relief to a number of SEF applicants from the requirement to be recognized as an exchange, subject to a number of conditions, including the requirement to submit a more fulsome application for a subsequent relief order which is to replace the temporary relief. It is also a condition of the temporary relief orders that the SEF will not provide direct access to an Ontario participant unless the Ontario participant is appropriately registered as applicable under Ontario securities laws or is exempt from or not subject to those requirements, and qualifies as an “eligible contract participant” under the CEA.
Similar relief was also granted to certain SEFs by the Autorité des marchés financiers (the AMF) in Quebec from the requirement to be recognized as an exchange under the Derivatives Act (Quebec) and from the requirements of National Instrument 21-101 Marketplace Operation and National Instrument 23-101 Trading Rules.
The Ontario Securities Commission yesterday released its statement of priorities for the fiscal year ending March 31, 2014. The statement follows the OSC's publication of a draft in April, and takes into account stakeholder comments received in response to the draft.
Of note, among the priorities listed for the upcoming year, will be a focus on improving shareholder democracy by facilitating the adoption of majority voting by TSX-listed issuers and publishing a consultation paper on key proxy voting infrastructure issues. The TSX announced in October 2012 that it intends to impose majority voting on all of its listed issuers as of December 31st of this year. The OSC states in its statement that it is supportive of the TSX’s initiative and that numerous commentators encouraged the OSC to continue to review shareholder democracy issues as outlined in 2011 in OSC Staff Notice 54-701. With respect to proxy voting infrastructure, the CSA plan to publish a concept paper this summer to outline and seek feedback on key issues.
Other priorities include a focus on disclosure, mainly through cost disclosure and performance reporting by advisers and dealers, delivery of fund facts in the place of a mutual fund prospectus and developing a summary disclosure document for exchange-traded funds or ETFs.
The OSC will also continue its study of a best interest duty on dealers and advisers and its discussion of mutual fund fees and fees for other investment products. Capital market structure and capital raising will be on the agenda as well, with the aim of completing stakeholder consultations on last year's prospectus exemption consultation paper and looking at options to expand access to capital for Ontario issuers, including an examination of Canada's capital market structure and the impact of the order protection rule, electronic trading and market data fees. Finally, as has been the focus for the last few years, in accordance with its G20 commitments, the OSC will also continue working with other CSA members towards implementation of an OTC derivatives regime, including with respect to clearing and trade reporting.
The Ontario Securities Commission, Quebec's Autorité des marchés financiers and the Manitoba Securities Commission have each published proposed harmonized rules that would require, among other things, that all over-the-counter derivative transactions be reported to trade repositories. The proposals would also define the types of derivatives subject to reporting requirements and attempt to enhance transparency and promote the effective regulation of trade repositories.
While the proposals in each jurisdiction are based on the draft model rules released by the CSA in December 2012, modifications were made to, among other things, clarify the treatment of physical commodities, limit the definition of "local counterparty" and clarify the reporting and recordkeeping requirements.
Meanwhile, those jurisdictions that require the implementation of legislative amendments before publishing province-specific rules, namely B.C., Alberta, Saskatchewan, Nova Scotia and New Brunswick, have published an updated version of the model rules that are substantially similar to those discussed above. While the various proposals have been published separately, regulators intend the rules that are ultimately adopted to be substantially harmonized across all jurisdictions. Comments on these additional proposals are also being accepted until September 6.
For more information, see proposed OSC Rule 91-506 Derivatives: Product Determination and OSC Rule 91-507 Trade Repositories and Derivatives Data Reporting, Quebec's Regulation 91-506 respecting Derivatives Determination and Regulation 91-507 respecting Trade Repositories and Derivatives Data Reporting, Manitoba's MSC Rule 91-506 Derivatives: Product Determination and Rule 91-507 Trade Repositories and Derivatives Data Reporting and Multilateral CSA Staff Notice 91-302.
Categories of registration and business triggers under CSA's proposed derivatives registration regime
As we discussed last month, the Canadian Securities Administrators Derivatives Committee recently published Consultation Paper 91-407 Derivatives: Registration, which contains regulatory proposals specific to the implementation of a registration regime for derivatives market participants in Canada. Under the Paper’s proposals, the imposition of “derivative-appropriate” registration requirements would be based on the type of activity conducted by derivative market participants regardless of the nature of the underlying asset.
The Committee developed the proposals in light of Canada’s G20 commitments to improve the regulation and oversight of OTC derivatives markets and with consideration of derivatives registration regimes in the U.S. and Europe. While the Committee also considered the existing securities regulatory framework, the proposed business triggers for derivatives registration and the requirements applicable to registrants would be substantially different than those applicable in the securities context, given the differences in the purpose of trading, the existence of risk-amplifying leverage in most categories of derivatives and the complexity of derivatives contracts.
Ultimately, the Paper discusses minimum requirements for each category of registration, namely those of (i) derivatives dealers; (ii) derivatives advisers; and (iii) large derivative participants.
Categories of registration
Persons carrying on the business of trading in derivatives or holding themselves out to be carrying on that business would be required to register as a derivatives dealer in each province and territory in which they conducted such business.
While the Ontario Securities Act contains a list of activities that are considered a “trade”, the Paper clarifies that certain activities such as the termination, material amendment, assignment, novation or disposition of a derivatives contract will also be considered a derivatives trade. Therefore, after inception, a derivatives trade will be considered to occur whenever there is a material change to the terms of the derivatives contract.
Further, a number of factors, largely derived from securities case law and regulatory decisions, would be considered when determining if a person is in the business of trading derivatives. The non-exhaustive list of factors that may suggest a business purpose or activity would include (i) the provision of services relating to the intermediation of trades between counterparties to derivative contracts; (ii) acting as a market maker by taking both a long and a short position in a derivative or category of derivatives; (iii) trading with the intention of being remunerated or compensated; (iv) contacting anyone to solicit derivatives trades; (v) providing clearing services to third parties; and (vi) engaging in activities similar to a derivatives dealer.
Under the factors provided, as with the analogous securities dealing registration requirements, dealing in derivatives does not have to be an entity’s primary business to be captured by the triggers proposed by the Committee.
Persons that carry on the business of advising others in relation to derivatives, or who hold themselves out to be in that business in any Canadian jurisdiction, would be required to register as a derivatives adviser. A person would be considered to be "advising" in relation to derivatives whenever they provide another person with any advice or direction relating to trading derivatives, including providing advice in relation to (i) the management of a portfolio of derivatives; (ii) the use of derivatives as an investment strategy or part of an investment strategy; and (iii) hedging strategies.
In determining whether a person was “in the business” of providing derivatives advice, a number of factors would be relevant, including whether the person was (i) directly or indirectly providing advice about derivatives trading activity with repetition, regularity or continuity; (ii) being, or expecting to be, remunerated or compensated; (iii) contacting anyone to solicit business relating to advising in derivatives trades; and (iv) engaging in activities similar to a derivatives adviser, including promoting a trading strategy or offering software that provided a client with guidance relating to the purchase of derivatives.
Large Derivatives Participant (LDPs)
According to the Paper, entities holding a “substantial position” in a derivative or category of derivatives, and whose exposure to derivatives markets results in counterparty exposure that could pose a serious risk to financial markets, should also be subject to registration. Registration under the LDP category would not be based on a business trigger. While the Paper does not provide one, the Committee recommended that consultation proceed to establish a threshold for this category of registrant.
The Committee also recommended that the new regime include the registration of individuals (i) where they are the ultimate designated person (such as the president or CEO), chief compliance officer or chief risk officer of a registrant; (ii) as a representative of a derivatives adviser where they provide clients with advice relating to derivatives, whether or not the client is a qualified party; and (iii) as a representative of a derivatives dealer where they provide services relating to trading to clients, whether or not the client is a qualified party.
Exemptions from requirement to register
The Paper proposes a number of exemptions from the registration requirement.
Dealers Providing Advice
A person registered as a derivatives dealer would be exempt from the obligation to register as a derivatives adviser where (i) the obligation to register as a derivatives adviser resulted solely from the provision of advice in relation to a derivatives trade; (ii) the advice was not in relation to an account over which that the derivatives dealer has discretionary trading authority; (iii) the derivatives dealer did not charge a fee for the provision of the advice; and (iv) the derivatives dealer had complied with all of the registration requirements applicable to a derivatives adviser.
The Paper proposes that government entities not be subject to an obligation to register. Further, crown corporations whose obligations were fully guaranteed by the applicable government would be exempted from registration as an LDP or as a derivatives dealer where their trading activity was restricted to trading as a counterparty with qualified persons. However, a crown corporation would not be exempt from a requirement to register where it (i) triggered registration as a derivatives adviser by advising entities that were not governments or crown corporations; (ii) triggered registration as a derivatives dealer and intermediated trades on behalf of clients that were not governments or crown corporations; or (iii) triggered registration as a derivatives dealer and trades with counterparties that were non-qualified parties.
The Paper recommends that recognized clearing agencies (or those exempt from recognition) not be subject to a requirement to register as a derivatives dealer, derivatives adviser or a LDP where the obligation to register resulted solely from carrying on the ordinary business of a clearing agency. (There is already or will be a separate registration regime for clearers.)
Transactions with Affiliated Entities
The Committee recommends that the registration requirements not apply to persons based on dealing or advising activities solely with affiliates.
Uniform definition of derivative across CSA jurisdictions is needed
The Paper does not define what would constitute a “derivative” for the purposes of registration and, at present, no single, harmonized definition of derivatives products exists across CSA members. Legislation in many Canadian jurisdictions contemplates that an instrument meeting the general definition of derivative may be treated as a derivative, a security, or excluded in whole or in part from regulation. Moreover, some jurisdictions include derivatives in the definition of security, while other jurisdictions maintain a separate definition altogether.
In CSA Consultation Paper 91-301 relating to reporting to trade repositories, the Committee introduced the “Scope Rule” to resolve conflicts that arise when a contract or instrument meets both the definition of "derivative" and "security" under applicable provincial legislation. The Scope Rule purports to classify which contracts or instruments are to be regulated as derivatives, securities or outside the scope of both derivatives and securities legislation altogether. In this respect, Consultation Paper 91-301 can provide some insight as to which types of instruments the Committee may recommend to be considered derivatives for the purposes of triggering registration as a derivatives dealer or adviser. In any event, the Committee will need to induce a high degree of regulatory coordination, both within Canada and between Canadian and global authorities, to ensure that a uniform and consistent definition is applied under the new registration regime. The CSA received a number of comments on certain issues with that definition in the context of the proposed trade reporting rule.
Absence of de minimus exemption
Unlike under Dodd-Frank, there is no proposed exemption for a person that engages in a de minimus level of swap transactions. The amount of business an entity engages in will be factored into the determination of whether the entity is carrying on business as a dealer.
Potential for compliance with two registration regimes
Persons dealing in or advising on derivatives that have securities as their underlying asset will be subject to registration under both the proposed derivatives regime and the existing securities regime. The Committee states that all types of derivatives should be subject to a consistent regime regardless of whether or not such derivatives have securities as their underlying asset. The Paper thus recommends that steps be taken in order to streamline the registration process to ensure that such persons can be registered and regulated in an efficient manner.
Investment funds to be regulated by the securities registration regime
According to the Committee, investment fund managers should continue to be registered under the securities registration regime regardless of the nature of the investment fund or the assets held by the fund. However, an advisor to a fund who triggers the obligations outlined above would be subject to the derivatives advisor registration requirements, in addition to the securities registration regime, if such an adviser provided advice in relation to both derivatives and securities.
Third party regulators to carry out regulatory functions
The Paper proposes that the CSA rely on third-party regulators to carry out some or all of the regulatory functions of the new registration regime. The Committee has stated that these regulators could include foreign regulators and regulators responsible for regulating financial institutions (i.e. OFSI) and self-regulatory organizations (i.e. IIROC).
Specifically, under the Consultation Paper, foreign derivatives dealers and advisers subject to an equivalent registration regime in their home jurisdiction could be exempted from certain registration requirements, such as with respect to financial and solvency obligations, compliance and risk management systems and entity-level record keeping. In such cases, however, registration in the applicable Canadian jurisdictions would still be required.
Although substituted compliance or equivalence may resolve conflicts and duplication, it may not be the most appropriate solution in every case. As the OTC Derivatives Regulator Group recently noted, close consultation by the CSA with the relevant authorities in other jurisdictions will be necessary to ensure the efficacy of substituted compliance. The details regarding how substituted compliance will work in practice is expected to be discussed in future meetings of international regulators.
The Canadian Securities Administrators today released the latest in a series of consultation papers considering the regulation of derivatives in Canada. Specifically, CSA Consultation Paper 91-407 considers the regulation of derivatives market participants through the implementation of a registration regime.
Under the recommended regime articulated by the paper, three categories of registration would be created, namely those of (i) derivatives dealers, being persons carrying on the business of trading in derivatives or holding themselves out to be carrying on that business; (ii) derivatives advisers, being those carrying on the business of advising others in respect of derivatives, or who hold themselves out to be in that business; and (iii) large derivative participants, being entities, other than derivatives dealers, that have a substantial aggregate derivatives exposure.
Those required to be registered under the proposed regime would then be subject to various requirements respecting such things as proficiency, solvency, honest dealing obligations, and gatekeeper and business conduct requirements in the case of derivatives dealers and advisers. Exemptions from registration requirements would also be available in certain circumstances. For example, clearing agencies would generally not have to register, and foreign derivatives advisers and dealers would be exempted from specific regulatory requirements where they are subject to equivalent requirements in their home jurisdictions.
The paper also recommends that registered entities that have clients or counterparties that rely on their advice be subject to additional registration requirements. Alternative proposals are considered where dealers are trading with non-qualified parties: one that would preclude dealers from entering into trades with counterparties that are non-qualified parties unless the counterparties receive advice from a registered derivatives adviser, and the second that would require that the dealer inform counterparties that are non-qualified that there is a conflict of interest.
According to the paper, if the first alternative is implemented, “representatives dealing with counterparties will not be required to be registered as all counterparties will either be qualified parties or will be represented by independent derivatives advisers.” In the case of the second alternative “a party entering into transactions with counterparties that are non-qualified parties will typically be considered to be in the business of trading derivatives unless that non-qualified party is represented by a derivatives dealer or adviser”. The CSA are seeking input on the appropriate definition of "qualified party". There is also a recommended exemption for crown corporations when dealing with qualified parties and not intermediating any trades.
Under the recommended proposals, an individual would have to register where the person is (i) the ultimate designated person, chief compliance officer or chief risk officer of the registrant; (ii) involved in providing clients with advice relating to derivatives; (iii) involved in providing trading services to clients as an intermediary to a trade; or (iv) involved in a trade with a counterparty that is a non-qualified party that is not represented by an independent derivatives adviser. The individual registration requirements would apply to frontline staff that deal with clients and those that manage or supervise such staff. Where individuals provide clients with advice, they would have to register whether or not the client was a qualified party.
The CSA are accepting comments on the consultation paper, including with respect to a number of specific questions regarding the paper's numerous recommendations, until June 17, 2013.
On December 31, 2012, the Alberta Securities Commission replaced Blanket Order 91-503 with Blanket Order 91-505 Over-the-Counter Derivatives.
As we discussed in an earlier post, an initial version of Rule 91-505 was published in February 2011, with a revised rule proposed in October 2012. As we discussed at the time, the revised proposal reintroduced the concept of “qualified parties” and created an exemption from the prospectus and registration requirements for all over-the-counter futures contracts where each party is a qualified party, subject to the potential for incremental future requirements as may be imposed as a result of the CSA’s ongoing initiatives relating to trade reporting, clearing and other associated matters in relation to derivatives.
The final Blanket Order is consistent with the form of the October proposal.
The Canadian Securities Administrators yesterday published for comment model provincial rules to introduce a framework for the regulation of derivatives across Canada. Specifically, the model rules would set out the scope of derivatives products and provide for regulations respecting trade repositories and derivatives data reporting. The model rules, which are based on Ontario's Securities Act, are intended to provide a "responsive and flexible" foundation for derivatives regulation.
Comments on the model rules are being accepted until February 4, 2013. Check back next week for further commentary.
The uncertainty around the extent of the extra-territorial reach of the Dodd-Frank Act into the business of Canadian and other non-U.S. market participants has been a major concern. Regulators are well aware of this concern and have their own reasons to want to reduce regulatory conflict. It is top of their agenda as well. To that end, on November 28, regulatory authorities from various international jurisdictions (including the OSC and AMF) met in New York to discuss reform of the cross-border OTC derivatives market. It looks as though progress was made but much work is yet to be done.
While the authorities noted that complete harmonization across jurisdictions would be difficult, their joint release identified the need to reduce regulatory uncertainty and reduce the application of conflicting rules. Ultimately, the meeting, which included representatives from the Ontario Securities Commission, Quebec's Autorité des marchés financiers, the Australian Securities and Investments Commission, Brazil's Comissão de Valores Mobiliários, the European Commission and European Securities and Markets Authority, Hong Kong's Securities and Futures Commission, Japan's Financial Services Agency, the Monetary Authority of Singapore, the Swiss Financial Market Supervisory Authority, and the U.S. Commodity Futures Trading Commission and Securities and Exchange Commission, was intended to continue moving towards the goal of an enhanced regime of OTC derivatives regulation, as pledged by G-20 leaders in 2009.
Ultimately, the authorities reached agreement on a number of points from which to move forward. First, the regulators agreed to consult each other prior to making any final decisions regarding which derivatives products will be subject to mandatory clearing. Further, any decision by a regulator in one jurisdiction to subject a product or class of products to a clearing requirement will result in each of the other authorities subsequently considering whether to subject the same product to the same requirement in their domestic jurisdictions.
Second, the authorities agreed to attempt to enter into supervisory cooperation agreements and bilateral enforcement cooperation arrangements in order to enhance supervision and oversight of cross-border market participants, intermediaries and infrastructures.
Third, on the issue of timing, the authorities stated that they will make efforts to implement OTC derivatives reforms "quickly" and in a manner "consistent with an orderly implementation process" in each respective jurisdiction. Reasonable transition periods to facilitate implementation will be included in the process.
Finally, the authorities agreed to further consider the possible approaches to regulating persons, transactions and infrastructure in respect of cross-border activity where more than one set of rules applies. The approaches to be considered include (i) recognition, where market participants, intermediaries and infrastructures have substantially met regulatory requirements; (ii) registration and substituted compliance, where an entity has already complied with foreign regulations; (iii) transactions and substituted compliance, where compliance with foreign regulations may be substituted for compliance with applicable transaction-level requirements; and (iv) registration categories and exemptions that would allow entities to comply with different sets of regulatory requirements based on characteristics and activities.
Going forward, the authorities state that they will continue to regularly consult each other, with the next planned meeting scheduled for early 2013. Topics of consideration for future meetings include: (i) options to address identified conflicts and duplicative rules; (ii) the basis for determinations of comparability of regulatory regimes; and (iii) developing a process for consultation prior to making final determinations regarding which derivative products will be subject to mandatory clearing.
In our blog post of March 11, 2011, we discussed the proposed repeal by the Alberta Securities Commission of Blanket Order 91-503 and its replacement with Rule 91-505 Over-the-Counter Derivatives. At the time, and in the context of ongoing efforts by the Canadian Securities Administrator to bring the regulation of OTC derivatives within the four corners of securities legislation to comply with G20 commitments, the proposed Rule 91-505 would have resulted in OTC derivatives and commodity futures contracts being considered "futures contracts" under the Securities Act (Alberta). Historically, under BO 91-503, such OTC derivatives and commodity futures contracts were exempted from the definition of “futures contract” and thereby not considered “securities” under the Securities Act.
In the context of the sea change in regulatory philosophy being undertaken by the CSA and reflected in proposed Rule 91-505, only a narrow registration exemption was proposed for OTC physical commodity contracts. The proposed Rule would have abandoned the current concept of prospectus and registration relief for a broad array of OTC transactions and commodity contracts between qualified parties.
In response to a number of comment letters and pursuant to ongoing attempts to harmonize the approach to derivatives regulation across Canada, the ASC on October 15, 2012 posted a revised Rule 91-505. While retaining the concept of bringing the regulation of futures contracts within the Securities Act and the exemption for physically settled OTC commodity contracts, the revised Rule 91-505 also reintroduces the concept of “qualified parties” and creates an exemption from the prospectus and registration requirements for all futures contracts where each party is a qualified party. As such, the revised Rule 91-505 is in this respect in keeping with the nature of the exemptions provided by Blanket Order 91-503, albeit drawing the regulation of OTC transactions back within the Securities Act.
One other important feature to note, and which reflects a nod to the CSA’s ongoing consultation process on OTC derivatives regulation, is the introduction of a number of potential future obligations in relation to such trades, including: (a) trade reporting; (b) trading/clearing of such OTC derivatives through a recognized exchange or clearing agency; and (c) minimum excess working capital requirements. The imposition of those requirements, if they proceed, will reflect the culmination of the CSA’s current consultative process.
The ASC is accepting comments on revised Rule 91-505 until November 16, 2012, which would suggest a desired effective date of Rule 91-505 as early as January 1, 2013.
As we discussed earlier this year, the CSA released a consultation paper in June that proposed making central counterparty clearing of eligible OTC derivatives mandatory. While today's release reiterated Canadian regulators' commitment to CCP clearing, the CSA stated that market participants would be able to do so through any CCP that was recognized by Canadian authorities, including global CCPs. According to the CSA, "global CCPs will provide a safe, robust and resilient environment for clearing OTC derivatives" provided that they comply with appropriate international safeguards.
New Brunswick, Nova Scotia and Manitoba have now issued blanket orders, substantially similar to those issued in other provinces, to exempt certain issuers from the recently enacted Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the Counter Markets.
As we've discussed previously on this blog, the Canadian Securities Administrators other than Ontario recently adopted MI 51-105 which, among other things, can subject issuers who carry out private placements in any of the adopting jurisdictions to Canadian public company obligations. The stated purpose of the instrument is to discourage the manufacture and sale of OTC quoted shell companies that can be used to facilitate abusive market practices.
In response to the concern that the instrument would have the unintended effect of subjecting major well-established issuers that trade OTC in the U.S. to Canadian public company reporting obligations, regulators have been providing blanket orders to exempt certain issuers from the application of the instrument. As we discussed on August 2, British Columbia, Alberta and Quebec issued blanket orders at the end of July, with Quebec's Autorité des marchés financiers revising its order on August 14 to clear up issues with interpretational issues.
British Columbia, Alberta and Quebec issue blanket relief in attempt at rolling back application of new OTC issuer rule
The securities commissions in British Columbia, Alberta and Quebec have each issued separate blanket orders exempting certain issuers from the application of Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the-Counter Markets (the Instrument). As discussed in detail in our post dated June 25, the final Instrument was to officially come into force on July 31, 2012 (assuming receipt of ministerial approval, as required) in each of the Canadian jurisdictions, other than Ontario (the Adopting Jurisdictions).
In each of the Adopting Jurisdictions, the Instrument imposes Canadian “reporting issuer” type obligations and other additional burdensome requirements on issuers having a class of securities that have been assigned a ticker symbol by the Financial Industry Regulatory Authority (FINRA) for quotation on an OTC market in the United States, and that do not otherwise have a class of securities listed or quoted for trading on a recognized North American stock exchange prescribed in the Instrument (being the TSX, the TSX-V, the CNSX and Alpha, in Canada and the NYSE, AMEX and NASDAQ, in the United States) where: (i) the issuer’s business is directed or administered from an Adopting Jurisdiction; (ii) the issuer, or a person acting on its behalf, engages in promotional activities in an Adopting Jurisdiction that promote or could be reasonably expected to promote the purchase or sale of the issuer’s securities; or (iii) at any time on or after July 31, 2012, the issuer is assigned a ticker symbol by FINRA for use on OTC markets in the United States, and on or before such date, the issuer distributed securities to a resident in an Adopting Jurisdiction where those securities become the issuer’s OTC-quoted securities.
BC Instrument 55-511, Alberta Blanket Order 51-513 and Decision No. 2012-PDG-0152 in Quebec (collectively, the Blanket Orders) are each intended to remedy the unintended application of the Instrument to certain issuers and transactions. Although meaningful relief is provided in each of the Blanket Orders, the relief granted in Québec is more comprehensive and market friendly than that granted in British Columbia and Alberta, as summarized below.
Relief granted for distribution to “permitted clients” in Québec
Significantly, the Blanket Order issued by the Autorité des marchés financiers (AMF), the securities regulatory authority in Québec, exempts issuers from the application of the Instrument where promotional activities are limited to investors that qualify as a “permitted client” (as defined in National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations and, essentially, highly “accredited investors”), where such activities are carried out by a registered investment dealer, exempt market dealer or dealer relying on the international dealer exemption provided in NI 31-103. This investor-based exemption has not been adopted in either British Columbia or Alberta.
Relief for issuers listed on certain exchanges
Each of the Blanket Orders expands on the list of exchanges recognized for the purposes of exempting issuers with a class of securities listed for trading on the same from application of the Instrument. The list of additional exchanges is comprised of the following:
- NASDAQ OMX;
- Borsa Italiana, MTA Tier;
- London Stock Exchange, except AIM;
- Hong Kong Stock Exchange;
- Deutsche Börse, except the First Quotation Board and the Entry Standard tier;
- Xetra, Prime Standard and General Standard tiers;
- SIX Swiss Exchange;
- Bourse de Luxembourg, except Euro MTF;
- Tokyo Stock Exchange, 1st Section and 2nd Section;
- Shanghai Stock Exchange;
- The Stock Exchange of Thailand, except The Market for Alternative Investment (mai);
- National Stock Exchange of India;
- Bombay Stock Exchange;
- Osaka Stock Exchange;
- Korea Stock Exchange; and
- Singapore Exchange.
In the case of British Columbia and Alberta, there is an additional requirement that the issuer have a “primary listing” in effect each time the issuer carries out any promotional activities or distributes securities to a person resident in British Columbia and Alberta. The British Columbia and Alberta Blanket Orders define “primary listing” to mean an issuer’s first listing of a class of its securities on any of the foregoing exchanges. As discussed in our prior summary, by its terms, the Instrument would not apply to any issuer listed on any of the North American stock exchanges prescribed in the Instrument.
Relief for investment funds in Québec
The Blanket Order issued by the AMF also exempts any issuer that is an investment fund from the application of the Instrument in its entirety. An “investment fund” is defined in applicable securities legislation to include both non-redeemable investment funds and mutual funds.
Relief for private placements of debt securities
The Blanket Orders each provide for an exemption from the Instrument for issuers that distribute non-convertible debt securities to investors resident in British Columbia, Alberta and Québec, provided the issuer does not have any class of securities, other than non-convertible debt securities, listed on an exchange or quoted on a quotation and trade reporting system (the non-convertible debt exemption). Since issuers which have securities listed on any of the exchanges identified in the Blanket Orders or on the prescribed North American exchanges are exempt from the application of the Instrument, those issuers that have securities, other than non-convertible debt securities, listed on any other exchange, or quoted on any quotation and trade reporting system are still at risk of being an “OTC reporting issuer” and having to comply with the Instrument. Subject to the regulators providing further interpretational guidance on what is intended by “quoted on any quotation and trade reporting system,” it can only be assumed this includes quotation on OTC markets generally. Effectively, the Blanket Orders can each be read to exempt issuers whose equity securities are subject to restrictions on transfer or otherwise not capable of being OTC-traded, such as wholly-owned finance subsidiaries and other similar private or closely-held issuers. This exemption is available notwithstanding that the issuer may have debt securities that may be OTC traded or have been assigned a FINRA ticker symbol.
In each of British Columbia, Alberta and Québec, the non-convertible debt exemption only refers to the issuer being exempt from the Instrument where it “distributes” non-convertible debt securities. Meanwhile the Instrument also applies to an “OTC issuer” that carries out “promotional activities” in the relevant jurisdiction on or after July 31, 2012. While it is arguable that “promotional activities” form part of a “distribution,” given separate reference to both in the Instrument, it can only be assumed that the debt issuer exemption does not extend to an issuer carrying out promotional activities where a private placement is not effected. However, as discussed above, the AMF has provided additional relief in its Blanket Order in the prescribed circumstances where promotional activities are limited to “permitted clients”.
Other jurisdictions and next steps
While we are aware of British Columbia, Alberta and Québec having to date issued blanket relief as summarized above, it is expected that similar relief will be provided by all other Adopting Jurisdictions (being all other Canadian provinces and territories, other than Ontario, which is not party to the Instrument). Although the Blanket Orders assist in providing relief for a broad range of issuers that, in our view, would inadvertently be caught by this Instrument, there remain a number of interpretational issues and other matters (including the omission of certain stock exchanges from the Orders, such as, among others, the Australian Stock Exchange and the New Zealand Stock Exchange). We continue to work with the relevant regulators to attempt to resolve these issues. We will keep you updated on the progress of these developments as they transpire.
The Canadian Securities Administrators in each province and territory of Canada other than Ontario (the adopting jurisdictions) recently adopted Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the-Counter Markets. As we’ve previously discussed, MI 51-105 is scheduled to come into force on July 31, 2012 and, assuming ministerial approval, will have significant implications for issuers that have, or will have in the future, a class of securities that are quoted on over-the counter markets in the United States and who do not also have securities that trade on the North American stock exchanges specified in the Instrument.
By operation of the Instrument, an issuer will become subject to Canadian public company reporting obligations where the issuer, among other things, engages in promotional activities in furtherance of the purchase or sale of their securities, either directly or through a third party representative, in or from an adopting jurisdiction on or after July 31, 2012, or where the issuer otherwise previously distributed securities to persons resident in an adopting jurisdiction if the issuer is subsequently assigned a ticker symbol by the Financial Industry Regulatory Authority in the United States (FINRA) for use on OTC markets in the United States at any time after July 31, 2012.
The stated purpose of the Instrument is to discourage the manufacture and sale in the adopting jurisdictions of OTC quoted shell companies that can be used to facilitate abusive market practices. However, the Instrument will have the unintended but significant effect of subjecting major well-established issuers who have securities listed on exchanges outside of North America and that only trade OTC in the United States to Canadian public company reporting obligations. Significantly, these issuers may unknowingly become subject to Canadian public company reporting obligations, as it is common market practice for U.S. broker-dealers to apply to have a FINRA ticker symbol assigned to an issuer’s securities without the knowledge or involvement of the issuer.
The Instrument defines an “OTC issuer” as an issuer that has a class of securities that have been assigned a ticker symbol by FINRA for use on any of the OTC markets in the United States (such as the OTC Bulletin Board, the Pink Sheets or the “grey market”) but does not include an issuer that has any class of securities that are listed or quoted on one or more prescribed Canadian or U.S. exchanges. However, an issuer will also be considered an “OTC issuer” if a FINRA ticker symbol is assigned to the issuer after July 31, 2012 and, on or before the date the symbol was assigned, the issuer distributed a security to a person resident in an adopting jurisdiction and that class of securities becomes the issuer’s OTC-quoted securities. As such, where a ticker symbol is assigned to a class of OTC securities trading in the United States, there is a risk that an issuer that has distributed securities to persons resident in an adopting jurisdiction could, regardless of when such securities were distributed, inadvertently become subject to Canadian public company reporting requirements and to the jurisdiction of securities regulators in the adopting jurisdictions.
Pursuant to MI 51-105, an OTC issuer will be considered an “OTC reporting issuer” and become subject to Canadian securities law requirements that apply generally to “reporting issuers” in the adopting jurisdictions if, after July 31, 2012, an OTC issuer’s business is “directed or administered,” or “promotional activities” are carried on, in or from an adopting jurisdiction. For these purposes, “promotional activities” means activities or communications by or on behalf of an issuer that promote or could reasonably be expected to promote the purchase or sale of the securities of the issuer. The regulators in the adopting jurisdictions consider “promotional activities” to include communications through an investment newsletter or similar types of promotional publications, as well as the provision of information to potential investors who request information or to potential private placement investors. Further, an issuer will be considered to carry out promotional activities in an adopting jurisdiction if it communicates from anywhere with persons in that jurisdiction, or communicates from an adopting jurisdiction with persons anywhere, in a way that promotes or reasonably could be expected to promote the purchase or sale of the issuer’s securities.
An OTC issuer that becomes an “OTC reporting issuer” will become subject to Canadian securities law requirements, including those requirements relating to continuous and timely disclosure that generally apply to Canadian public companies, as well as governance requirements relating to the mandate and composition of audit committees, CEO/CFO certifications and corporate governance disclosure. An OTC Reporting Issuer will have to file a prescribed form of notice in respect of any persons that carry out promotional activities on its behalf, and its directors, officers, promoters and control persons will have to deliver “personal information forms” to the applicable regulators.
The Instrument also imposes specific restrictions on the use of prospectus exemptions and the ability to resell securities, and will require securities issued by OTC reporting issuers to carry specific legend notations in certain circumstances. Most notably, if securities of an OTC reporting issuer are acquired on or after July 31, 2012, but prior to the date that the issuer is assigned a ticker symbol by FINRA, those securities may only be resold in reliance upon prescribed prospectus exemptions, or through an investment dealer registered in a Canadian jurisdiction if a trade is executed through an OTC market in the United States. The Instrument has not been adopted in Ontario and may not directly impact issuers whose capital markets activities are restricted strictly to Ontario and do not otherwise have any connection to an adopting jurisdiction. The Instrument is scheduled to come into force in every other province and territory of Canada on July 31, 2012, subject to the receipt of applicable ministerial approvals.
Yesterday, the Canadian Securities Administrators published Consultation Paper 91-406 describing the CSA Derivatives Committee's proposals relating to central counterparty clearing of over-the-counter derivatives. The consultation paper is the latest in a series of eight papers intended to build on the high-level proposals found in Consultation Paper 91-401 released in November 2010.
Ultimately, the paper proposes that regulators make CCP clearing of eligible OTC derivatives mandatory. Under the Committee's recommendations, CSA members would also develop rules and procedures to determine the eligibility of OTC derivatives contracts for central clearing and procedures for the recognition of CCPs and the approval of CCP rules and policies in regards to the clearing of OTC derivatives contracts.
Comments on the consultation paper are being accepted until September 21, 2012.
On June 6, the International Organization of Securities Commissions (IOSCO) published its Final Report on International Standards for Derivatives Market Intermediary Regulations. The report, which focuses on OTC derivative market intermediaries (DMIs) that deal with non-retail clients and counterparties, makes various recommendations with respect to: (i) the obligations of DMIs; (ii) requirements to manage counterparty risk; and (iii) protecting participants in the OTC derivatives market from unfair, improper or fraudulent practices.
The report sets out its recommendations in very general terms that are not likely to provide much in the way of specific guidance for local regulators. It recommends for example the establishment of minimum standards for the registration or licensing of DMIs. Relevant material information on licensed or registered DMIs should be publically available. According to the recommendations, market authorities should also consider imposing some form of capital or other financial resources requirements for DMIs that are not prudentially regulated.
The report also recommends that DMIs be subject to business conduct standards tailored to the OTC derivatives market. DMIs would also be required to have effective corporate governance frameworks in place, supervisory policies and procedures to manage their OTC derivatives operations, and risk management systems to manage OTC derivatives related business risks.
Ultimately, the report is intended to further G-20 Leaders' objective of reforming the OTC derivatives market to improve transparency, mitigate systemic risk and protect against market abuse. Of more interest to Canadian market participants will be the CSA consultation paper on market intermediary regulations to be published later this summer.
Margaret Grottenthaler -
As we discussed last month, the Canadian Securities Administrators Derivatives Committee recently released the latest in a series of eight papers intended to build on the high-level proposals found in Consultation Paper 91-401 regarding the regulation of OTC derivatives. Specifically, Consultation Paper 91-405 considers the scope and characteristics of a proposed end-user exemption to address market participants that generally only trade to hedge commercial risks. According to the paper, this limited segment of end-users, not systemically important to the market, should be exempted from most of the proposed regulations concerning OTC derivatives. The CSA are accepting comments on the consultation paper until June 15, 2012.
The Consultation Paper considers various criteria for determining who should qualify for the end user exemption. According to the CSA's proposal, an end user would include participants that: (i) trade for their own account; (ii) are not financial institutions; and (iii) hedge to mitigate commercial risks related to the operation of their business or a related affiliated entity or series of legal entities within that affiliated group. End users that otherwise meet the criteria for the exemption may still be found ineligible for the exemption, however, if they are deemed to be "Large Derivatives Participants" considered key participants in the market or whose default would represent a systemic risk to the market. An upcoming consultation paper on registration is expected to consider the thresholds for Large Derivatives Participants. The Committee also specifically rejected including certain criteria in determining whether a participant qualifies as an end-user, including those based on: (i) trade volume or notional dollar values of trades; (ii) sector specific exceptions; and (iii) standardized contracts and clearing.
In considering the definition of "hedging" for the purposes of mitigating commercial risks, the CSA make a number of observations. Specifically, the consultation paper states that the relevant derivatives transactions would have to specifically relate to the risk being hedged and should "reasonably be considered to be a suitable instrument for managing the risk." According to the CSA, the definition of hedging should also include positions that are treated as a hedge for accounting purposes as well as other positions that can be demonstrated to reduce the risk of loss arising from the end-user's business activity.
Ultimately, the CSA cite with approval the definition of hedging accepted by the Committee on Payment and Settlement Systems (CPSS). Generally, the CPSS characterizes hedging as being intended to offset or reduce the risk related to fluctuations in the value of an underlying interest or a position, or to substitute a risk to one currency for a risk to another currency. Under the CPSS definition, the transaction or series of transactions also has to result in a high degree of negative correlation between changes in the value of the underlying interest or position being hedged and changes in the value of the derivatives with which the value of the underlying interests or positions is hedged. According to the CPSS, there must also be reasonable grounds to believe that the transaction no more than offsets the effect of price changes in the underlying interest or position being hedged.
This characterization of hedging, however, assumes that the risk to be hedged will always relate directly to an underlying position or interest. In doing so, the consultation paper ignores activities such as the purchasing of weather derivatives intended to mitigate against the risk of an inclement winter, but that would not directly correlate to an underlying value in frost or snow.
Notification to Regulators
While participants seeking to rely on the end-user exemption would not require formal approval by regulators, they would have to provide notice of an intention to rely on the exemption. This one-time notice would include basic information about the market participant and would only have to be updated if there was a material change in the information.
According to the CSA, the process to be followed by eligible end-users would include attaining approval by the end-user's board of directors of the business plan or strategy authorizing management to use OTC derivatives contracts as a risk management tool. The CSA are silent, however, on how this requirement would apply to non-corporations. The consultation paper also suggests that the business plan would have to be disclosed in order to allow regulators to determine whether there had been compliance with the exemption. According to the consultation paper, these requirements are intended to ensure that the implications of trading OTC derivatives and the implementation of a hedging strategy will be considered by the board and management.
Reporting and Recordkeeping
While end-users would not have to report individual trades to a regulator, the trades would still have to be reported to a trade repository. According to CSA Consultation Paper 91-402, for derivative transactions between non-financial intermediaries, the parties would have to select one of the counterparties to the transaction to be the reporting party.
Considering the breadth of OTC derivatives activity captured, the reporting obligation may prove problematic. For example, is it expected that the obligation to report would capture individuals entering into contracts to hedge against increasing electricity prices, or farmers hedging to protect again inclement weather?
Users of the exemption would also have to maintain records of all trading activity, a record of the board's approval of the use of OTC derivatives and records demonstrating the analysis completed to demonstrate satisfaction of all necessary requirements. The consultation paper, however, does not provide information regarding whether the regulator may inspect the records, or the length of time that such records would have to be maintained.
As stated above, the consultation paper, which includes specific questions for the consideration of commentators, is open for public comment until June 15.
The Canadian Securities Administrators, except for the OSC, today released Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the-Counter Markets, intended to improve disclosure by issuers whose securities are quoted in U.S. OTC markets and with a significant connection to a Canadian jurisdiction. The instrument is also intended to discourage the manufacture and sale in Canada of U.S. OTC quoted shell companies that can be used for abusive purposes.
As we discussed in our post describing a draft version of the rule published in June 2011, a significant connection to a Canadian jurisdiction will be found to exist where (i) the OTC issuer's business is directed or administered in or from Canada; (ii) promotional activities are conducted from Canada; or (iii) the issuer distributes securities in Canada prior to obtaining a ticker symbol for the purpose of having its securities quoted on an OTC market in the U.S. and those securities become the issuer's OTC-quoted securities. Under the new rules, issuers subject to the instrument will generally have to comply with the continuous disclosure regime to which venture issuers are subject and, additionally, file annual information forms (which venture issuers may do voluntarily, but are not required to).
The instrument follows British Columbia's adoption of a local rule regulating issuers quoted in U.S. OTC markets and that have a significant connection to B.C. Having found that the adoption of the B.C. rule resulted in OTC issuers migrating to other Canadian jurisdictions, the CSA released a proposed draft of the multilateral instrument in June 2011. The final version released today reflects the comments received to the proposed draft. Assuming ministerial approvals are obtained, the OTC rule will come into force on July 31, 2012.
On May 4, the Ontario Securities Commission released a statement regarding a meeting held in Toronto earlier this month and attended by various international regulatory agencies regarding the regulation of OTC derivatives. Various issues surrounding implementation were discussed, including transparency, margin for uncleared derivatives, coordination of clearing mandates, access to data in trade repositories, and cross border clearing house crisis management. Ultimately, the meeting's purpose was to provide a forum for discussion among the regulators as they work toward international harmonization of the regulatory requirements.
In addition to the OSC and Quebec's Autorité des marchés financiers, the meeting included representatives from the Australian Securities and Investments Commission, Brazil's Comissão de Valores Mobiliários, the European Commission and European Securities and Markets Authority, Hong Kong's Securities and Futures Commission, Japan's Financial Services Agency, the Monetary Authority of Singapore, the Swiss Financial Market Supervisory Authority, and the U.S. Commodity Futures Trading Commission and Securities and Exchange Commission.
The Canadian Securities Administrators (CSA) last week released Consultation Paper 91-405 Derivatives: End-User Exemption, the latest in a series of eight papers intended to build on the high-level proposals found in Consultation Paper 91-401 released in November 2010.
As is suggested by its title, the paper considers an end-user exemption to OTC derivatives regulation. Ultimately, an end-user exemption is intended to avoid discouraging the use of OTC derivatives by market participants that are not in the business of derivatives trading but that trade in OTC derivatives to mitigate commercial risks related to their business. As such, according to the CSA, an end-user exemption must address this specific segment of the market without undermining the broad objective of increased regulation of OTC derivatives contracts.
Thus the paper, among other things, sets out the CSA Derivatives Committee's position on the application of an end-user exemption, the criteria for determining eligibility, and what an eligible end-user would need to do in order to rely on the exemption.
The consultation paper, which includes specific questions for the consideration of commentators, is open for public comment until June 15.
On February 21, the European Union adopted a regulation on short selling and certain aspects of credit default swaps. The regulations are intended to introduce common EU transparency requirements and harmonize the powers that regulators can use in exceptional situations where there is a serious threat to financial stability. As we discussed in an October 2010 post, the regulation was initially proposed by the European Commission in a few years ago.
On February 17, the Investment Industry Regulatory Organization of Canada (IIROC) republished proposed amendments to its Dealer Member Rules that would extend the current margin treatment on swap offsets to partial swap offsets. The proposals are intended to ensure that the capital requirements reflect the reduced position risk of partial swap offsets on interest rate and total performance swaps. The proposals, initially published in February 2009, now include housekeeping amendments to clarify the minimum margin requirements for unhedged interest rate and total performance swap positions.
Comments are being accepted on the proposed amendments until March 19, 2012. For more information, see IIROC Notice 12-0057.
The Canadian Securities Administrators released a consultation paper today intended to build on earlier proposals to construct a framework for the treatment of market participant collateral in centrally cleared OTC derivatives transactions. Specifically, the paper addresses the segregation of assets put forward as collateral for OTC derivatives transactions cleared through a central counterparty by customers that access the CCP indirectly through clearing members. The paper also addresses the transfer of customer collateral and customer positions upon the default or insolvency of the clearing member of a CCP.
According to the CSA, the paper's recommendations are intended to ensure that "CCPs clearing OTC derivatives possess adequate rules and infrastructure to facilitate the segregation and portability of collateral in a manner that provides market participants with appropriate protections". To that end, the paper recommends, among other things: (i) that clearing members be required to segregate customer collateral from their own proprietary assets and that the Complete Legal Segregation Model (whereby all customers' collateral is permitted to be held on an omnibus basis, but is recorded and attributed by both the CCP and clearing member to each customer based on their collateral advanced) be employed; (ii) that if CCPs or clearing members are permitted to reinvest posted customer collateral, investments should be restricted to instruments with minimal credit, market and liquidity risk; (iii) that CCPs should hold customer collateral at one or more supervised and regulated entities that have robust accounting practices, safekeeping procedures and internal controls; (iv) requiring CCPs to make the segregation and portability arrangements contained in their rules and policies available to the public in a clear and accessible manner; (v) that provincial market regulators enact rules requiring that every OTC derivatives CCP be structured to facilitate the portability of customer positions and collateral; and (vi) that parties to an uncleared OTC derivatives transaction be free to negotiate the level of segregation required for collateral.
The CSA is accepting public comment on the consultation paper, including with respect to the specific questions posed regarding its recommendations, until April 10, 2012.
The paper is one of a series of eight papers building on the high-level proposals found in Consultation Paper 91-401 released in November 2010. For more information, see CSA Consultation Paper 91-404 Derivatives: Segregation and Portability in OTC Derivatives Clearing.
Last week, the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions published a final report regarding OTC derivatives data reporting and aggregation requirements. Among other things, the report sets out recommendations with respect to such things as minimum data reporting requirements, access to data by authorities, and the development of an international product classification system for OTC derivatives. As we discussed in a post last year, the CPSS and IOSCO released a draft of the report in August 2011, and the final version reflects public comments received during the consultation process.
On November 30, 2011, the Quebec Government passed omnibus amendments to financial services legislation under Bill 7, An Act to amend various legislative provisions mainly concerning the financial sector. Bill 7 amends various Quebec statutes regulating the provision of financial services across a broad range of areas such as whistleblower immunity, electronic communications with regulatory authorities, the receivership process for regulated firms, insider trading rules, fraudulent trading and the disclosure of false information to the Autorité des marchés financiers (AMF), Quebec’s financial services regulator.
Bill 7 also includes various housekeeping amendments to the Derivatives Act (Quebec) (QDA), as well as the following:
- Incorporating contracts for difference in the definition of a “derivative” regulated under the QDA.
- Additional requirements (not yet in force) governing the initial and ongoing business conduct of “qualified persons” as described in our other post dated today.
- Amendments in respect of the use of set-off related to cash posted as credit support, as more fully described in our Structured Finance blog post of November 18, 2011.
- Provisions governing the regulation of “trade repositories” as “regulated entities” subject to recognition by the AMF, consistent with the high level recommendations of the Canadian Securities Administrators in their CSA Consultation Paper 91-402 Derivatives: Trade Repositories.
- Changes to the exemption for over-the-counter (OTC) derivatives transactions. While activities or transactions in OTC derivatives involving “accredited counterparties” only will continue to be exempted from the derivatives registration and qualification requirements under the QDA, those transactions are no longer generally exempt from the application of various market supervision, enforcement and other procedural remedies available to the AMF and the Québec Bureau de décision et de révision.
- Specifying that a derivative cannot be invalidated for the sole reason that a counterparty is not an “accredited counterparty” or the derivative “otherwise departs from the Act”, unless the cause of the invalidity is set out in the terms of the derivative.
- Additional provisions governing the ability of the AMF to inspect market participants or compel the production of documents.
- Provisions governing liability for misrepresentation “about the offering or trading of a derivative”.
On December 16, 2011, Quebec’s financial services regulator, the Autorité des marchés financiers (AMF), tabled proposed amendments to the Derivatives Regulation (Quebec) (QDA) which are intended to implement the provisions of the Derivatives Act (Quebec) governing “qualified persons” (the Proposals) In addition to the derivatives dealer and adviser registration requirements applicable to dealers and advisers in derivatives (the “derivatives registration requirement”), the QDA requires that a person, other than a regulated entity1 who “creates or markets a derivative” must be qualified by the AMF, as prescribed by regulation, before the derivative is offered to the public (the "qualification requirement"). Under an amendment not yet in force, the qualified person must also have the marketing of the derivative authorized by the AMF, as prescribed by regulation (the “authorization requirement”).
As outlined below, the Proposals would, among other changes, significantly increase the disclosure, compliance and reporting requirements applicable to Canadian and foreign intermediaries offering listed derivatives products in the Quebec market to any person, or OTC derivatives to persons other than “accredited counterparties”, unless a discretionary exemption can be obtained. The Proposals are published for a period of 30 days after which the AMF may submit the Proposals to the Minister of Finance for approval, with or without amendments. The AMF is accepting written comments on the Proposals until February 1, 2012.
Market participants conducting derivatives-related activities in the Quebec market should carefully review their product lines, and seek detailed advice as to whether the new qualification/authorization requirements will impact this business and what actions should be taken in contemplation of these new rules.
Impact of the Proposals
The Proposals are significant for several reasons.
First, the Proposals, if adopted, would round out the basic framework governing the regulation of both OTC and standardized derivatives first introduced in Quebec in 2009. They follow on the enactment of more detailed amendments to the “qualified persons” provisions of the QDA effective November 30, 2011, as described in our other post dated today.
Second, the Proposals represent an innovative means of regulating the offering of derivatives to persons other than eligible counterparties outside of the conventional prospectus-based framework of securities regulation which has generally been employed by regulators in other Canadian jurisdictions to regulate trades in all or certain categories of derivatives. The basic mechanics of this new qualification requirement are outlined below.
Third, and more importantly, upon the adoption of these rules, material transitional relief issued by the AMF in conjunction with the implementation of the QDA would lapse.2 The effect of this change is that:
- OTC derivative transactions involving eligible “accredited counterparties” in Quebec would continue to be exempt from the derivatives registration and the qualification/authorization requirements.
- Market participants offering OTC derivatives to Quebec-resident persons other than qualified “accredited counterparties” would now be subject to the derivatives registration and the qualification/authorization requirements.
- Market participants offering standardized (listed) derivatives to any Quebec-resident person (including to “accredited counterparties”) could no longer rely on blanket and other transitional or discretionary relief previously issued by the AMF. These market participants would have to apply to the AMF for qualification/authorization within 30 days of the coming into force of the new rules and, as the case may be, comply with the derivatives registration requirement (unless an exemption is available)3, or obtain separate discretionary relief from the AMF.
The Proposals do not specify how much time, if any, will be given to the market to transition to the new “qualified persons” regime. The QDA came into force in 2009 with a six-month transition period. It is to be hoped that, in this period of intense regulatory change (particularly in the major derivatives markets outside Canada), the final rules will include a transition period at least that long.
Key Features of the Qualification Process
As noted above, the Proposals build on recent amendments to the QDA made under Bill 7, An Act to amend various legislative provisions mainly concerning the financial sector which further flesh out the cornerstones of the qualification/authorization requirements (the “qualified persons amendments”).
The qualified persons amendments, once in force, would introduce general provisions governing the initial and ongoing business conduct of “qualified persons”, including requirements that a qualified person have an effective corporate and organizational structure with adequate personnel, financial and technological resources and appropriate business policies and procedures and governance practices; that it take the necessary measures to ensure the security and reliability of its transactions and activities; that it offer derivatives to the public through a registered dealer or register as a dealer; that it comply with initial and periodic reporting requirements; and that it comply with safekeeping and segregation requirements.
The Proposals would further provide that:
- A qualified person must participate in a contingency fund that protects the assets entrusted to it by its counterparties, or comply with minimum working capital requirements as calculated on Form 31-103F1 Calculation of Excess Working Capital4 or under the Joint Regulatory Financial Questionnaire and Report of the Investment Industry Regulatory Organization of Canada (IIROC). The minimum required capital would be C$20 million plus 5% of amounts due to counterparties to a derivative that a qualified person is marketing which exceed C$10 million.
- A qualified person must maintain proper books and records to ensure efficient operations and demonstrate compliance with the QDA.
- A qualified person must have an emergency and contingency plan in place to ensure business continuity.
- An applicant for qualification must provide documents in support of its compliance with specified requirements of the qualified persons amendments, a completed Schedule B Application for Qualification (including background organizational, business and regulatory compliance information on the applicant, and information on distribution methods, client disclosure, electronic systems and operations and audited financial information). The Schedule B application must be accompanied by a completed Form 33-109F4 Registration of Individuals and Review of Permitted Individuals for each of its “permitted individuals”(e.g., directors, the chief executive officer, the chief financial officer, the chief operating officer and individuals having beneficial ownership of, or direct or indirect control or direction over, 10% of the voting securities of the applicant) unless the Form 33-109F4 information is already on file with the AMF (e.g., as in the case of applicants which are already Quebec-registered firms).
- An applicant for authorization must provide a completed Schedule C Application for Authorization to Market a Derivative, including a detailed description of the derivative, and associated trading methods, prospective clients, risks and costs and fees. The AMF must make any objection to an application for authorization within 21 days after submission of the application.
- Designated information set out in the Schedule B and Schedule C applications must be included in the risk information document that a derivatives dealer must provide to its clients before the first trade in a derivative.
- A qualified person must notify the AMF “without delay” if its excess working capital or risk adjusted capital calculated as described above is less than zero or in the case of “any failure, malfunction or material delay of [its] systems or equipment”.5
- A qualified person must notify the AMF of any material change to the information provided in its applications for qualification or authorization, within 7 days of the change. The rules provide definitions of what constitutes a “material change” in respect of a qualified person or a derivative. Other changes to such information would have to be notified within 30 days following the end of the quarter in which the change occurred.
- A qualified person must also notify both the AMF and “the counterparties to a derivative that [it is] marketing, including counterparties waiting to trade such a derivative” of “any change that could affect the trading of such a derivative or the transactions under way in respect of such a derivative at least 10 days prior to the change”. This 10-day prior notice requirement raises a number of conceptual and practical issues, including the absence of any materiality threshold, the absence of any guidance as to the type of change that would trigger the notice requirement and the issue of changes that may arise over which a qualified person has no reasonable ability to give a 10-day prior notice, particularly in the case of a qualified person that is part of a global financial services group and in a dynamic financial markets environment. Hopefully, this requirement will be modified or further clarified through additional guidance.
- A qualified person must, within 90 days after the end of its financial year provide to the AMF:
- audited financial statements prepared in accordance with Canadian GAAP applicable to publicly accountable enterprises (there would appear to be no provision for the delivery of financial statements prepared in accordance with IFRS, U.S. GAAP or other accounting principles as contemplated in Regulation 52-107 respecting Accounting Principles and Auditing Standards), an adjustment to the Proposals which should be contemplated given the number of foreign stakeholders potentially affected by these rules;
- the number of contracts entered into in Quebec and their notional value for all derivatives offered to the public during the latest fiscal year; and
- the percentage of contracts, for each of the latest four quarters, that were profitable for counterparties.
- audited financial statements prepared in accordance with Canadian GAAP applicable to publicly accountable enterprises (there would appear to be no provision for the delivery of financial statements prepared in accordance with IFRS, U.S. GAAP or other accounting principles as contemplated in Regulation 52-107 respecting Accounting Principles and Auditing Standards), an adjustment to the Proposals which should be contemplated given the number of foreign stakeholders potentially affected by these rules;
Interested stakeholders should consider submitting comments on these proposals by February 1, 2012.
1 The term “regulated entity” includes exchanges, alternative trading systems, clearing houses, trade repositories and self-regulatory organizations that are subject to the requirement to be recognized by the AMF.
2 In connection with the adoption of the QDA on February 1, 2009, the AMF issued a discretionary blanket decision on January 22, 2009 (the “AMF Blanket Decision”) by way of broad transitional relief (AMF decision No. 2009-PDG-0007 (January 22, 2009), as supplemented and extended by AMF notices of October 2, 2009 and September 24 2010). The AMF Blanket Decision sets out a temporary exemption from the derivatives registration requirement and the derivatives qualification requirement for specified derivatives activities carried out solely with “accredited investors” as defined under Regulation 45-106 respecting Prospectus and Registration Exemptions (45-106).
3 The Derivatives Regulation (Québec) (the “QDR”) provides an exemption (the “standardized derivatives exemption”) from the derivatives registration requirement under the QDA for a person authorized to act as a dealer or an adviser or authorized to exercise similar functions under legislation applicable in a jurisdiction outside Quebec where its head office or principal place of business is located to the extent it carries on business solely for an “accredited counterparty” and its activity involves a standardized derivative that is offered primarily outside Quebec. The standardized derivatives exemption does not, however, provide an exemption from the derivatives qualification or authorization requirements.
4 Regulation 31-103 respecting Registration Requirements, Exemptions and Ongoing Registrant Obligations.
5 The term “material” would appear to qualify the terms “failure”, “malfunction” or “delay” in the governing French language version. We would hope that this technical translation error will be rectified in the final provision.
The Canadian Securities Administrators released a consultation paper today addressing the regulation of OTC derivatives markets. Specifically, the paper makes various recommendations regarding surveillance and monitoring, market conduct and enforcement that are intended to strengthen financial markets and manage specific risks related to OTC derivatives. The paper is one of a series of eight papers building on the high-level proposals found in Consultation Paper 91-401 released in November 2010.
Surveillance and Monitoring
Citing the limited market information currently available to regulators relating to the trading of OTC derivatives, the paper recommends that further study and research be undertaken on the development of a comprehensive surveillance system for monitoring OTC derivatives markets to supplement current market surveillance. According to the report, a comprehensive approach to surveillance and monitoring would include enabling regulator access to trading data and monitoring participant positions.
Market Conduct Rules
To address the perceived lack of consistency in market conduct rules applicable to OTC derivatives across Canadian jurisdictions, the CSA recommend extending certain regulations pertaining to securities markets to OTC derivatives markets. Such regulations would include record keeping and audit trail requirements and prohibitions to prevent market manipulation and fraud, misrepresentations and insider trading.
According to the CSA, compliance, investigation and enforcement powers currently found in securities legislation should also be extended to cover trading in OTC derivatives.
Comments on the proposals are being accepted until January 25, 2012. For more information, see CSA Consultation Paper 91-403 Derivatives: Surveillance and Enforcement.
Earlier this week, the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions released a consultative report that makes various recommendations regarding OTC derivatives data reporting and aggregation requirements. As we discussed in October 2010, IOSCO formed a Task Force on OTC Derivatives Regulation last year with a mandate that included coordinating the efforts of international regulators with respect to OTC derivatives and producing a report on data reporting and aggregation requirements by July of this year.
Among other things, the report recommends that: (i) at a minimum, transaction level data be reported to trade repositories and that such data include at least transaction economics, counterparty information, underlier information, operational data and event data; (ii) trade repositories implement measures to provide effective and practical data access to authorities; (iii) a standard system of Legal Entity Identifiers be developed and implemented for the aggregation of OTC derivatives data; and (iv) a standard product classification system for OTC derivatives products be developed, led by industry and in consultation with authorities.
The CPSS and IOSCO are accepting comments on the consultative report until September 23, 2011.
The Canadian Securities Administrators today released a consultation paper that proposes a framework of rules for the reporting of OTC derivatives transactions and the operation of trade repositories. The paper builds on the high-level proposals released in CSA Consultation Paper 91-401, published in November 2010, and considers such issues as trade repository governance requirements, transaction reporting obligations and access to confidential trade repository information. The proposals, intended to provide consistency with international principles, are open for public comment until September 12, 2011. For more information, see CSA Consultation Paper 91-402 Derivatives: Trade Repositories.
Late last week, the Canadian Securities Administrators, other than the OSC, released for comment a proposed multilateral instrument that would essentially apply continuous disclosure requirements to OTC issuers that have a significant connection to a Canadian jurisdiction (including those that are already reporting issuers at the time the rule comes into force. An OTC issuer would be an issuer who has securities quoted on any U.S. OTC market, unless the issuer is also listed or quoted on another prescribed market. A significant connection would exist where (i) the OTC issuer's business was directed or administered in or from Canada; (ii) promotional activities were conducted from Canada; or (iii) if the issuer distributed securities in Canada prior to obtaining a ticker symbol for the purpose of having its securities quoted on an OTC market in the U.S. and those securities became the issuer's OTC-quoted securities.
The rule is aimed at curbing the manufacture and sale in Canada of U.S. OTC quoted shell companies that can be used for abusive purposes. The BCSC adopted a similar rule back in 2008 which, according to the CSA notice, led to the migration of some OTC reporting issuers to other Canadian jurisdictions. In this respect, the proposed rule would also impose certain prohibitions and restrictions, including denying the use of certain exemptions, requiring that certain sales be made through registrants and imposing legend requirements.
Issuers subject to the instrument would generally have to comply with the continuous disclosure regime to which venture issuers are subject and, additionally, also file annual information forms (which venture issuers may do voluntarily, but are not required to). Once an issuer triggered the requirements, the OTC Rule would continue to apply for at least one year, continuing to apply after that time only if the issuer was directed or administered or carried out promotional activities in or from a Canadian jurisdiction. The CSA is accepting comments on the proposed instrument until September 9, 2011. For more information, see Proposed Multilateral Instrument 51-105 Issuers Quoted in the U.S. Over-the-Counter Markets.
As we discussed on Friday, the Canadian Securities Administrators published for comment last week proposed new rules for regulating securitized products. Our colleagues in the Structured Finance group have published a more detailed review of these proposals, including some of the issues the proposals raise, on their blog.
The Canadian Securities Administrators (CSA) today published for comment proposals to establish a new framework for regulating securitized products. The proposals consist of a new instrument governing supplementary disclosure requirements for prospectus distributions of securitized products, as well as new disclosure and certification rules. According to the CSA, the proposals are intended to facilitate transparency in the securitization market, ensure that investors have access to adequate information, and be proportionate to the risks associated with the types of securitized products available in Canada. Comments are being accepted by the CSA until July 1, 2011.
On February 28, the Alberta Securities Commission proposed the repeal of Blanket Order 91-503, which currently exempts most over-the-counter derivatives from the definition of "futures contract" under the Alberta Securities Act and, thus, exempts such OTC derivatives from regulation as "securities".
The ASC would replace Blanket Order 91-503 with Rule 91-505 Over-the-Counter-Derivatives, which is intended to restore the ASC's authority to regulate OTC derivatives transactions as futures contract transactions under the Act. The proposed Rule 91-505, however, would recognize the fact that such transactions are generally confined to large institutional entities and exempt distributions of a futures contract from the prospectus requirement under the Act.
However, an exemption from the dealer registration requirement would only apply to OTC physical commodity contracts. The Rule defines OTC physical commodity contract to mean a futures contract that (i) is not an exchange contract; (ii) contains an obligation to make or take future delivery of a commodity other than cash or a currency; and (iii) does not allow for cash settlement in place of physical delivery.
Unless addressed in the context of further harmonization of dealer registration requirements or otherwise, as it currently stands, the proposal replaces the broader dealer registration exemption with a narrow exemption limited to OTC physical commodity contracts. As such, under the proposal, there would no longer be an exemption for qualified parties.
The ASC is accepting comments on its proposal until April 29, 2011. For more information, see ASC Staff Notice 91-703 Over-the-Counter Derivatives.
On February 25, the OSC released for comment a draft of its 2011-2012 Statement of Priorities. According to the OSC, its planning for the year was influenced by developments in the overall investment marketplace, the regulatory arena domestically and internationally and stakeholder perceptions of regulatory effectiveness. Ultimately, the OSC identified five broad priorities, namely to:
- better demonstrate its commitment to investor protection by undertaking policy and rule development as well as compliance and enforcement programs;
- intensify operational, compliance and enforcement efforts;
- modernize its regulatory systems and approaches, including by focusing on risk oriented regulatory responses and implementing a robust framework for OTC derivatives;
- pursue a coordinated approach to securities regulation by supporting the development of a federal securities regulator and working to harmonize and modernize regulation through the CSA; and
- demonstrate accountability for its performance as a leading securities regulator in Canada.
Comments on the are being accepted by the OSC until April 27, 2011. For more information, see OSC Notice 11-765.
As we discussed on our Structured Finance blog in December 2009, the Saskatchewan Financial Services Commission, Securities Division issued General Order 91-907 in November of that year exempting over-the-counter (OTC) derivatives trading among qualified parties from the registration and prospectus requirements under the Saskatchewan Securities Act, 1988.
The General Order and Companion Policy have now been amended to include an exemption where: (i) the OTC derivative is a contract for the production of natural gas or the purchase and sale of natural gas; and (ii) each party to the contract is engaged in the production of natural gas or the purchase or sale of natural gas.
On December 8, Ontario's Bill 135, the Helping Ontario Families and Managing Responsibility Act 2010, received Royal Asset. The Act amends the Ontario Securities Act and, among other things, (i) establishes a regulatory framework for trading in derivatives in Ontario; (ii) allows the Ontario Securities Commission to regulate credit rating organizations; (iii) provides the OSC authority to recognize and make decisions related to alternative trading systems and (iv) extends current prohibitions on insider trading and tipping to issuers that have a "real and substantial connection" to Ontario and whose securities are listed and posted on the TSX-V. Most of the amendments came into force on the day of Royal Assent, while certain provisions principally relating to the regulation of derivatives will not come into force until a date still to be proclaimed.
On November 19, the U.S. Securities and Exchange Commission proposed new rules that would require security-based swap data repositories (SDRs) to register with, and provide swap data to, the SEC. The proposal would also require SDRs to accept transaction data and maintain it for at least five years after the expiration of the applicable swap. The SEC has also proposed rules requiring parties to security-based swap transactions to report information regarding each transaction to a registered SDR, which would then be required to publicly disseminate certain information regarding the transaction. The proposals are being made pursuant to Dodd Frank, which authorizes the SEC to regulate security-based swaps. According to the SEC, "[t]aken together, the rules ... seek to provide improved transparency to regulators and the markets through comprehensive regulations for [security-based swaps] transaction data and SDRs." Meanwhile, the Commodity Futures Trading Commission is planning on similar rules with respect to swaps falling under its jurisdiction.
See Release No. 45-63347 - Security-Based Swap Data Repository Registration, Duties, and Core Principles and No. 34-63556 - Regulation SBSR - Reporting and Dissemination of Security-Based Swap Information.
As expected, the government of Ontario has now introduced proposed amendments to the Securities Act (text not yet available) that would allow the Ontario Securities Commission to develop a regulatory framework to govern over-the-counter (OTC) derivatives. According to the government's economic update released this afternoon, the proposed framework would be consistent with the federal government's plan to implement a national securities regulator.
In addition to tackling OTC derivatives regulation, the proposed amendments would also "provide for regulatory oversight of credit rating agencies and strengthen the oversight of alternative trading systems".
According to various media outlets, including the Globe and Mail and the Financial Post, the Ontario government is expected to introduce proposals later today relating to the regulation of derivatives. The expected move may raise the question of how Ontario's proposals will fit with those of other jurisdictions. Watch for more details once the proposals are released this afternoon.
Omnibus financial legislation introduced by the Quebec government on November 10, 2010 includes technical amendments to Quebec's derivatives legislation, as well as provisions intended to improve the oversight of persons authorized to market a derivative and to strengthen the process of authorization of the marketing of the product.
The technical amendments would include expanding the list of instruments included in the definition of "derivative" under the Derivatives Act (Quebec) (the QDA) to cover contracts for differences (CFDs) specifically.
Bill 128 would also incorporate more detailed requirements to provisions under the QDA that are not yet in force governing persons qualified under the QDA to create or market a derivative. These new provisions include requirements that a qualified person maintain a corporate and organizational structure and adequate human, financial and technological resources to enable it to operate effectively and ensure the security and reliability of its transactions and activities. A qualified person would also be required to have adequate business policies and procedures and appropriate governance practices, including, in particular, with respect to the independence of its directors and the auditing of its financial statements. The amendments also clarify that a qualified person would be required to register as a dealer or offer derivatives to the public through a dealer.
CDS Clearing and Depository Services Inc. today released proposed amdendments to implement the Canadian Derivatives Clearing Corporation's fixed income clearing facility. According to CDS, the proposals would: (i) create a new mode of settlement indicator enabling participants to instruct CDS to report trades so-identified to a Third Party Clearing System (TPCS); (ii) permit CDS to report trades to CDSS as a TPCS; (iii) limit CDS liability in respect of trades or trade information received from a TPCS; (iv) specify the settlement process by which trades reported to CDS by a TPCS are settled; and (v) permit partial settlement of trades from CDCC as a TPCS. Comments are being accepted on the proposed amendments for 30 days from today.
The Canadian Securities Administrators yesterday published a consultation paper on over-the-counter derivatives regulation in Canada intended to address "some of the deficiencies that have become apparent in the OTC derivatives market". Specifically, the consultation paper provides background on the need for regulation and provides a number of specific proposals. Among other things, the report recommends:
- central clearing of OTC derivatives that are determined to be appropriate for clearing and capable of being cleared, such as standardized derivatives;
- reporting of all derivatives trades by Canadian counterparties to a trade repository;
- electronic trading of OTC derivative products; and
- in accordance with the recommendations of the Basel II Accord, imposing capital requirements proportionate to the risks that an entity assumes.
The focal point of the proposal, being the central clearing of OTC derivatives, reflects the approach taken by the Dodd-Frank Act. With respect to trade reporting to a trade repository, while the report makes no recommendation regarding a specific time requirement for reporting it does state that real-time reporting will ultimately be required. The report further recommends that provincial regulators obtain authority to conduct surveillance on OTC derivatives markets, develop robust market conduct standards and obtain authority to investigate and enforce against abusive practices.
The report also recommends that defined categories of end-users be exempted from these proposals but acknowledges that this approach requires further study to determine, among other things, applicable conditions and thresholds. A number of other issues are also identified as requiring further study and analysis, including the segregation of capital in the OTC derivatives context, the location and type of central counterparty clearing house (referred to as a “CCP”), including assessment of the use of international CCPs vs. a Canadian solution. Registration requirements and exemptions from such requirements are also not covered in the report but will reportedly be the subject of future consultation.
The report specifically notes that clear jurisdictional authority and specific rule-making powers will need to be set out in provincial securities and derivatives legislation to address all of the subject areas addressed. The CSA will also need to develop information sharing and co-operation agreements with international regulators, foreign trade repositories and CCPs.
The Committee has set out a number of specific questions pertaining to its recommendations and is accepting comments on the consultation paper until January 14, 2011. The Committee is working under Canada’s G20 commitment to meet a 2012 deadline and will continue to move forward by developing legislative proposals and drafting proposed rules.
On October 15, the International Organization of Securities Commissions (IOSCO) announced the formation of a task force intended to coordinate the efforts of international regulators with respect to over-the-counter (OTC) derivatives markets. Specifically, the Task Force on OTC Derivatives Regulation will be charged with developing consistent international standards, coordinating other related international initiatives and serving as a centralized group within IOSCO for the consultation and coordination generally on related issues.
The Task Force's work, to follow a phased approach will include: (i) conducting a study by the end of January 2011 on exchange and electronic platform trading for derivatives; (ii) producing a report by July 2011 on data reporting and aggregation requirements; and (iii) setting out consistent international standards for OTC derivatives regulation in the certain areas.
On Wednesday, the U.S. Securities and Exchange Commission published proposed Regulation MC under the Securities Exchange Act of 1934, intended to mitigate conflicts of interest for security-based swap clearing agencies, security-based swap execution facilities and national securities exchanges that post or make available for trading security-based swaps. Under proposed Regulation MC, the agencies, facilities and exchanges noted above would be required to adopt ownership and voting limitations as well as certain governance requirements. Comments are being accepted by the SEC for 30 days after the date of the proposal's publication in the Federal Register.
The SEC also adopted an interim final rule requiring that security-based swap transactions that were entered into before the July 21, 2010 signing of the Dodd-Frank Act (and which had not expired as of that date) be reported to the SEC or a registered security-based swap data repository. According to SEC Chairman Mary Schapiro, "[t]his interim final rule provides a means for the Commission to gain a better understanding of the security-based swap markets, including their size and scope".
The Securities and Exchange Commission (SEC) issued a proposal this week to require issuers of asset-backed securities to perform a review of the assets underlying the relevant securities and publicly disclose the review's findings and conclusions. While the proposal would not dictate the level or type of review to be performed, the SEC expects that the "issuer's level and type of review ... may vary depending on the circumstances." The SEC is accepting public comment on its release until November 15.
Last month, the European Commission unveiled a proposed regulation intended to address short selling and certain aspects of credit default swaps. According to the EC, its proposal would, among other things, improve transaction transparency, provide for a coordinated European framework and address specific risks of naked short selling. If adopted, the regulation is expected to take effect on July 1, 2012.
AMF Staff issued a notice today further extending the term of the temporary exemption provided under its February 1, 2009 blanket decision No. 2009-PDG-0007 (the Blanket Order). The Blanket Order provides relief from the derivatives dealer and adviser registration requirements and the derivatives qualification rules under the Derivatives Act (Quebec) for specified derivatives activities carried out solely with “accredited investors” (as defined under National Instrument 45-106 Prospectus and Registration Exemptions). The original exemption had been extended to September 28, 2010 in a March 26, 2010 AMF Staff notice. Today's notice further extends the Blanket Order for an indefinite term and states Staff's intention to publish any amendments to the relief "at an appropriate time".
Citing the need to increase transparency and reduce counterparty and operational risk, the European Commission recently released new proposals to regulate the OTC derivatives market. Among other things, the proposals would require trades in OTC derivatives in the EU to be reported to central data centres (trade repositories) accessible to regulators. A new European Securities and Markets Authority would be responsible for registering and monitoring trade repositories, while standard OTC derivatives would have to be cleared through central counterparties. The EC expects the proposals to be promulgated by the end of 2011.
The TMX Group Inc. issued a paper today providing its unique perspective on issues deriving from the financial crisis and discussing how the core competencies of a combined regulated exchange and clearing house are designed to meet G-20 objectives respecting improving over-the-counter (OTC) derivatives markets. The TMX Group has obviously given considerable thought on how Canada should respond to prevent similar crises from recurring, in particular with respect to the operation of less-regulated OTC derivatives markets.
Specifically, TMX Group discussed how its core competencies respecting trading, clearing, data warehousing and regulatory services can be mapped onto G-20 requirements, which include strengthening prudential oversight, improving risk management, increasing transparency, promoting market integrity, protecting against market abuse, mitigating systemic risk and reinforcing international cooperation. TMX Group also stated that its core competencies achieve the business requirements of market participants. As such, the paper recommended that Canadian regulators utilize domestic facilities with international linkages to provide the regulatory oversight of OTC derivatives markets.
Under Quebec’s derivatives legislation, the Chief Compliance Officer (CCO) of a derivatives portfolio manager is required to have at least three years of relevant derivatives experience and to have passed all required IIROC exams with respect to derivatives for an officer of a derivatives dealer (the Derivatives Proficiency Requirements) in addition to satisfying the proficiency requirements of National Instrument 31-103 Registration Requirements and Exemptions.
On July 27, 2010, the Autorité des marchés financiers, Quebec's financial services regulator, issued a blanket decision which exempts the CCO of a derivatives portfolio manager from the Derivatives Proficiency Requirements provided the firm has designated an Officer Responsible for Derivatives Operations who meets prescribed proficiency requirements that are detailed in the blanket decision with respect to options, futures and swap-related products.
The decision is in effect as of July 30, 2010.
With the recent approval of financial regulatory reform legislation in the United States, SEC Chairman Mary Schapiro provided an outline of next steps in a speech last week to the Center for Capital Markets Competitiveness in Washington D.C. Specifically, Ms. Schapiro discussed five topics that new rules will need to address, namely, (i) oversight of OTC derivatives and the need for joint rulemaking between the CFTC and SEC; (ii) fiduciary duty in respect of existing standards of care applicable to broker-dealers and investment advisors; (iii) registration requirements for hedge funds, (iv) expanded corporate disclosure, including upcoming rules that will set new standards of independence for compensation committees; and (v) credit rating agencies. According to Ms. Schapiro, the next year will a busy one for the SEC and CFTC as a number of new proposals are introduced.
As we previously discussed, the New Brunswick Securities Commission recently proposed an amendment to its Local Rule 91-501 Derivatives to modify the language respecting the exemption for "qualified parties". Specifically, the amendment states that the registration requirement does not apply "where each party to the trade is a qualified party acting as principal". The NBSC has now set the date of implementation of the amendment as September 1, 2010.
On July 15, 2010, Quebec's financial services regulator, the Autorité des marchés financiers (the AMF), published two guidelines with respect to the investment management practices of financial institutions, including insurers, portfolio management companies controlled by an insurer, mutual insurance associations, financial services cooperatives and trust and savings companies governed by any of the following Quebec acts: An Act respecting insurance, An Act respecting financial services cooperatives and An Act respecting trust companies and savings companies.
Respectively, the "Investment Management Guideline" (at page 132) and the "Derivatives Risk Management Guideline" (at page 168) set out, in a principles-based approach, AMF guidelines with respect to the sound and prudent investment management practices that financial institutions are required to apply. A draft "Investment Management Guideline" (at page 137) had previously been circulated for public consultation by the AMF in November 2009, and the two recently circulated guidelines are a result of the consultation process. The AMF has stated that due to the complexity and risk-potential of derivatives, it has been decided to establish a separate guideline devoted specifically to derivatives risk management. The AMF has noted that its guidelines are based on core principles and guidance issued by international organizations, including the Basel Committee on Banking Supervision and the International Association of Insurance Supervisors.
The guidelines come into effect on August 1, 2010 and the AMF expects each financial institution to develop strategies, policies and procedures based on its nature, size, complexity and risk profile, to ensure the adoption of the principles underlying the guidelines by August 1, 2012. The AMF has also stated that where a financial institution has already implemented such a framework, the AMF may verify whether it enables the institution to satisfy the requirements of sound and prudent investment management practices prescribed by law.
On June 30, an amendment to Quebec's Derivatives Regulation came into force, which states that Regulation 23-102, which adopts National Instrument 23-102 Use of Client Brokerage Commissions in the province, applies to dealers and advisers governed by the Derivatives Act.
On June 11, the U.S. Commodity Futures Trading Commission (CFTC) announced that it was proposing a rule that would require that co-location and proximity hosting services be available to all qualified market participants willing to pay for the services. Comments on the proposals are being accepted until July 12, 2010.
The Canadian Securities Administrators (CSA) today published CSA Staff Notice 45-307 Regulatory Developments Regarding Securitization. The Notice follows work completed by the CSA subsequent to the publication of its consultation paper on ABCP in October 2008, and states that the CSA's focus "has broadened to encompass all securitized products". The CSA are also considering international regulatory developments in developing their proposals, including recent IOSCO and SEC reports and recommendations.
According to the Notice, the CSA are specifically contemplating changes to the current approach to the issuance of securitized products in the exempt market, enhancements to the disclosure requirements for securitized products distributed by prospectus and changes to continuous disclosure for reporting issuers that have distributed securitized products.
The CSA expect to publish their securitization proposals in the fall, while proposals relating to the regulation of credit rating organizations are expected this summer.
On June 11, the Canadian Securities Administrators (CSA) published revised guidance relating to the reporting of certain derivative-based transactions, including equity monetizations, intended to "assist reporting insiders who have entered into such transactions and to promote consistency in filings." The notice provides examples of arrangements and transactions involving derivatives along with guidance as to how to report these arrangements and transactions on SEDI. A revised notice was also published by the CSA setting out questions and answers intended to assist users in filing information on SEDI. The Q&As are set out based on the steps in the SEDI filing process and the type of SEDI filer.
Guidance: CSA Staff Notice 55-312 Insider Reporting Guidelines for Certain Derivative Transactions (Equity Monetization) (Revised)
Q&A: CSA Staff Notice 55-316 Questions and Answers on Insider Reporting and the System for Electronic Disclosure by Insiders (SEDI)
The Investment Industry Regulatory Organization of Canada (IIROC) today published proposed amendments to its Dealer Member Rules that would address the fairness of pricing and transparency of OTC market transactions. Initial proposals on the subject were previously published for comment in April 2009 and IIROC has revised its proposals in light of comments received.
Specifically, IIROC's proposals would: (i) require dealers to fairly and reasonably price securities traded in OTC markets, with an exception for primary market transactions and OTC derivatives set out in the rule; (ii) require dealers to disclose yield to maturity on trade confirmations for fixed-income securities and notations for callable and variable rate securities; and (iii) require dealers to include on trade confirmations sent to retail clients in respect of OTC transactions a statement indicating that they have earned remuneration on those transactions unless the amount of any mark-up or mark-down, commissions and other service charges is disclosed on the confirmation. A draft guidance note, describing the scope of the proposed rule, fair pricing considerations and documentation requirements, has also been published by IIROC.
The proposals are open for a 30-day comment period.
On May 25, the Committee of European Securities Regulators (CESR) released a statement describing the "intensifying close co-ordination of its members' market surveillance efforts" in light of recent market volatility in euro denominated debt instruments. The CESR also stated that it is of the view that structural reforms should be "rapidly introduced to enhance the transparency, organisation and functioning" of the bond and CDS markets, which are currently largely over-the-counter. According to the CESR, it is also working on measures to enhance the "organisation and integrity of OTC derivatives markets".
The proposed federal Securities Act tabled by the federal government on May 26 establishes a framework for the regulation of exchange-traded and over-the-counter derivatives markets and their participants. Don’t expect to see a new regime too soon though. This legislation has not yet been introduced as a Bill but only laid before Parliament on a Ways and Means motion. The draft legislation has been referred to the Supreme Court of Canada to obtain a ruling as to whether it is within the legislative competence of the federal Parliament and will not be introduced until that question is resolved. Provinces are given the choice to opt into the federal scheme as well. Many provinces (not including Quebec and Alberta) have taken part in the process and would be expected to opt into the national scheme.
Even if not all provinces opt in, a relatively uniform approach across the provinces to the regulation of exchange-traded and OTC derivatives will be welcome, given the patchwork of inconsistent approaches that currently prevails. The substance of the regulatory regime will be in the relevant regulations, policies and exemptions. The proposed Act merely establishes the broad framework for regulation. Further details may be forthcoming when the Canadian Securities Transition Office (the CSTO) releases its detailed commentary in the next few weeks.
The proposed Act suggests that the regulators are sensitive to the differences between traditional securities and securities markets and derivatives and their markets.
The Act establishes categories of derivatives and deals with each category in a different way. The categories are “prescribed derivatives”, “exchange-traded derivatives”, and “designated derivatives”. Prescribed derivatives are treated like traditional securities. Exchange-traded and designated derivatives are subject to Part 7 of the Act, which deals specifically with derivatives. The definition of “derivative” is quite wide, but regulation largely depends on categorization in one of the three categories. Also, the regulators may make a designation under the Act that certain contracts or instruments are not derivatives. This effectively creates a fourth category of excluded derivatives (our term, not the Act’s). The definition is:
“derivative” means an option, swap, futures contract, forward contract or any other financial or commodity contract or instrument whose market price, value, or delivery, payment or settlement obligations are derived from, referenced to or based on an underlying interest including a value, price, rate, variable, index, event, probability or thing. It does not include a contract or instrument that is designated under subsection 237(1) [i.e. by the Chief Regulator] not to be a derivative or that is within a class of contracts or instruments that are designated by the regulations not to be derivatives.
Some features of note are:
The Act contemplates that there will be certain securities that have derivative features that it would be appropriate to classify and regulate as securities. Although the term “derivative” is widely defined in the Act, the definition of “security” includes only “a derivative that is within a prescribed class of derivatives”. We expect that prescribed derivatives would be the types of hybrid products that would under the existing provincial regimes be most like investment contracts. For example, notes with derivative features that are distributed through a dealer network to investors may be the type of derivative to be prescribed – one where the securities-like features predominate. For these types of derivatives, prospectus and registration requirements would apply.
We note also with respect to bank offered principal protected notes, that evidences of deposit of Canadian financial institutions and of authorized foreign banks in respect of their business in Canada are excluded from the definition of “security”, as they are under existing provincial legislation.
No one will be able to trade in an exchange-traded derivative in Canada unless the exchange is (a) a recognized exchange (i.e. those recognized to do business in Canada subject to Canadian regulatory oversight) or (b) an exchange that is accepted by the Chief Regulator (presumably those exchanges that do not do business in Canada and hence would not be subject to regulatory oversight, but where there are customers for those products in Canada). (s.89)
It is clear that prospectus requirements do not apply to exchange-traded derivatives (s.91). Other parts of the Act can be deemed (with necessary modification) to apply to them (s.92).
The category most participants in OTC derivatives markets will be interested in is the designated derivatives category.
Unless exempted, a prescribed form of risk disclosure statement will be required to be both filed and delivered to trade in a designated derivative. What types of derivatives fall within or outside this category will be determined by the regulator. We expect that there will be a large class of exempt transactions, along the lines of the exemptions that currently exist for contracts between qualified parties in various provinces, such as Quebec, Alberta and British Columbia. The types of transactions one might anticipate being subject to the prescribed risk disclosure requirement are FX transactions or CFD’s with retail investors.
It is clear that prospectus requirements do not apply to designated derivatives (s.91).
Further, the regulations can designate which parts of the Act that otherwise apply to securities (other than the prospectus requirements) will apply to designated derivatives or some sub-class of them (i.e. it would deem them to be securities for some purposes) (s.92). The regulations could presumably modify the requirements of the Act to be more appropriate for the type of derivatives in issue or the method of transacting. There is a clear attempt to build in maximum flexibility.
For example, trade reporting to a repository might be applied to derivatives even if they are exempt from disclosure requirements or participants are exempt from registration requirements.
Given the wide definition of “derivative” and the difficulty there will be in defining categories precisely, inevitably certain types of contracts and relationships that do not engage any securities or financial markets concerns will appear to be swept into the regime. In light of that there is a clear power to exclude defined categories from the application of the Act. An example of this might be commercial contracts for the delivery of commodities.
Regulation Making Power
The Authority (i.e. the new federal securities regulator) has wide regulation making powers, many of which relate to “derivatives” (s.227). Clearly the powers include establishing the categories referred to above of prescribed derivatives and designated derivatives as well as the exemptions from those categories. In addition, the Authority can prescribe requirements, conditions and standards of conduct to be met, and practices to be carried out, by, for example, exchanges, clearers and the persons that trade in different classes of derivatives with different classes of persons. It can prescribe requirements with respect to registration and prohibitions and restrictions applicable to persons that trade in different classes of derivatives with different classes of persons.
For example, this regulation-making power could extend to imposing trade reporting requirements or perhaps even mandatory clearing. There is a public comment process built into the legislation and regulations must be approved by the relevant Minister.
If this legislation is eventually enacted, the regulators will have a great deal of flexibility in terms of regulating derivatives or particular aspects of derivatives markets. The Act gives no indication of how derivatives will actually be regulated under this Act. We would anticipate that bi-lateral contracting of OTC derivatives between sophisticated parties will remain free of disclosure and registration requirements. We suspect many of the policy decisions remain to be made on many significant issues (such as clearing and trade reporting) and that they will not be made until more of an international consensus emerges.
The Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) released two reports yesterday regarding OTC derivatives. The first, Guidance on the application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties to OTC derivatives CCPs, provides guidance to central counterparties clearing OTC derivatives in applying the Technical Committee's 2004 recommendations. Considerations for trade repositories in OTC derivatives markets, meanwhile, provides a set of considerations for trade repositories in OTC derivatives markets and relevant authorities.
The Investment Industry Regulatory Organization of Canada (IIROC) recently released its Strategic Plan for 2010-2012. The plan describes IIROC's vision and values and sets out the challenges it faces in fulfilling its mandate. Specifically, the plan discusses the following goals:
- Promoting a culture of compliance and high standards among those subject to IIROC's jurisdiction. This will include a reorganization of IIROC's rules to enhance comprehension, providing compliance examination findings and recommendations to members and undertaking periodic industry-wide compliance audits.
- Delivering effective, efficient and expert regulation. Projects that IIROC will undertake in pursuit of this goal include the implementation of a risk-based methodology for registration and completing its framework approach to IFRS.
- Maintaining market integrity by actively monitoring market structure developments and market-related events. IIROC states that it will reduce timelines to complete enforcement investigations and bring proceedings, clarify roles and relationships in order to strengthen the client/adviser relationship and continue to develop its policies respecting OTC and debt markets.
- Ensuring that it discharges its responsibilities in a cost-effective manner, which will include the implementation of an equitable Dealer and Marketplace Member fee model.
- Maintaining a confident and well-trained staff.
The U.S. Senate Committee on Agriculture, Nutrition and Forestry introduced a draft bill today intended to "bring 100% transparency" to financial markets. According to the news release of Committee Chair Blanche Lincoln, D-Ark, the bill includes mandatory clearing and trading requirements, requires real-time reporting of derivatives trades and would prohibit federal assistance to banks that "engage in risky derivative deals". Thus, the proposed legislation appears to take a tougher stance in its attempts to regulate financial institutions than the legislative proposals emanating from the Senate Committee on Banking, Housing, and Urban Affairs.
The U.S. House of Representatives passed comprehensive financial reform legislation in December 2009, which addressed OTC derivatives trading, but the Senate has yet to pass the House Bill or agree to a different proposal. The latest indications, however, are that the Senate is preparing for a vote in the upcoming weeks. What the final regulations will look like, however, remains unclear.
The International Monetary Fund (IMF) recently released a chapter of its semiannual Global Financial Stability Report dealing with over-the-counter derivatives. Specifically, the chapter considers the role of central counterparties in making OTC derivatives markets "safer and sounder" and reducing counterparty risk.
The New Brunswick Securities Commission (NBSC) yesterday published a proposed amendment to Local Rule 91-501 Derivatives. LR 91-501, which came into force on September 28, 2009, imposes registration and risk disclosure requirements in respect of trades in "derivatives" as defined in the Rule, other than trades among qualified parties.
The proposed amendment published yesterday would modify the language respecting the exemption to state that the registration requirement does not apply "where each party to the trade is a qualified party acting as principal". The change is being proposed in light of inquiries from industry and should clarify the NBSC's intention that the exemption only applies where both parties are qualified parties acting as principal.
The NBSC is accepting comments on the proposed amendment until June 7, 2010. For more information on LR 91-501, see our post of March 25 respecting a derivatives FAQ published by the NBSC.
The U.S. SEC announced on March 25 that its staff is conducting a review of the use of derivatives by mutual funds, exchange-traded funds (ETFs) and other investment companies to determine whether additional protections for those funds are required under the Investment Company Act of 1940 (the Act) . Staff of the SEC also intend to identify if any changes to the SEC's rules or guidance may be warranted. Pending the completion of the review, SEC staff will be deferring consideration of exemptive requests under the Act to permit ETFs that would make significant investments in derivatives.
The Autorité des marchés financiers (the "AMF", Quebec’s financial services regulator) announced today that the temporary exemption provided under its February 1, 2009 blanket decision from the derivatives dealer and adviser registration requirements under the Derivatives Act (Quebec) (the "Act") for specified derivatives activities carried out solely with “accredited investors” (as defined under National Instrument 45-106 Prospectus and Registration Exemptions ("NI 45-106"), will remain available until September 28, 2010. Prior to this announcement, the temporary exemption had been set to expire on March 27, 2010. The exemption remains available subject to the following conditions:
- the derivatives activities must be carried out solely with “accredited investors” in accordance with the conditions set forth in NI 45-106 (including the filing of a report under Part 6); and
- the activities must relate only to certain specified categories of derivatives, including:
- an option or a negotiable futures contract pertaining to securities, or a Treasury bond futures contract;
- an option on a commodity futures contract or financial instrument futures contract; or
- commodities futures contracts, financial futures contracts, currencies futures contracts and stock indices futures contracts.
The AMF also announced that the corresponding exemption from the derivatives qualification rules under the Act will continue to remain available for the time being and that the AMF will advise market participants of any changes to this exemption.
The Ontario Securities Commission (OSC) today published a revised Statement of Priorities for the financial year ending March 31, 2011. The OSC initially released a draft Statement of Priorities in December 2009, and the revised version includes changes made in consideration of public comments received. Specifically, the changes to the draft publication include (i) a reference to the creation of an independent panel focusing on investor issues; and (ii) a new initiative to signal the OSC's intention to direct more resources to the regulation of OTC derivatives.
As we reported back in January, the New Brunswick Securities Commission published answers to frequently asked questions regarding Local Rule 91-501 Derivatives. Last week, the NBSC published a revised notice expanding on its answer regarding whether the rule applies to spot foreign exchange contracts. Specifically, the revised notice states that "LR 91-501 does not apply to spot foreign exchange transactions involving the purchase or sale of a currency (i.e. transactions such as changing money at a currency exchange or withdrawing cash at a foreign ATM)." Whether other spot foreign exchange transactions are subject to LR 91-501, however, remains unclear, as the NBSC's use of "i.e." raises questions as to whether the example provided was intended to be comprehensive.
The Provincial/Territorial Council of Ministers of Securities Regulation (Council) issued its 2009 Progress Report yesterday outlining the various regulatory activities undertaken last year across Canadian jurisdictions. The issues considered in the Council's Progress Report include the federal transition to a single securities regulator, the upcoming changeover to IFRS and the introduction in various jurisdictions of harmonized securities transfer legislation.
The Progress Report also provides a preview of initiatives that the Council anticipates the CSA will undertake during the next year, namely, a new rule dealing with oversight of credit rating organizations, the development of a harmonized regulatory framework for derivatives, including OTC derivatives, hedge fund regulation and executive compensation requirements.
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On January 7, the New Brunswick Securities Commission (NBSC) published NBSC Notice 91-701 to respond to certain frequently asked questions on NBSC Local Rule 91-501 Derivatives (the Rule). As discussed in our previous update dated December 14, 2009, the Rule imposes registration and risk disclosure requirements in respect of trades in “derivatives” as defined in the Rule, other than trades among qualified parties.
The notice clarifies that a qualified party that engages in a derivatives transaction is responsible for determining whether the other party is also a qualified party. To do so, it may rely on factual statements made by the other party provided that it does not have reasonable grounds to believe that the statements are false. The qualified party is also responsible for determining whether the exemptions under the Rule are applicable based on the facts supplied by the other party and should retain all documentation relating to its determination.
The notice is somewhat ambiguous in response to the question of whether the Rule applies to principal protected notes (PPNs) and refers readers to CSA Staff Notices 46-303 and 46-304. In characterizing PPNs as investment products that offer an investor potential returns “based on the performance of an underlying investment”, it appears that NBSC staff is suggesting that they would fall within the definition of “derivative” under the Rule. However, the notice does clarify that the Rule does not apply to spot foreign exchange contracts and that the registration exemptions contained in the Rule may be relied on by insurance companies, loan and trust companies, investment dealers, portfolio managers, investment fund managers (and certain persons authorized to act as such or carry out similar functions), and certain registered individuals (all as referred to in paragraphs (d), (f). (j) and (k) of the definition of “qualified party”) when acting as agent or trustee for a fully-managed account.
The notice also provides a six-month transition period for financial sector participants having to implement new derivatives-related compliance measures, giving them until March 28, 2010 to phase in compliance obligations arising from the Rule.
On December 11, the U.S. House of Representatives approved comprehensive legislation intended to "modernize America's financial rules" in response to last year's market meltdown. The Wall Street Reform and Consumer Protection Act of 2009, which passed by a vote of 223-202, combines a number of legislative initiatives announced in the past year into a single piece of legislation numbering almost 1300 pages in length.
The bill includes provisions respecting (i) shareholder approval of executive compensation and golden parachutes; (ii) enhanced compensation structure reporting; (iii) the regulation of OTC derivatives and specifically the requirement that all standardized swap transactions between dealers and "major swap participants" be cleared and traded on an exchange or electronic platform; and (iv) the registration and regulation of advisers to private pools of capital.
There is no guarantee, however, that the bill will become law, as it must now go to the Senate for consideration.
On December 1, Susan Wolburgh Jenah, President and CEO of the Investment Industry Regulatory Organization of Canada (IIROC) spoke at the Compliance Legal Section's annual compliance conference in Toronto. Ms. Jenah discussed the initiatives undertaken by IIROC over the past year, including improving the quality and timeliness of IIROC guidance with a focus on new and complex products and also provided hints of things to expect over the course of the next year.
Specifically, Ms. Jenah discussed a number of initiatives currently being developed by IIROC, including:
- the Rulebook Re-write project (she identified the next step as being the submission of the revised rules to the IIROC Board for approval and their publication in tranches according to subject matter);
- revised complaint-handling rules;
- IIROC's Client Relationship Model for client-advisor relations; and
- a new rule to improve "transparency and fair pricing" for OTC traded securities.
The last three items were the subject of published proposals over the last year and, according to Ms. Jenah, are in various stages of development and consultation.
Saskatchewan securities division releases registration and prospectus exemption for qualified persons entering into OTC derivatives
The Saskatchewan Securities Act, 1988 (the Saskatchewan Act) includes within its definition of “security” a futures contract or option that is not an exchange contract. Given the wording of the definition, there has been uncertainty as to whether OTC forwards and other OTC derivatives transactions would fall within this category and consequently be subject to the registration and prospectus requirements of the Saskatchewan Act. The issue has now been addressed by the Saskatchewan Financial Services Commission, Securities Division. On November 26, 2009, it issued General Order 91-907 exempting over-the-counter (OTC) derivatives trading among qualified parties from the registration and prospectus requirements under the Saskatchewan Act. The Companion Policy to the General Order states that the Act's definition of "security" includes futures contracts and options that are not exchange contracts and, thus, parties that currently enter into futures contracts or options are subject to the registration and prospectus requirements of the Saskatchewan Act.
Citing the rationale that “qualified parties” are able to "determine for themselves, without assistance from a registrant or any mandated disclosure under the Saskatchewan Act, whether entering into an OTC derivative is appropriate in the circumstances", the General Order permits such parties to enter into OTC derivatives contracts without having to meet the prospectus and registration requirements of the Act. In making the order, the Securities Division cited similarities to Blanket Order 91-503 in Alberta and Blanket Order 91-501 in British Columbia. To rely on the exemptions provided under the order, both parties must be qualified parties. A party is entitled to rely on a representation from its counterparty as to its qualified party status as long as it has no reasonable grounds to believe that the representation is false. In light of the order it will now be appropriate to include a representation in ISDA Master Agreement schedules or other documentation that the parties are “qualified parties within the meaning of Saskatchewan Financial Services Commission General Order 91-907”.
The General Order is substantially similar to the British Columbia order adopted in 1999. Two key differences are, in Saskatchewan, (1) the additional condition that a person relying on the exemption in clause (p) of the order be an “accredited investor” and (2) the availability of an additional exemption for certain OTC derivatives where the OTC derivative is a contract for the production, purchase or sale of an agricultural commodity and each party to the contract is engaged in the production, purchase or sale of that commodity. The exemption in clause (p) is made available for those that deal in a commodity and enter into an OTC derivative where a material component of the underlying interest is, directly or indirectly, the commodity or a related, affecting or correlating commodity, security or variable and is intended to exempt OTC derivatives entered into for commercial hedging purposes.
The publication of the General Order in Saskatchewan follows a number of developments relating to the regulation of derivatives in Canada. These include a staff notice issued by the Ontario Securities Commission on the applicability of Ontario securities laws to contracts for differences or CFDs, foreign exchange contracts and similar OTC derivatives as well as the publication by the British Columbia Securities Commission of a Companion Policy to Blanket Order 91-502 to clarify circumstances in which a forex contract could be considered a “security” for BC securities law purposes.
Earlier, effective September 28, 2009, the New Brunswick Securities Commission also published Local Rule 91-501 Derivatives (the New Brunswick Rule). The New Brunswick rule was adopted in conjunction with amendments to the Securities Act (New Brunswick) that clarified the authority of the New Brunswick Securities Commission to regulate exchange contracts and amended the definition of “security” to include futures contracts or options that are not exchange contracts. The New Brunswick Rule applies to trades in derivatives, which term is defined in the rule to include exchange contracts, options, swaps and futures contracts that are not exchange contracts and other contracts determined by the New Brunswick Securities Commission to be derivatives. Notably, the rule also lists specific types of instruments that are excluded from this definition, including certain types of insurance or annuity contracts, conventional convertible securities, asset-backed securities, strip bonds and others. The rule exempts trades in derivatives from certain provisions of the securities legislation (including prospectus and continuous disclosure requirements) and imposes registration and risk disclosure requirements in respect of such trades, other than trades among qualified parties. The New Brunswick Rule also imposes a recognition requirement upon regulated entities, such as exchanges and alternative trading systems, that trade in derivatives.
The Ontario Securities Commission today published a request for comments regarding the draft Statement of Priorities for its fiscal year ending March 31, 2011. The document sets out the OSC's goals for the year and identifies key regulatory priorities. Specifically, the Commission has identified the following goals: (i) identifying the important issues and dealing with them in a timely way; (ii) delivering fair, vigorous and timely enforcement and compliance programs; (iii) championing investor protection, especially for retail investors; and (iv) supporting and promoting a more flexible, efficient and accountable organization.
Further, the OSC's key regulatory priorities for 2010-11 include: (i) deepening its focus on investor protection; (ii) responding to market developments (iii) addressing the adequacy of regulatory coverage; (iv) maintaining a strong and visible enforcement presence; and (v) improving the way the Commission works. Of particular interest may be the OSC's comments regarding the adequacy of regulatory coverage. On this point, the OSC identified its intention to address:
- the risks related to products and the distribution of securities in the exempt market;
- the regulatory framework for trading OTC derivatives;
- regulatory requirements applicable to non-conventional investment funds; and
- the appropriate regulation of credit rating agencies.
The OSC is accepting written submissions until February 15, 2010.
The British Columbia Securities Commission today published a Companion Policy to Blanket Order 91-502 Short Term Foreign Exchange Transactions to clarify when a foreign exchange contract may be considered a "security" for the purposes of the British Columbia Securities Act.
The Companion Policy states that under s. 1(1) of the Securities Act, the following three components of the definition of “security” could describe a forex contract:
(a) a document, instrument or writing commonly known as a security;
(l) an investment contract;
(n) an instrument that is a futures contract or an option but is not an exchange contract.
The Blanket Order states that a contract or other obligation to purchase or sell the currency of any jurisdiction, where the terms of the transaction require settlement not later than three business days after the entering into of the transaction, is not a futures contract, provided that the contract or obligation is not otherwise a security under the Securities Act. The purpose of the Companion Policy is to clarify that the Blanket Order is limited to determining when a foreign exchange contract is not a futures contract. A forex contract may still be a “security” if it falls under any of the other relevant branches of the definition.
In this respect, the Companion Policy cites three decisions of the B.C. Securities Commission where the Commission concluded that a forex contract was an “investment contract” and, therefore, a security. The Companion Policy thus clarifies that in determining whether a forex contract is a security, the Blanket Order cannot be relied upon in a vacuum. Whether another part of the definition of security applies to the relevant contract must also be considered, even when settlement is required within three business days by the terms of the transaction. The Companion Policy notes that the Blanket Order is also designed to provide relief from registration and prospectus requirements for those managing currency risk in their business operations and is not meant to provide registration relief for other investors.
On October 30, the British Columbia Securities Commission (BCSC) announced amended conditions of registration for investment dealers that maintain an office in British Columbia and trade in U.S. OTC markets, and who have not filed a prescribed form of undertaking. Specifically, the BCSC has clarifed certain aspects of the previous obligations, amended Form B (reporting of OTC trading commissions) and revised language to reflect National Instrument 31-103 Registration Requirements. Of particular note, the conditions now specify who can act as a designated individual, as IIROC has removed that definition from its Dealer Member Rules. Like their previous incarnation, the conditions of registration include the effective management of risks and monitoring, recordingkeeping and reporting requirements. An interpretation note was also published to explain how the BCSC interprets the conditions. The amended obligations are effective immediately and are set to expire on December 31, 2011.
In response to numerous inquiries, the Ontario Securities Commission (OSC) issued a notice today outlining the OSC Staff's view on the applicability of securities laws to offerings of Contracts for Difference (CFDs), foreign exchange contracts (FX contracts) and similar OTC derivative products. While the notice focuses on CFDs, the guidance is intended to apply generally to FX contracts and OTC derivatives as well.
Specifically, OSC Staff consider CFDs to be securities and, as such, CFD providers offering such products to Ontario investors must comply with registration and prospectus requirements of Ontario securities law absent statutory exemptions or exemptive relief. The notice states, however, that as the prospectus requirement may not be well-suited for certain types of OTC derivative products, OSC staff "may be prepared to recommend relief" from the prospectus requirement under certain situations. The circumstances under which an exemption may be provided are discussed in the notice and an example of such an exemption was provided last week.
The notice is intended to provide interim guidance until such time that a harmonized approach to the regulation of OTC derivatives is developed by the Canadian Securities Administrators and/or Ontario introduces derivatives legislation.
OSC grants relief allowing international dealer to distribute CFDs via an IIROC member affiliate without filing prospectus
On October 16th, the Ontario Securities Commission (OSC) granted relief on an application by CMC Markets U.K. and its Canadian affiliate allowing CMC Canada to distribute contracts for difference and foreign exchange contracts (collectively, CFDs) to Ontario investors without having to file a prospectus. CFDs are derivative products that "allow clients to obtain exposure to markets and instruments that may not be available directly, or may not be available in a cost-effective manner."
In granting the relief, the OSC stated that the requested relief would "substantially harmonize the Commission's position on the offering of CFDs to investors in Ontario with how those products are offered to investors in Quebec" under the Derivatives Act (Quebec). Under the QDA, such products may be offered through the distribution of a standardized risk disclosure document rather than a prospectus. The OSC noted that it had previously recognized that similar disclosure may be better suited for such products than a prospectus.
Thus, the requested relief was granted provided that, among other things, CMC U.K. remains registered with the U.K. Financial Services Authority, CMC Canada maintains its registration as an investment dealer with the OSC and as a member of Investment Industry Regulatory Organization of Canada and all distributions are conducted pursuant to the rules of the QDA and the Autorité des marchés financiers.
The relief is valid for the earliest of four years, the suspension of the ability of the applicants to offer CFDs in the U.K. or Quebec and the coming into force in Ontario of legislation regarding the distribution of OTC derivatives.
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Specifically, the draft legislation requires that standardized OTC derivatives be centrally cleared by a securities or derivatives clearing organization, while encouraging the use of such standardized derivatives through higher capital and margin requirements for non-standardized derivatives. Financial regulatory agencies will have access on a confidential basis to OTC derivative transactions, while aggregated data on open positions and trading volumes will be available to the public. Meanwhile, federal banking agencies, the Commodity Futures Trading Commission and Securities and Exchange Commission will supervise and regulate OTC derivative dealers and major market participants. The Treasury Department hopes to have the reforms passed by the end of the year.
Recent rulemaking across Canada and proposed rules in Quebec (if adopted) will have a significant impact on the cross-border trading activities of non-Canadian dealers, advisers, futures commission merchants (FCMs) and commodity-trading advisers (CTAs) with respect to commodity futures contracts and commodity futures options (futures) as well as security options.
On July 17, 2009, the Canadian Securities Administrators (CSA) published their final proposal for National Instrument 31-103 - Registration Requirements and Exemptions (31-103). Subject to governmental and other local approval requirements, 31-103 will come into force on September 28, 2009 (the Implementation Date). While the regulation of futures activities was not the focus of 31-103, the new securities registration rules will have some impact on the regulation of futures activities in Canada. For further information and a complete breakdown of the new regime, please refer to Stikeman Elliott’s Registration Reform in Canada: The Finish Line is Here.
The pending adoption of 31-103 in Quebec can be expected to accelerate the implementation of rules under the Quebec Derivatives Act (QDA), which came into force in Quebec on February 1, 2009 and governs trading and advisory activities relating to all forms of derivatives. On July 31, 2009, as part of this implementation process, the Autorité des marchés financiers (AMF), Quebec’s financial services regulator, published a proposed Regulation to amend the Derivatives Regulation (the Proposed Quebec Regulation). The Proposed Quebec Regulation incorporates by reference various registration-related instruments and material provisions of 31-103 and would (if adopted) introduce an important registration exemption for non-Quebec dealers and advisers in exchange-traded derivatives offered primarily outside Quebec, provided they limit their activities to “accredited counterparties” (as defined in the QDA).
Unfortunately, the regulation of futures and security options across all Canadian jurisdictions has not undergone a process of streamlining and harmonization similar to Canadian securities legislation, and remains very fragmented. Consequently, the rules regarding the futures and security options activities of non-Canadian FCMs and CTAs in Canada vary significantly by province and territory.
National Instrument 31-103
31-103 is intended to harmonize, streamline and modernize registration requirements and exemptions for dealers, advisers and investment fund managers across all Canadian provinces and territories (jurisdictions) with respect to securities. It regulates the registration of firms and individuals and consolidates requirements for registration, including proficiency, solvency and insurance requirements, as well as ongoing compliance requirements for registrants. These include requirements with respect to financial reporting, know-your-client, suitability, client disclosure, safekeeping of assets, recordkeeping, account activity reporting, complaint handling and other compliance procedures. The CSA note that, to create flexible regulation, 31-103 combines principles, supported by guidance in a Companion Policy, with prescriptive elements where considered appropriate.
31-103 represents a major overhaul of the current securities registration regime and has significant implications for non-Canadian FCMs, dealers, CTAs, advisers and investment fund managers currently doing business on a registered or exempt basis in any jurisdiction of Canada.
However, 31-103 does not harmonize, streamline or modernize registration requirements and exemptions across Canada with respect to futures and security options. The CSA stated during the comment process that the regulation of futures was beyond the scope of 31-103. However, because futures and security options are regulated in some jurisdictions as securities, 31-103 will be relevant in those jurisdictions but not others.
A key development under 31-103 is the creation of an “international dealer exemption” and an “international adviser exemption” for trading with or advising “permitted clients” (including, specified institutional clients, entities with net assets of more than C$25,000,000 and individuals with net financial assets before taxes of more than C$5,000,000). The international dealer exemption is available for dealers registered in their home jurisdiction and is limited to dealing in non-Canadian securities and certain Canadian debt securities. The international adviser exemption is available to advisers that are registered or exempt in their home jurisdiction and is limited to advising on non-Canadian securities and to a very limited extent in Canadian securities where the advice on Canadian securities is incidental to the provision of advice on non-Canadian securities (for example, advising on a global portfolio with a small Canadian allocation). Reliance on these exemptions requires the prior filing of agent-for-service-of-process forms in each jurisdiction where the exemption is proposed to be relied on, along with the delivery of mandated client disclosure notices and compliance with annual filing requirements.
Three different regimes for the regulation of futures
After the implementation of 31-103, there will continue to be three regimes governing the regulation of futures and security options in Canada and the applicable regime will depend on the Canadian jurisdiction in which an FCM or CTA is doing business. The rules vary significantly depending on the applicable regime. In the first regime, futures and security options fall within the definition of a “security” and thus are regulated in the same manner as securities. In the second regime, futures are governed by separate futures or derivatives legislation while security options are regulated under securities legislation. In the third regime, futures and options are governed by securities legislation but subject to separate treatment under the definition of “exchange contracts” in the securities legislation. Each of these regimes and where they are applicable is discussed below.
In Nova Scotia, Prince Edward Island, Newfoundland, Yukon Territory, Northwest Territories and Nunavut, futures and security options fall within the definition of “security” under applicable securities legislation. Consequently, under 31-103 FCMs that are registered and CTAs that are registered or exempt in their home jurisdiction may rely on the “international dealer exemption” and “international adviser exemption” provided that the conditions of those exemptions are met (see above).
This represents a significant change, since prior to 31-103 FCMs that were not registered in these jurisdictions could deal on an exempt basis with “accredited investors” in Canadian or non-Canadian futures, security options and securities. Under the 31-103 international dealer exemption, FCMs are limited to dealing with “permitted clients” in non-Canadian futures, security options and securities. Because of the transition rules, FCMs should review their current client base and determine the appropriate time to make the required filings in order to rely on the international dealer exemption.
For CTAs, the new 31-103 international adviser exemption is an improvement, as previously there was no exemption for CTAs for advising on non-Canadian futures, security options and securities in these provinces and territories. The required international adviser exemption filings would need to be made prior to relying on this new exemption.
Separate futures or derivatives statutes
In Ontario, Manitoba and Quebec, trading in and advising with respect to investing in futures are regulated under the Commodity Futures Acts in Ontario and Manitoba and the QDA in Quebec. These statutes include FCM and CTA registration requirements and exemptions from such requirements, which are not affected by the new securities registration regime established under 31-103.
In Ontario, FCMs may continue to rely upon statutory exemptions under the Commodity Futures Act (Ontario) (Ontario CFA) such as the “hedger” exemption and the “unsolicited” trade exemption to trade with, or on behalf of, Ontario resident clients. Under the Ontario CFA, there are no exemptions from the adviser registration requirement and thus CTAs would be required to be registered. However, the Ontario Securities Commission (OSC) has recently granted discretionary relief to several firms that are registered to trade securities as “international dealers” in Ontario, allowing them to also trade futures with “designated institutions.” We would expect that the OSC will continue to be willing to grant similar exemptions to firms based on the requirements of the 31-103 international dealer exemption; however, this remains to be determined. Firms that have previously received this type of exemption may continue to rely upon such relief. In Ontario, security options fall within the definition of "security" and therefore, after the Implementation Date, non-Canadian firms may rely on the “international dealer exemption” and the “international adviser exemption” to trade or advise “permitted clients” in Ontario with respect to security options. Transition issues under 31-103 will need to be considered prior to making the filings to rely on these exemptions.
In Manitoba, there are no available statutory exemptions for trading or advising with respect to futures. A firm that wishes to trade in or advise on futures with clients residing in Manitoba would have to seek discretionary relief. Security options will continue to be covered by the definition of “security” under Manitoba securities legislation and thus, after the Implementation Date, non-Canadian firms may rely on the international dealer exemption and the international adviser exemption to trade and advise “permitted clients” in Manitoba with respect to security options. Again, transition issues under 31-103 will need to be considered.
In Quebec, the recently enacted QDA regulates futures and security options, as well as other types of derivatives. Under the Proposed Quebec Regulation, the AMF is proposing registration relief for persons “authorized to act as a dealer or adviser or authorized to exercise similar functions in a jurisdiction outside Quebec where its head office or principal place of business is located” in relation to activities involving exchange-traded derivatives (futures and security options) offered primarily outside Quebec with “accredited counterparties” only. However, the exemption contemplates registration relief only, and does not provide any exemption from the derivatives qualification and approval requirements governing the creation and marketing of derivatives in Quebec. It does not specifically exempt non-Quebec market participants from other ongoing compliance requirements applicable to “dealers” and “advisers” under the QDA, as does the OTC derivatives exemption. Consequently, the precise scope of this exemption is not yet entirely clear. For additional information, please refer to Stikeman Elliott’s newsletter, released earlier this month, regarding Proposed Quebec Derivatives Regulation.
Securities statutes with definition of “exchange contracts”
In Alberta, British Columbia, New Brunswick (after the Implementation Date) and Saskatchewan, trading and advising in “exchange contracts” (standardized exchange-traded futures and security options) are regulated under the Securities Acts in those provinces. However, in these provinces, the registration requirements and exemptions applicable to exchange contracts are different from those applicable to securities. Exchange contracts are expressly excluded in these four jurisdictions from the international dealer exemption and the international adviser registration exemption under 31-103, with the result that dealers or advisers relying on those exemptions for their securities-related activities in any of these jurisdictions could not rely on the exemptions for trading or advising activity in respect of exchange contracts. In Alberta, British Columbia and New Brunswick but not Saskatchewan, 31-103 provides two limited dealer-registration exemptions for trading in exchange contracts. The first exemption is for a trade made solely through an agent who is a registered dealer, if the dealer is registered in a category that permits the trade. The second is an exemption for an unsolicited order placed with an individual who is not a resident of, and does not carry on business in, the local jurisdiction. However, the scope and practical application of the latter exemption is very limited due to the definition of “individual” (i.e. natural person) and existing commentary from the regulators, which suggests that this exemption may only be relied upon for one trade.
Some non-Canadian firms have applied for and received discretionary relief in both British Columbia and Alberta in order to trade exchange contracts with certain investors. In British Columbia, the discretionary relief permits non-Canadian firms to trade in non-Canadian exchange contracts with “accredited investors.” In Alberta, the discretionary relief permits non-Canadian firms to trade in non-Canadian exchange contracts with “qualified parties.” This relief will continue to apply in British Columbia and Alberta after the Implementation Date.
Montreal Exchange and ICE Futures Canada
The Montreal Exchange (MX) permits non-Canadian firms to apply for foreign approved-participant (FAP) status, which provides these firms with direct access to the MX, including the Montreal Climate Exchange (MCEX). In addition, many non-Canadian firms have access to ICE Futures Canada (ICE Canada). Firms that are FAPs or have access to ICE Canada should review their current status and trading activities to determine the impact of these new rules on such activities.
Canadian activities chart
For a summary of the basic permitted activities and exemptions in the Canadian provinces and territories for non-Canadian firms trading in or advising on futures and security options, please refer to our Canadian Securities/Futures Activities Chart.
Amendments to the Quebec Derivatives Regulation announced - Proposed exemption for exchange-traded derivatives offered primarily outside Quebec
Comment period open until August 31, 2009
On July 17, 2009, the Canadian Securities Administrators (the CSA) published their final proposal for National Instrument 31-103 - Registration Requirements and Exemptions (31-103). Subject to governmental and other local approval requirements, 31-103 will come into force on September 28, 2009 (the Implementation Date). The adoption of 31-103 in Quebec can be expected to accelerate the further implementation of the Quebec Derivatives Act (QDA) which came into force in Quebec on February 1, 2009 and governs trading and advisory activities relating to all forms of derivatives.
On July 31, 2009, as part of this implementation process, the Autorité des marchés financiers (AMF), Quebec’s financial services regulator, published a proposed Regulation to amend the Derivatives Regulation (the Proposed Regulation). The Proposed Regulation incorporates by reference various registration-related instruments and material provisions of 31-103 and sets out an important registration exemption for non-Quebec dealers and advisers in exchange-traded derivatives offered primarily outside Quebec provided they limit their activities to “accredited counterparties”.
The draft instrument is open for comment until August 31, 2009 and is scheduled to come into force on the Implementation Date, subject to ministerial approval following the end of the 30-day comment period.
Key Requirements of the QDA
The QDA imposes a requirement to register as a derivatives dealer or adviser for any person that engages in those activities in Quebec. The QDA also sets out a recognition requirement for “regulated entities” (including exchanges, alternative trading systems not registered as derivatives dealers or other published markets, clearing houses, information processors and self-regulatory organizations) that carry on derivatives activities in Quebec. The QDA further requires that any person other than a “recognized regulated entity” that seeks to “create or market” a derivative must be qualified by the AMF (the derivatives qualification requirement) and that the derivative must be approved by the AMF (the derivatives approval requirement). The QDA also contains rules for the purposes of determining whether so-called “hybrid products” are to be regulated as derivatives under the QDA or as securities under Quebec securities legislation.
The OTC Derivatives Exemption - By way of background, section 7 of the QDA sets out an important blanket exemption for OTC derivatives “involving accredited counterparties only or in any other cases specified by regulation” from the application of certain specified provisions, including the derivatives dealer and adviser registration requirements, the derivatives qualification and approval requirements, and certain limited procedural and enforcement-related provisions, except in the case of market manipulation and fraud (the OTC Derivatives Exemption). The list of “accredited counterparties” includes most of the leading Quebec institutional investors, as well as accredited persons meeting certain subjective (knowledge and experience) and objective (minimum financial assets) tests and qualified “hedgers”.
Exchange-Traded Derivatives - As noted in our previous updates, the QDA does not currently contain any exemption for exchange-traded derivatives activities that is equivalent to the OTC Derivatives Exemption. With the coming into force of the QDA on February 1, 2009, this marked a significant departure from the existing “accredited investor” exemptions under Quebec securities legislation on the basis of which many Canadian, U.S. and other foreign dealers had historically engaged in exchange-traded derivatives activities outside of Quebec for Quebec-resident institutional investors.
The AMF Blanket Decision – In the interim, the AMF had responded to the above concerns in part by issuing a blanket decision on January 22, 2009 (the AMF Blanket Decision) that sets out a temporary exemption from the derivatives dealer and adviser registration requirements and the derivatives qualification rules under the QDA for specified derivatives activities carried out solely with accredited investors as defined under the soon to be revised National Instrument 45-106 Prospectus and Registration Exemptions (45-106) (see Registration Reform – Quebec’s Derivatives Act) The AMF has not indicated for how long the AMF Blanket Decision will remain in effect.).
The Proposed Exchange-Traded Derivatives Exemption for Non-Quebec Derivatives Dealers and Advisers
Overview of the Proposed Exemption - Under the Proposed Regulation, the AMF is proposing more general and permanent registration relief for activities in relation to exchange-traded derivatives offered primarily outside Quebec with “accredited counterparties” only.
Specifically, the Proposed Regulation provides that “a person authorized to act as a dealer or adviser or authorized to exercise similar functions under legislation applicable in a jurisdiction outside Québec where its head office or principal place of business is located is exempt from the registration requirement to the extent it carries on business solely for an accredited counterparty and its activity involves a standardized derivative that is offered primarily outside Québec” (the Proposed Exchange-Traded Derivatives Exemption). A “standardized derivative” is defined under the QDA as “a derivative that is traded on a published market, whose intrinsic characteristics are determined by that market and whose trade is cleared and settled by a clearing house.”
The proposed exemption is essentially the exchange-traded derivatives equivalent of the OTC Derivatives Exemption but is significantly more limited in its scope. In particular, the exemption contemplates registration relief only. It does not provide any exemption from the derivatives qualification and approval requirements governing the creation and marketing of derivatives in Quebec, and it does not specifically exempt non-Quebec market participants from other ongoing compliance requirements applicable to “dealers” and “advisers” under the QDA as does the OTC Derivatives Exemption.
No Clear Exemption from Ongoing Requirements Applicable to Dealers and Advisers -The OTC Derivatives Exemption provides a clear exemption from the application of the provisions of the QDA governing the business operations and client relationships of dealers and advisers under the QDA. In the absence of an equivalent carve-out, non-Quebec market participants relying on the Proposed Exchange-Traded Derivatives Exemption, on the other hand, will remain technically subject to these provisions. The relevant provisions, include, for example, the requirement to deliver to a client the risk information document prescribed by regulation and the requirement to provide to the client, prior to recommending or executing any trade, “(1) information the client ordinarily needs for the purposes of their business relationship; (2) information required to make an informed decision and give clear trade instructions; and (3) information on the margin requirements to which the trade is subject and on the consequences of the client failing to meet those requirements when called to do so.” The QDA further requires that any document required to be communicated to a client under the QDA be provided in both English and French or in French only.
Qualification of “Accredited Counterparties” -Non-Quebec FCMs and CTMs seeking to rely on the proposed exemption will have to qualify their clients and prospects as ”accredited counterparties” in much the same way as the OTC industry has done during the six-month phase-in period for compliance with the QDA. The proposal does not, however, provide an equivalent transition period to permit the qualification of existing clients for purposes of this exemption.
The AMF previously published a Policy Statement Respecting Accredited Counterparties. The policy statement was drafted in connection with the OTC Derivatives Exemption but may be helpful for purposes of relying on the Proposed Exchange-Traded Derivatives Exemption. Market participants seeking to rely on the proposed exemption should obtain representations from Quebec-resident clients and prospects as to their specific status as an “accredited counterparty” and consider appropriate amendments to their contractual documentation.
As certain categories of “accredited counterparties” involve factual determinations which, in certain cases, cannot be independently verified, detailed representations will be required in such cases. In addition, in certain cases, reliance on the exemption may require enhanced due diligence to back up a market participant’s reasonable reliance on a client or prospect’s status as an “accredited counterparty”.
The Incorporation of the 31-103 and Other Registration-Related Provisions
The QDA is formulated as principles-based legislation and its key provisions cross-reference regulations which (for the most part) have yet to be published. The current Derivatives Regulation covers a limited range of matters, including the minimum asset requirement for self-certified “accredited counterparties”, the rules for self-certification of operating rules of “recognized regulated entities”, and the prescribed risk disclosure document to be delivered by derivatives dealers.
The Proposed Regulation addresses a number of outstanding procedural and substantive matters by incorporating by reference the provisions of National Instrument 31-102 National Registration Database and National Instrument 33-109 Registration Information (as amended in conjunction with the adoption of 31-103), as well as most provisions of 31-103 governing the registration of individual representatives, and the business operations and client relationships of registered portfolio managers and dealers.
These provisions will generally apply only to persons and entities registered as derivatives dealers and advisers under the QDA and include initial and ongoing proficiency requirements for advising representatives, associate advising representatives and chief compliance officers of registered derivatives advisers, requirements governing internal control systems (including the implementation of compliance systems and the designation of an “ultimate designated person” and a “chief compliance officer”), restricted business practices, requirements governing the acquisition of a registrant’s securities or assets, working capital requirements, insurance and financial reporting requirements, provisions governing registrant relationships with clients (including with respect to the management and disclosure of conflicts of interest, referral arrangements, complaint handling and dispute resolution procedures), relationship disclosure, safekeeping of account assets, and the prohibition on registrants lending money, extending credit or providing margin to clients.
As noted above, in the absence of a clear exemption from these requirements under the Proposed Exchange-Traded Derivatives Exemption, a number of these requirements may technically apply to non-Quebec market participants seeking to rely on the exemption in connection with their activities with “accredited counterparties”.
The Proposed Regulation also cross references a very limited number of registration exemptions under 31-103, including the so-called “client mobility exemption” (which would allow a registered firm and representative to continue to deal with a small number of clients who move to another Canadian jurisdiction without the need to register in that other jurisdiction) and the adviser registration exemption for “general advice” not purporting to be tailored to the needs of the particular recipient of the advice.
The Proposed Regulation also sets out the new registration categories for representatives of derivatives dealers and advisers registered under the QDA, the proficiency requirements for registered representatives of derivatives advisers, the registration requirements and responsibilities of the “ultimate designated person” and the “chief compliance officer” designated by QDA registrants and provisions governing the suspension and revocation of registration under the QDA.
Market participants who wish to comment on any aspect of the Proposed Regulation should submit their comments to the AMF no later than August 31, 2009.
 The term “derivative” is defined under the QDA as “an option, a swap, a futures contract or any other contract or instrument whose market price, value, or delivery or payment obligations are derived from, referenced to or based on an underlying interest, or any other contract or instrument designated by regulation or considered equivalent to a derivative on the basis of criteria determined by regulation”. A “standardized derivative” would include listed futures, options on futures and equity options.
The AMF has not yet clarified that OTC derivatives such as Credit Default Swaps which, as a result of recent technological developments in the infrastructure for trading OTC derivatives and legislative proposals in the United States and in other jurisdictions, may be traded on automated trading platforms or become subject to mandatory clearing by a central counterparty, should not be re-characterized as “standardized derivatives”. The Alberta Securities Commission addressed this issue last year in restating Blanket Order 91-503 Over-The-Counter Derivatives Transactions and Commodity Contracts (April 11, 2008) to include an option, forward contract, contract for differences or other instrument of a type commonly considered to be a derivative, or any combination of any of them, if the agreement is cleared through an acceptable clearing corporation. See Alberta Issues New OTC Derivatives Blanket Order (April 29, 2008).
|Secretary Geithner speaking in February|
Photo Courtesy of
Chairman Schapiro noted that while transactions involving OTC derivatives can replicate the economics of securities transactions without involving the purchase or sale of actual securities, such transactions currently fall outside the umbrella of federal securities laws. As such, Chairman Schapiro discussed a "functional and sensible approach to regulation", in which the SEC would have primary responsibility for securities-related OTC derivatives, while the responsibility for all other derivatives, including those related to such things as commodities, energy and foreign exchange would rest with the Commodity Futures Trading Commission. Citing the close relationship between the securities markets and securities-related OTC derivatives, Chairman Schapiro emphasized the importance of ensuring that such OTC derivatives be "subject to the federal securities laws so that the risk of arbitrage and manipulation of interconnected markets is minimized." Subjecting securities-related OTC derivatives to federal securities laws would also provide a unified and consistent framework for securities regulation.
For the testimony of the other witnesses that appeared before the Subcommittee, click here.
On May 22, 2009, the Investment Industry Regulatory Organization of Canada (IIROC) released proposed amendments to Dealer Member Rule 1300.1, regarding the trading in securities of U.S. over-the-counter (OTC) issuers. Under the proposed amendments, Dealer Members would not be permitted to accept an order to sell OTC issuer securities until the dealer had "made the inquiries necessary to form a reasonable belief" that it knew the "true identity of every beneficial owner of those securities". In cases where the beneficial owner is not a natural person, the dealer would have to form a reasonable belief as to the identity of every natural person who controls the beneficial owner. Exemptions to this requirement would be permitted for American Depository Receipts and for any OTC securities for which the issuer has a class of securities listed or quoted on the TSX, TSXV, CNQ, NYSE, AMEX or NASDAQ and under certain circumstances, isolated trades.
The intention of the amendments is to "discourage abusive and illegal OTC market activity", which the notice stated has been a "source of scandal". IIROC cited the actions taken in British Columbia to prevent such abuse and the need to prevent such behaviour moving elsewhere within Canada. Comments on the proposed amendments are being accepted until July 21, 2009.
IIROC publishes proposals regarding fair pricing of OTC securities and trade confirmation disclosure requirements
The Investment Industry Regulatory Organization of Canada today published proposed amendments to the Dealer Member Rules with respect to fair and reasonable pricing of over-the-counter traded securities (including fixed income securities) and trade confirmation disclosure requirements. The fair pricing proposal would cover OTC transactions for retail and institutional clients and require that Dealer Members “make a reasonable effort to obtain a price for the customer that is fair and reasonable in relation to prevailing market conditions.” The proposed rule also considers issues respecting mark-ups and mark-downs in the case of principal transactions and commissions or service charges in the case of agency transactions. A draft Guidance Note on the OTC proposal was also published.
The proposed amendments would also require disclosure of the yield to maturity for fixed income securities on trade confirmations as well as a remuneration statement on all OTC transactions for retail clients “where the amount of the mark-up or mark-down, commissions and other service charges” has not been disclosed.
IIROC is accepting comments on the proposals until July 16, 2009.
First Policy Statements Published
As a follow-up to the recent announcement by the Quebec Government on the coming into force of the new Derivatives Act (the “QDA” or “Act”) on February 1, 2009, the Autorité des marchés financiers (the “AMF”, Quebec’s financial services regulator) issued a press release on January 26, 2009 to announce a series of important transitional measures. The coming-into-force documents published by the AMF also include three policy statements relating to the definition of “accredited counterparties”, the characterization of “hybrid instruments” and self-certification of rules made by “recognized regulated entities”.
The QDA is the first comprehensive standalone derivatives legislation to be adopted in Canada. The Act regulates both over-the-counter (OTC) and exchange-traded derivatives, subject to certain carve outs for OTC derivatives activities involving “accredited counterparties” (the “OTC Derivatives Exemption”) and in other cases to be specified by regulation.
Noting that the QDA is principles-based legislation, the AMF commented in its press release that the legislation “specifies obligations of results and transfers the responsibility for establishing the most effective means of assuming such obligations to market participants and other regulated entities”. Exactly what standard is implied by this reference to “obligations of results” in the context of these principles-based rules is not yet clear.
Key transitional measures
The key transitional measures announced by the AMF in the coming-into-force package include the following:
- A blanket decision (the “Blanket Decision”) that sets out a temporary exemption from the derivatives dealer and adviser registration requirements and the derivatives qualification rules under the QDA for specified derivatives activities carried out solely with “accredited investors” as defined under National Instrument 45-106 Prospectus and Registration Exemptions (NI 45-106), subject to certain conditions, as more fully discussed below.
- A six-month window (to August 1, 2009) to enable financial sector participants to phase in the implementation of derivatives-related compliance measures to address new requirements under the QDA. In particular, this window will enable participants in the OTC derivatives industry to qualify current OTC counterparties as “accredited counterparties” for new transactions (and, depending on the terms, potentially for re-couponing), obtain appropriate counterparty representations and make the required amendments to ISDA and other documentation.
- The postponement of the coming into force of provisions dealing with derivatives dealer and adviser registration categories and procedures. This measure will permit the QDA to incorporate the registration rules under proposed National Instrument 31-103 Registration Requirements (Proposed NI 31-103) expected to be adopted later this year. A complete analysis of Proposed NI 31-103 is available on our Registration Reform information page.
- The postponement of the coming into force of provisions dealing with the prior authorization of derivatives offered by persons other than “recognized regulated entities” that are subject to the qualification procedure to “create or market” derivatives. The stated intention of this measure is to “permit the [Canadian Securities Administrators] to complete harmonization initiatives with respect to derivatives offered to the public”.
The Blanket Decision
Significantly, the QDA does not contain any exemption for exchange-traded derivatives activities equivalent to the OTC Derivatives Exemption or the “international dealer” and “international adviser” exemptions under Proposed NI 31-103. This is a significant departure from the existing “accredited investor” exemptions under Quebec securities legislation on the basis of which many Canadian, U.S. and other foreign dealers have historically engaged in exchange-traded derivatives activities outside of Quebec for Quebec-resident institutional investors.
The AMF has responded to these concerns in part by issuing the Blanket Decision for an unspecified temporary period. The Blanket Decision provides an exemption from the derivatives dealer and adviser registration requirements and the derivatives qualification rules under theQDA for specified derivatives activities. The exemption is subject to the following conditions:
- the derivatives activities must be carried out solely with “accredited investors” as defined under NI 45-106 and in accordance with the conditions set forth in that instrument (including the filing of a report under Part 6); and
- the activities must relate only to the following categories of derivatives (the “Specified Categories”) currently regulated under the Securities Act (Quebec):
- An option or a negotiable futures contract pertaining to securities, or a Treasury bond futures contract;
- An option on a commodity futures contract or financial instrument futures contract;
- Commodities futures contracts, financial futures contracts, currencies futures contracts and stock indices futures contracts.
The coming-into-force package includes ancillary statements that would appear to imply that the relief under the Blanket Decision is restricted to OTC derivatives. There is in fact no such restriction in the decision and we understand that the decision is intended to cover both OTC and exchange-traded derivatives of a type covered by the Specified Categories. All other derivatives are subject to the QDA. Industry participants that engage in trading or advisory activities in Quebec not covered by the transitional relief described above will have to apply for specific exemptive relief.
Recognition of “regulated entities”
The QDA also governs the activities of so-called “regulated entities”, which are defined under the Act to include exchanges, alternative trading systems (not registered as derivatives dealers) or other published markets, clearing houses, information processors and self-regulatory organizations (SROs). The QDA provides that “no regulated entity may carry on derivatives activities in Québec” unless it is recognized by the AMF. Under the QDA, recognized regulated entities are subject to various requirements covering their operating rules, activities, governance practices, information disclosure and the filing with the AMF of annual audited financial information. Certain types of regulated entities previously recognized by the AMF under securities legislation are partially grandfathered under the QDA. The AMF has not issued any guidance on what will constitute derivatives-related “activities in Québec” for purposes of these rules. This is an important jurisdictional issue for U.S. and international exchanges, ATSs, clearing organizations, information processors and SROs, etc.
Three policy statements published
The coming-into-force package also includes three policy statements issued by the AMF:
- The Policy Statement respecting Accredited Counterparties provides certain guidance on the definition of “accredited counterparties” as applied to financial institutions and the accreditation of certain counterparties.
The statement specifies that the status of a counterparty as an “accredited counterparty” is to be determined “at the time a derivative is entered into” and that “a counterparty is not required to ensure that the other counterparty continues to be accredited during the life of the derivative”. Since the availability of the OTC Derivatives Exemption is conditioned on the requirement that the OTC derivative involve “accredited counterparties only”, the statement notes that an accredited counterparty is “responsible for determining whether the other party is also accredited”. In doing so, “a counterparty may rely on the factual statements made by the other party provided that it does not have reasonable grounds to believe that such statements are false. However, the counterparty is nonetheless responsible for determining whether, on the basis of the facts, the exemption is applicable.” The statement further requires that counterparties keep a documentary record sufficient to establish that they properly relied on the exemption.
Counterparties to OTC derivatives involving at least one Quebec-resident counterparty should, therefore, give and obtain reciprocal representations as to their respective status as “accredited counterparties” and consider appropriate amendments to their contractual documentation. As certain categories of “accredited counterparties” involve factual determinations which, in certain cases, cannot be independently verified, detailed representations will be required in such cases. In addition, in certain cases, a counterparty will have to perform enhanced due diligence to back up its reasonable reliance on the other counterparty’s status as an “accredited counterparty”.
- The Policy Statement respecting Hybrid Products explains the characterization test under the QDA for “hybrid products” based on the basis of which an instrument that combines elements of both derivatives and securities may be presumed to be predominantly a security and not subject to the QDA. The statement also provides examples of hybrid products presumed to be securities, including certain types of principal protected notes and other structured notes.
- The Policy Statement respecting Self-Certification covers self-certification of operating rules made by recognized regulated entities.
As discussed in a previous post, the Expert Panel on Securities Regulation released its Final Report and Recommendations entitled “Creating an Advantage in Global Capital Markets” on January 12, 2009. The Expert Panel was established by the federal Minister of Finance to provide advice and recommendations on various areas of securities regulation. Its key recommendations include establishment of a single securities regulator to administer a national securities act, establishment of an independent adjudicative tribunal, advancing a more principles-based approach to securities regulation and modernizing Canada’s approach to the regulation of derivatives. Along with its Final Report the Expert Panel also published a draft national Securities Act to serve as a starting point for the development of national legislation to govern Canadian capital markets.
With respect to derivatives, the Expert Panel recommends adopting a common regulatory basis for the regulation of exchange-traded derivatives. Specifically, the Expert Panel has endorsed an approach similar to that taken by British Columbia and Alberta through provincial securities legislation and by Ontario through its Commodity Futures Act. Reflecting this recommendation, the draft national Securities Act provides for the regulation of exchange-traded derivatives by imposing registration requirements on those who trade in exchange contracts and by requiring that exchanges facilitating the trading and clearing of exchange contracts be recognized and their form of contract be accepted by the securities regulator. The Expert Panel also favours more regulatory oversight for over-the-counter (OTC) derivatives under the authority of a national securities regulator. However, it deferred making any specific recommendations on an appropriate regulatory approach, advocating instead that the national regulator have sufficient policy depth and resources to determine the best approach to the regulation of OTC derivatives working in conjunction with regulators in the United States and in other jurisdictions who are undertaking similar reviews of OTC regulation.
The Expert Panel recommends a voluntary approach for transitioning from thirteen separate regulators to a single, national regulator. Until all provinces and territories choose to participate in a common regulatory scheme, the Expert Panel recommends that the federal government consider a transition feature to allow some market participants to opt-in to exclusive regulation under the national regime.
No transitional relief issued to date
The Quebec Government has proclaimed the Derivatives Act (QDA) in force as of February 1, 2009. The Act had received royal assent on June 20 2008.
The QDA is the first comprehensive standalone derivatives legislation to be adopted in Canada. The Act regulates both over-the-counter (OTC) and exchange-traded derivatives, subject to certain carve outs for OTC derivatives activities involving “accredited counterparties” and in other cases to be specified by regulation. An earlier post regarding the adoption of the QDA can be found here.
Highlights of the QDA
Some of the highlights of the new legislation are noted below:
The QDA will regulate trading and advisory activities with respect to all forms of “derivatives” (broadly defined), including both “standardized derivatives” and OTC derivatives.
Section 7 of the QDA sets out an important blanket exemption for OTC derivatives “involving accredited counterparties only or in any other cases specified by regulation” from the application of certain specified provisions, including the dealer and adviser registration requirements, the derivatives qualification procedure and certain limited procedural and enforcement-related provisions, except with respect to market manipulation and fraud (the OTC Derivatives Exemption).
Significantly, the QDA does not contain any exemption for exchange-traded derivatives activities equivalent to the OTC Derivatives Exemption or the “international dealer” and “international adviser” exemptions under Proposed NI 31-103 Registration Requirements. This is a significant departure from the existing “accredited investor” exemptions under Quebec securities legislation on the basis of which many Canadian, U.S. and other foreign dealers have historically engaged in exchange-traded derivatives activities outside of Quebec for Quebec-resident institutional investors.
Since the QDA is formulated as principles-based legislation and its key provisions cross-reference regulations which (for the most part) have yet to be published, the enactment of the legislation will raise a number of significant compliance issues, particularly given the absence of any transitional relief.
The situation will be particularly problematic for US and other foreign FCMs and CTMs which have longstanding business with institutional clients in Quebec and have historically relied on the “accredited investor” exemption from the dealer and adviser registration requirement. The QDA sets out a fast-track registration mechanism for dealers and advisers registered under the Securities Act (Quebec). There are, however, no rules which would permit registration of foreign market participants or even Ontario limited market dealers.
Selected Key Issues
Key issues to consider include the following:
- The need for Canadian, U.S. and other market participants with derivatives activities in Quebec to review their product and service offerings into Quebec for compliance issues under the Act;
- The possible need to make consequential amendments to existing client agreements;
Exchange-traded Derivatives Activities
- The need for Quebec registered dealers and advisers to transition their registrations under the QDA to cover exchange-traded derivatives activities;
- In the case of previously exempt trading and advisory activity with qualified Quebec clients involving exchange traded futures and options, the urgent need to apply for discretionary relief under the QDA, failing which such activities may have to be discontinued;
- The possible need for exemptive relief to cover proprietary trading activities in exchange-traded derivatives, including proprietary activities of Quebec institutional investors on foreign derivatives exchanges and automated-trading systems;
- The possible need for exemptive relief for fully registered Quebec dealers with discount brokerage activities;
OTC Derivatives Activities
- The need for parties to OTC derivatives transactions between or including a Quebec counterparty, to amend their representations under applicable ISDA Master Agreements to include reciprocal representations as to their status as “accredited counterparties” under the QDA in order to rely on the OTC Derivatives Exemption;
- The need to obtain more detailed representations from certain types of counterparties recognized as “accredited counterparties” based on certain factual requirements of that definition (e.g., hedgers);
- The need for enhanced KYC (Know Your Client) and suitability verifications for certain categories of “accredited investors” (e.g., parties who can establish in a “conclusive and verifiable manner” that they meet the specified knowledge and experience test, the minimum asset test and a net asset test with respect to repayment and delivery obligations (the minimum threshold for this third test has not been specified under the Draft Derivatives Regulation (discussed below));
The Draft Derivatives Regulation covers a limited range of matters, including the minimum asset requirement for self-certified “accredited counterparties” (discussed above), the rules for self-certification of operating rules of “recognized regulated entities”, the rules for qualification of persons seeking to create or market derivatives in Quebec, and the prescribed information document to be delivered to by derivatives dealers. The AMF has not published a revised draft of these regulations addressing comments made by industry stakeholders last November. The AMF is expected to publish companion policies on certain specific interpretation issues.
Given the absence of transitional provisions, it is particularly critical that Canadian and foreign market participants immediately consider the impact of the QDA to identify potential jurisdictional, legal and operational issues that may be raised by this legislation with respect to their activities in Quebec.
On November 14, 2008, the President’s Working Group on Financial Markets (PWG) announced a number of initiatives intended to provide regulatory oversight and prudent management of the over-the-counter derivatives market in the U.S. These initiatives include the implementation of central counterparty services for credit default swaps and the signing of a Memorandum of Understanding between the Federal Reserve, SEC and the Commodity Futures Trading Commission with respect to information sharing and consultation regarding CDS central counterparties issues. The PWG also announced a set of policy objectives to “guide efforts to address challenges associated with OTC derivatives.”
In June, the BCSC imposed Conditions of Registration for B.C. investment dealers that trade in securities of over-the-counter (OTC) issuers through a B.C. office. Investment dealers that trade in American OTC markets must complete and file Form B, which records the information required under the conditions, within 30 days of the end of each calendar quarter.
The conditions expire on December 31, 2011.
IIROC has approved amendments to Dealer Member Rules 100.2, 100.2(j) – Interest Rate Swaps and 100.2(k) – Total Performance Swaps in order to clarify the margin requirements for swaps where the counterparty is a regulated entity. The amendments were approved by the IDA Board of Directors on December 12, 2007 and took effect September 8, 2008.
Important developments for Canadian and cross-border derivatives activities in the Québec market
Québec's new Derivatives Act (the Act) received royal assent on June 20, 2008 and will come into force on dates to be set by the Government. The Act will regulate both over-the-counter (OTC) and exchange-traded derivatives in standalone legislation, subject to certain carve outs for OTC derivatives activities involving "accredited counterparties" and in other cases to be specified by regulation.
Some of the highlights of the new legislation are noted below. Since the key provisions of the Act cross-reference regulations that have yet to be published, it is still too early to determine the exact scope and application of the Act and its potential impact on the various segments of the Canadian and cross-border derivatives market. It is expected that the Act and companion regulations (once published) will enter into force at the same time over the course of the next few months.
Bill 77, the legislative proposal to establish a new Derivatives Act, was tabled by the Québec Minister of Finance on April 9, 2008. Bill 77 followed the publication in August 2007 by the Autorité des marchés financiers (AMF), Québec's financial markets regulator, of a proposed framework for the regulation of the derivatives markets in Québec, which included drafts of the legislation, regulations and policy statements, as well as an earlier concept paper published in May 2006. The proposed framework and concept paper both attracted detailed comments by Canadian and foreign stakeholders in the industry.
As noted in our April 2008 Structured Finance Update, Québec Legislates in the Canadian Derivatives Market and Releases a New Derivatives Act, the driving factor underlying the fast-track adoption of this legislation is the Québec government's determination to stake Québec's position as the lead jurisdiction in the derivatives space in Canada. Québec's position is centered on the trading activities of the Montréal Exchange (MX) (the Canadian financial derivatives exchange) and the new Montréal Climate Exchange (MCeX)1.
Over the two-day period leading up to the adoption of the final legislation, the Québec government's Public Finance Commission (the Commission) held hearings with leading Québec stakeholders, which had been invited to provide oral comments on key aspects of the draft legislation. Given this timeframe, the Act does not differ materially from the draft of Bill 77, although certain technical amendments were adopted as part of the final legislation and the companion regulations may address various issues brought to the attention of the Commission.
Key Features of the Proposed Derivatives Act Regulation of both OTC and exchange-traded derivatives
The Act will regulate trading and advisory activities with respect to all forms of "derivatives", which is broadly defined, including both "standardized derivatives" and OTC derivatives. The proposed Act would define an "over-the-counter derivative" as "any derivative other than a standardized derivative" and a "standardized derivative" as "a derivative that is traded on a published market, whose intrinsic characteristics are determined by that market and whose trade is cleared and settled by a clearing house". This definition would include U.S. and other foreign listed futures and options.
Derivatives dealer and adviser registration requirements
The Act imposes a dealer registration requirement on any person who engages or purports to engage in (1) derivatives trading on the person's own behalf or on behalf of others; or (2) any act, advertisement, solicitation or conduct directly or indirectly in furtherance of an activity described in (1). Significantly, proprietary trading activities are subject to registration. The Act also imposes an adviser registration requirement on any person who engages or purports to engage in the business of advising others as to derivatives or the buying or selling of derivatives, or who is in the business of managing derivatives portfolios. A dealer or adviser registered under the Québec Securities Act that meets the conditions under the Act for registration to carry on business in derivatives and pays the prescribed fees would be deemed to be registered under the new Act. Existing Québec registrants could also transition their registration under the Act.
No exemption for exchange-traded derivatives activities involving accredited counterparties.
As discussed below, the Act provides for certain important exemptions for OTC derivatives activities involving "accredited counterparties", including an exemption from the dealer and adviser registration requirements under the act. Significantly, the Act does not contain any corresponding exemptions for exchange-traded derivatives activities. This is a significant departure from the existing "accredited investor" exemptions under Québec securities legislation on the basis of which many Canadian, U.S. and other foreign dealers have historically engaged in exchange-traded derivatives activities outside of Québec for Québec-resident institutional investors.
It is expected that the draft regulations will bridge the Act with proposed National Instrument 31-103 Registration Requirements (Proposed NI 33-103) of the Canadian Securities Administrators (CSA). Proposed NI 31-103 is an attempt by the CSA to streamline and harmonize securities dealer and adviser registration requirements across all jurisdictions2.
The regulations will have to address a number of open issues, including, for example, whether dealers that are not fully-registered "investment dealers" (e.g., "exempt market dealers") could also benefit from a deemed or short-form registration procedure, whether the passport system for registration will permit registrants registered in other Canadian jurisdictions to access a deemed or short-form registration procedure, and whether exemptions equivalent to the "international dealer" and "international adviser" exemptions under Proposed NI 31-103 will be adopted to enable the continuation of existing cross-border trading and advisory arrangements into which Québec institutional investors have entered with U.S. and other foreign financial intermediaries.
Recognition of "regulated entities"
The Act will also provide for the recognition by the AMF of "regulated entities" seeking to carry on derivatives-related activities in Québec as an exchange, alternative trading system, published market, clearing house, regulation services provider, information processor or self-regulatory organization. Recognized regulated entities would be subject to various requirements covering their operating rules, activities, governance practices, information disclosure and the filing with the AMF of annual audited financial information. The AMF has not issued any guidance on what will constitute derivatives-related activities in Québec. This is an important jurisdictional issue for U.S. and international exchanges, ATSs, clearing organizations, etc. Hopefully, this will be clarified in the draft regulations.
Qualification of non-regulated and non-registered entities
Any person other than a recognized "regulated entity" or a registered dealer would have to be "qualified" by the AMF in the manner to be prescribed by regulation before offering standardized or OTC derivatives. The exact nature and scope of this "qualification" procedure remains to be seen.
Carve-out for OTC derivatives involving "accredited counterparties"
As noted above, the Act carves out OTC derivatives "involving accredited counterparties only or in any other cases specified by regulation" from the application of certain specified provisions. These include the dealer and adviser registration and qualification procedure and certain limited procedural and enforcement-related provisions, except with respect to market manipulation and fraud. The remaining provisions of the proposed legislation, including the offence provisions and the broad rulemaking authority which is delegated to the AMF to, among other things, "make rules concerning derivatives transactions", will equally apply to OTC derivatives. The OTC derivatives industry had hoped for a blanket carve-out for non-retail OTC derivatives activities, subject to market manipulation and fraud. Going forward, the extent to which the AMF regulates OTC derivatives using this broad-rule making authority to limit the scope of the OTC derivatives exemption under the Act will be an important issue affecting the enforceability of OTC derivatives contracts involving Québec counterparties.
The list of "accredited counterparties" includes governments, municipalities, "financial institutions" (which may be defined by regulation), dealers and advisers registered in and outside Québec, as well as certain qualified persons (to be defined by regulation), certain qualified investment funds, charities, persons wholly owned by "accredited investors" within the meaning of National Instrument 45-106 and "hedgers". It will be important for the regulations or the AMF to provide for the ability to rely on factual representations as to a party's status as an "accredited counterparty" within the meaning of the Act.
Federally regulated banking products.
One of the perennial areas of concern with the proposal to broadly regulate derivatives in Québec has been the extent to which the legislation would purport to regulate products, services and activities that are subject to the exclusive federal jurisdiction over banks and other financial institutions. Certain comments in response to the earlier proposals had urged the government to adopt the more targeted definition of OTC derivatives recommended by the Ontario Commodity Futures Act Advisory Committee in its final report of January 20073 in conjunction with the principles-based approach to derivatives regulation generally favoured by the industry. The Québec government, however, has elected to adopt the "catch and release" approach to the definition and regulation of derivatives recommended by the AMF. The Act does not expressly exclude federally regulated financial products, so the draft regulations will be of critical importance in ensuring that any jurisdictional and related characterization issues are clearly resolved.
The "hybrid product" test
One important feature of the Act in the resolution of such issues is the concept of "hybrid product", which has been imported from the United States Commodity Exchange Act. The concept is principally designed to eliminate any legal uncertainty in the regulatory characterization of structured securities products with embedded derivatives. The hybrid product test under the Act sets out a three-pronged test to establish whether any given instrument can be "presumed to be predominantly a security". The presumption applies (1) if the offeror receives payment of the purchase price upon delivery of the product; (2) if the purchaser is under no obligation to make any payment in addition to the purchase price (e.g., as margin deposit, margin, settlement) during the term of the product or at maturity; and (3) if the terms of the instrument do not include margin requirements based on a market value of the underlying interest. The "hybrid product" test will be of critical importance for structured products issued by federally regulated banks that currently rely on broad-brush exemptions from the dealer registration and prospectus filing requirements under Québec securities legislation to distribute principal protected notes and other structured products on a retail basis.
Once the proposed regulations are published, it will be important to review specific derivatives contracts or activities in the Québec derivatives market to identify potential jurisdictional, legal and operational issues that may be raised by the new derivatives legislation.
1For more on the Montreal Climate Exchange see the
June 2008 edition of Stikeman Elliott's Structured Finance Update.
2For more information regarding Registration Reform, please visit Stikeman Elliott's
Corporate Finance and Securities page.
3Final Report to Minister Gerry Phillips, Minister of Government Services and Minister responsible for securities regulation, January 2007.
A legislative proposal to establish a new Derivatives Act was tabled by the Québec Minister of Finance on April 9, 2008. Bill 77 follows the publication in August 2007 by the Autorité des marchés financiers (Québec's financial markets regulator) of a proposed framework for the regulation of the derivatives markets in Québec and an earlier concept paper in May 2006, both of which attracted detailed comments by Canadian and foreign stakeholders in the industry. The proposed Québec Derivatives Act would regulate both over-the-counter (OTC) and exchange-traded derivatives in standalone legislation, subject to certain carve outs for OTC derivatives activities involving designated "accredited counterparties".
The stated purpose of the Act is to "foster honest, fair, efficient and transparent derivatives markets and to protect the public from unfair, improper and fraudulent practices and market manipulation." In the Québec Minister of Finance's April 9, 2008 press release, Minister Monique Jérôme-Forget stated that the legislation is intended to "provide the industry with a clear legislative framework that meets its needs for legal security, flexibility and efficiency. It will afford users of derivatives the protection they need, helping make Québec one of the best places in the world to trade derivatives".
Some of the highlights of the proposals are noted below. However, since the key provisions of the Act cross-reference regulations which have yet to be published, it is too early to size up the exact scope and detailed application of the Act and its potential impact on the various segments of the Canadian and cross-border derivatives market.
The Québec Derivatives Landscape
The driving factor underlying this initiative is the Québec government's determination to stake Québec's position as the lead jurisdiction in the derivatives space in Canada centered on the trading activities of the Montreal Exchange (MX). Maintaining Québec's hold on the highly lucrative Canadian exchange-traded derivatives business has been a key issue underlying the proposed combination of the MX and TSX Group to create TMX Group. It has also propelled Québec's move to capture early-stage carbon trading opportunities through the establishment of the Montréal Climate Exchange (MCeX) as the leading platform for publicly traded environmental products in Canada. The MCeX, a joint venture of the Montréal Exchange (MX) and the Chicago Climate Exchange (CCX), plans to launch trading of futures contracts on Canada carbon dioxide equivalent (CO2e) units on May 30, 2008, subject to regulatory approval. See http://www.stikeman.com/cps/rde/xchg/se-en/hs.xsl/10915.htm
The MX also has stakes in the Boston Options Exchange (BOX), a U.S. automated equity options market, for which the MX is the technical operator, and the Canadian Resources Exchange (CAREX), established with NYMEX, to develop the Canadian energy trading market and OTC and exchange-traded derivatives with financial or physical settlement on Canadian-based energy (including natural gas, heavy crude oil and power), metals and soft commodities. The combined TMX will also have a position in Natural Gas Exchange (NGX), a leading North American exchange for the trading and clearing of natural gas and electricity contracts.
Key Features of the Proposed Derivatives Act
The proposed Derivatives Act would regulate trading and advisory activities with respect to all forms of "derivatives" (broadly defined), including both "standardized derivatives" and OTC derivatives. The proposed Act would define an "over-the-counter derivative" as "any derivative other than a standardized derivative" and a "standardized derivative" as "a derivative that is traded on a published market, whose intrinsic characteristics are determined by that market and whose trade is cleared and settled by a clearing house".
The proposed Derivatives Act would impose a dealer registration requirement on any person who engages or purports to engage in (1) derivatives trading on the person's own behalf or on behalf of others; or (2) any act, advertisement, solicitation or conduct directly or indirectly in furtherance of an activity described in (1). The proposed Act would also impose an adviser registration requirement on any person who engages or purports to engage in the business of advising others as to derivatives or the buying or selling of derivatives, or in the business of managing derivatives portfolios. A dealer or adviser registered under the Québec Securities Act which meets the conditions under the proposed Derivatives Act for registration to carry on business in derivatives and pays the prescribed fees would be deemed to be registered under the new Act. Existing Québec registrants could also transition their registration under the new Act.
The proposed Act would also provide for the recognition by the Autorité des marchés financiers (AMF) of "regulated entities" seeking to carry on derivatives-related activities in Québec as an exchange, alternative trading system, published market, clearing house, regulation services provider, information processor or self-regulatory organization. Recognized regulated entities would be subject to various requirements covering their operating rules, activities, governance practices and information disclosure and the filing with the of annual audited financial information. The AMF has not issued any guidance on what will constitute derivatives-related activities in Québec. This will be an important jurisdictional issue for US and international exchanges, ATSs, clearing organizations, etc.
Any person other than a recognized "regulated entity" or a registered dealer would have to be "qualified" by the AMF in the manner to be prescribed by regulation before offering standardized or OTC derivatives.
Significantly, the proposed legislation would not completely exempt OTC derivatives from the application of the Act. The proposed Act would carve out OTC derivatives "involving accredited counterparties only or in any other cases specified by regulation" from the application of certain specified provisions, including the dealer and adviser registration and qualification procedure and certain limited procedural and enforcement-related provisions, except with respect to market manipulation and fraud. The remaining provisions of the proposed legislation, including the offence provisions and the broad rulemaking authority which is delegated to the AMF to, among other things "make rules concerning derivatives transactions" would equally apply to OTC derivatives.
The list of "accredited counterparties" would include governments, municipalities, "financial institutions" (to be defined by regulation), dealers and advisers registered in and outside Québec, as well as certain qualified individuals (to be defined by regulation), certain qualified investment funds, charities, persons wholly owned by "accredited investors" within the meaning of National Instrument 45-106 and "hedgers".
The companion regulations to the proposed Derivatives Act have not yet been published, so the exact scope and the detailed application of the legislation are currently uncertain. One of the perennial areas of concern with the proposal to broadly regulate derivatives in Québec has been the extent to which the legislation would purport to regulate products, services and activities which are subject to the exclusive federal jurisdiction over banks and other financial institutions.
Certain comments in response to the earlier proposals had urged the government to adopt the more targeted definition of OTC derivatives recommended by the Ontario Commodity Futures Act Advisory Committee in its final report of January 20071 in conjunction with the principles-based approach to derivatives regulation generally favoured by the industry. The Québec government, however, has elected to adopt the "catch and release" approach to the definition and regulation of derivatives recommended by the AMF. The proposed Derivatives Act does not trace any kind of clear line in the sand to expressly exclude federally regulated financial products so the draft regulations will be of critical importance in ensuring that any jurisdictional and related characterization issues are clearly resolved.
Once the proposed regulations are published, specific derivatives contracts or activities in the Québec derivatives market will have to be reviewed to review potential jurisdictional, legal and operational issues which may be raised by the new derivatives legislation.
1Final Report to Minister Gerry Phillips, Minister of Government Services and Minister responsible for securities regulation, January 2007.
NI 81-107 aims at improving fund governance by requiring investment funds to establish Independent Review Committees.
The Canadian Securities Administrators (CSA) have finalised NI 81-107 - Independent Review Committee (IRC) for Investment Funds (the Instrument), the first proposed version of which was released in January 2004. It was revised and subsequently republished for comment in May, 2005. Although this final version of the Instrument does not differ substantively from the May 2005 version, which was reported in our Funds Update of August 2005, it does address and clarify several issues that emerged during the comment period.
The Instrument and related amendments
The Instrument requires every investment fund that is a reporting issuer to have a fully independent body (the Independent Review Committee, or IRC) which is responsible for overseeing decisions that pose or have the potential to pose a conflict of interest. The Instrument also sets out a standard of care for investment fund managers with a view to ensuring that the interests of the investment fund are at the forefront when a fund manager is faced with a conflict of interest.
The Instrument applies to all public mutual funds, labour-sponsored or venture-capital funds, scholarship plans, and closed-end funds listed for trading on a stock exchange or quoted on an OTC market, regardless of size. It does not apply to pooled funds that sell securities to the public on a private-placement basis only, nor does it apply to funds that invest for the purpose of exercising control of, or being actively involved in, the management of issuers.
The Instrument will have far-reaching effects on the investment fund industry, with several consequential amendments also contemplated for various other instruments, including NI 81-101 - Mutual Fund Prospectus Disclosure, NI 81-102 - Mutual Funds, and NI 81-106 - Investment Fund Continuous Disclosure. Existing conflict of interest and self-dealing prohibitions in securities legislation will continue to apply, subject to exemptions in NI 81-107 and NI 81-102 allowing a manager to proceed with certain transactions that have received IRC approval under the Instrument.
Conflict of interest matters
The fund manager is expected to refer all matters in which a conflict of interest arises or is perceived to arise to the IRC in accordance with policies and procedures determined by the manager. This is consistent with the manager's overriding duty to act honestly and in good faith, and in the best interests of the investment fund.
A "conflict of interest" is a matter in respect of which a "reasonable person would consider the manager or an entity related to the manager to have an interest that may conflict with the manager's ability to act in good faith and in the best interests of the investment fund.". According to the Commentary to the Instrument (the Commentary), this includes inter-fund trades, transactions in securities of related issuers and purchases of securities underwritten by related underwriters, and extends to any proposed course of action that a fund, a manager or an entity related to the manager is restricted or prohibited from proceeding with by a conflict of interest or self-dealing provision contained in securities legislation.
An "entity related to the manager" includes agents of the manager and extends to the third-party portfolio managers or advisers, sub-advisers of a fund, as well as persons or companies who can "materially affect" the management and policy of the manager. Portfolio managers' decisions made on behalf of the fund that may affect the manager's ability to make decisions in the best interests of the fund are caught, but conflicts of interest at the service-provider level generally do not trigger regulation by the Instrument. Examples of what might be captured in this context include portfolio management processes allocating investments among a family of investment funds, and certain trading practices such as negotiating soft dollar arrangements.
The Instrument requires managers to create written policies and procedures to be followed when they are confronted with an actual or perceived conflict of interest. Such policies must also set out the applicable internal process for referring matters to the IRC for review or approval. Managers of more than one investment fund may establish blanket policies and procedures for all, or separate ones for each. Records of any activity subject to the review of the IRC must be maintained, and any such matters submitted to the IRC must be accompanied by information sufficient for the IRC to properly carry out its functions. In addition to implementing their own policies and procedures, managers are also expected to make reasonable inquiries about the policies and procedures implemented by their portfolio managers and advisers in respect of possible conflicts.
Certain conflict of interest matters must be approved by the IRC before the manager may proceed: for example, inter-fund trades, transactions in securities of a related issuer, or an investment in a class of securities of an issuer underwritten by an entity related to the manager. All other conflict of interest matters, though not subject to formal approval, must be submitted to the IRC for review and a recommendation as to whether the proposed action achieves a fair and reasonable result for the investment fund. The Instrument requires the manager to at least consider the IRC's recommendation in relation to these types of conflicts. Although IRC approvals or recommendations are generally provided on a case-by-case basis, a manager can act on standing instructions permitting it to engage in a particular conflict of interest action on a continuing basis on terms and conditions imposed by the IRC.
Unfortunately, the CSA did not see fit to impose a materiality or significance threshold in connection with the fund manager's obligation to refer conflict of interest matters to the IRC, with the Instrument providing that all conflicts be referred to the IRC for review or approval, as the case may be. That having been said, the definition of "conflict of interest matter" imposes a "reasonableness" standard which, according to the Commentary, denotes an exclusion of inconsequential matters. In determining what conflict transactions need to be reviewed by the IRC, managers are directed to follow industry best practices, which will emerge over time.
Appointment and composition of the IRC
The manager may appoint one IRC for all of its funds, or for any group of funds that it manages. Managers of investment funds may also share an IRC with other investment fund managers. This will very likely result in the emergence of a cottage industry of third-party IRC service providers.
The CSA expect the size of an IRC to be consistent with its workload, the minimum size being three members, all of whom must be "independent." A member is "independent" if he or she has no material relationship with the manager, the investment fund or an entity related to the manager. The Commentary sets out examples of individuals who would and would not qualify: for example, a person who is or has recently been an employee or executive officer of the manager (or is related to a recent former employee or executive officer) is unlikely to qualify; a member of the board of directors of a manager (whether independent or not) is also unlikely to meet the "independent" standard required for membership of an IRC (although a former independent member might). In certain circumstances, an independent member of the board of an investment fund may be considered "independent." For investment managers who have and wish to retain independent board members, the requirement to appoint a separate, independent IRC may seem duplicative.
The Instrument requires the manager of the fund to appoint the fund's first IRC. Subsequent appointments are in the sole domain of the IRC, which has the power to appoint new members or reappoint existing members to fill vacancies. Members of the IRC can be removed from office either by a majority of the IRC or by a majority of the securityholders of the investment fund voting at a special meeting convened for that purpose. In filling a vacancy or reappointing a member, the IRC is required to consider the fund manager's recommendations. To promote continuity and independence, a member of the IRC may serve for terms ranging from a minimum of one to a maximum of three years (the CSA recommends staggered terms of office). Consecutive terms may be served, but these may not exceed six years unless agreed to by the manager.
Liability and Indemnification of IRC members
The Instrument imposes a duty on the IRC to "act honestly and in good faith, with a view to the best interests of the investment fund." To assuage concerns about potential liability of IRC members, the CSA have taken steps to clearly define the functions, duties and obligations of the IRC (emphasizing its very specific and limited role), with a duty of care owed to the investment fund only. Further, the Commentary notes that the IRC is generally only required to consider matters referred to it by the manager. The CSA have concluded that exposure to liability should be commensurate with the narrow mandate of the IRC to review and make recommendations on conflicts of interest, and that any defences available generally to corporate directors should also be available to IRC members. The investment fund is required to indemnify IRC members for costs and expenses associated with the defence of an action, provided there has been no fault or omission on the part of the IRC member, who must also have acted in good faith, and, in the case of actions enforced by a monetary penalty, in the reasonable belief that his or her conduct was lawful. In addition, the Instrument permits the fund and manager to indemnify or purchase insurance coverage for IRC members even if they are not absolved from fault or omission, subject to the same good faith conditions as apply in respect of the mandatory indemnity cover. The CSA expect any such coverage to be on reasonable commercial terms.
The IRC's written charter
The IRC is required to adopt a written charter setting out its mandate, responsibilities and functions. Funds within a family are not required (but are permitted) to have separate charters. Although the Instrument permits the IRC broad discretion to tailor its written charter to its own particular circumstances, the CSA do indicate that they expect the written charter to include policies and procedures to be followed when reviewing conflict of interest matters, criteria regarding compensation and expenses, and policies relating to ownership by IRC members of securities of the investment fund, manager, or company that provides services to the investment fund. The Instrument requires the IRC to consider the manager's recommendations in formalizing its charter, which may include additional functions to those prescribed by the Instrument and securities legislation (bearing in mind that any such additional functions are not regulated by the Instrument).
Compensation, fees and expenses
The fund is obliged to pay all reasonable costs and expenses incurred by the IRC from the assets of the fund (which may, in turn, be reimbursed to the fund by the manager). The manager is required to set the initial compensation of the IRC. Thereafter, the Instrument grants the IRC sole authority to set its own reasonable compensation going forward; however, it must take into account the manager's recommendations in doing so. If the IRC fails to follow the manager's recommendation on the amount and type of compensation, this must be disclosed in the annual report to the securityholders, giving reasons and describing the process and criteria it applied.
Reporting requirements of the IRC
The IRC is required to report on the adequacy and effectiveness of the policies and procedures on conflicts matters on an annual basis. Focusing on both substantive and procedural aspects, this assessment must include a review of the effectiveness and adequacy of the manager's conflicts policies and procedures, and a consideration of its own effectiveness (including an assessment of the independence and compensation of its members). Written results of the assessment must be delivered to the manager, along with recommendations on any changes that should be made to the manager's policies and procedures.
In addition, the IRC must prepare an annual report to securityholders describing the IRC and its activities during the year. If the IRC is of the view that an action by the manager is not fair and reasonable, or if the manager proceeds with an action in relation to which the IRC did not give a positive recommendation, this must be reported. The annual report to securityholders must be filed with the securities regulatory authorities no later than the date on which the investment fund files its annual financial statements, and must be made available and prominently displayed on the investment fund or manager's website.
The Instrument also imposes a positive duty on the IRC to report to the securities regulators any instances where a manager has failed to comply with a condition imposed by securities law or the IRC in respect of a conflicts matter requiring IRC approval. The CSA has indicated that it will treat any such failure to comply as a breach of securities legislation, exposing the manager to regulatory action, which could include unwinding the transaction. The IRC also has authority (but is not obliged) to communicate directly with the securities regulators as and when it sees fit on any other matter.
Implementation and Transition
The Instrument has been or is expected to be adopted as a rule in British Columbia, Alberta, Manitoba, Newfoundland and Labrador, Nova Scotia, Ontario and New Brunswick. It will be adopted as a commission regulation in Saskatchewan and as a regulation in Quebec. It is expected to come into force on November 1, 2006. A one-year transition period is contemplated so that, although managers must appoint an initial IRC for a fund by May 1, 2007, the Instrument will not apply to the fund and manager until November 1, 2007. A fund manager can, however, elect to have the Instrument apply earlier by giving notice to the fund's principal regulator and thereby take advantage of the exemptive relief available for certain conflict of interest matters.
How do I learn more?
We have also prepared a more detailed NI 81-107 publication entitled "Answers to Questions you may be asking about NI 81-107" which is available on request. Further, if you wish to be added to any of our special interest mailing lists please contact us at firstname.lastname@example.org
Canadian Securities Administrators to Implement Multilateral Instrument 55-103 Insider Reporting For Certain Derivative Transactions (Equity Monetization)
The Canadian Securities Administrators (CSA) have published the final version of Multilateral Instrument 55-103 - Insider Reporting For Certain Derivative Transactions (Equity Monetization). The Multilateral Instrument was previously released for comment on February 28, 2003 and was a subject of our prior updates. The Multilateral Instrument is expected to come into force on February 28, 2004, subject to ministerial approvals. British Columbia is expected to adopt similar requirements in a different manner.
The Multilateral Instrument is stated to be intended to address concerns that current insider reporting requirements may not cover certain derivative-based transactions, including equity monetization transactions. Derivative-based transactions, including monetization transactions, can enable an investor to transfer part or all of the economic risk associated with the ownership of securities of an issuer, without transferring legal and beneficial ownership of such securities. Investors enter into monetization transactions for a variety of reasons, including tax planning strategies, to improve liquidity and to achieve portfolio diversification.
The Multilateral Instrument also sets out to introduce greater consistency with the reporting requirements under U.S. securities law in relation to equity monetizations, i.e. equity monetizations that are reportable under U.S. insider reporting requirements will also generally be covered by Canadian insider reporting requirements, unless subject to an exemption.
The Multilateral Instrument does not address control block issues or early warning reports, which the CSA indicated may be considered in the context of the proposed Uniform Securities Legislation initiative.
Reporting Obligations under the Multilateral Instrument
The Multilateral Instrument does not prohibit insiders from entering into equity monetization and similar derivatives transactions. Rather it requires insiders to report the existence, material terms, material amendments and terminations of such transactions. However, other requirements of Canadian securities laws, such as (i) insider trading laws that generally prohibit insiders (and certain others) from trading in securities of a reporting issuer while in possession of material undisclosed information about the issuer; and (ii) the escrow requirements of National Policy 46-201 - Escrow for Initial Public Offering, may prohibit an insider from entering into equity monetization and similar derivatives transactions either while in possession of material undisclosed information or generally.
Under the Multilateral Instrument, unless exempted, an insider is required to file an insider report in a circumstance where the insider enters into, materially amends, or terminates an agreement, arrangement or understanding of any nature or kind, the effect of which is to alter, directly or indirectly:
(a) the insider's economic interest in a security of the reporting issuer; or
(b) the insider's economic exposure to the reporting issuer.
What is "Economic Interest" in a Security?
The term "economic interest" in a security is defined (the definition being considerably simplified from the prior draft) as:
(a) a right to receive, or an opportunity to participate in, a reward, benefit or return from the security, or
(b) exposure to a loss or a risk of loss in respect to the security.
This term is meant to have broad application, and is intended to refer to the economic attributes ordinarily associated with beneficial ownership of a security, such as the potential for capital gains, capital losses and interest dividends, or other distributions. Similarly, a "security of the reporting issuer" is broadly defined in the Multilateral Instrument and is deemed to include:
(a) a put, call, option or other right or obligation to purchase or sell securities of the reporting issuer; and
(b) a security, the value or market price of which are derived from, referenced to or based on the value, market price or payment obligations of a security of the reporting issuer.
What is "Economic Exposure" to the Reporting Issuer?
"Economic exposure" in relation to a reporting issuer is defined as the extent to which the economic or financial interests of a person or company are aligned with the trading price of the securities of the reporting issuer or the economic or financial interests of the reporting issuer. The term "economic exposure" is also intended to have broad application, and is meant to catch a situation where an insider changes his or her ownership interest in securities of a reporting issuer, either directly through the purchase or sale of securities of the reporting issuer or indirectly through derivative transactions involving those securities.
What is the Difference between "Economic Interest" and "Economic Exposure"?
The CSA indicate that in many cases, an arrangement caught by the "economic exposure" test will also be caught by the "economic interest" in a security test. However, the tests are not identical.
For example, if an insider holds no shares of the reporting issuer, but enters into an actual or synthetic "short position" in the expectation that the share price will fall, the CSA indicate that the "economic interest" test may not apply since the insider will not be altering his or her economic interest in any securities of the reporting issuer (note that Section 130(1) of the Canada Business Corporations Act prohibits an insider from knowingly selling, directly or indirectly, a security of a reporting issuer or any of its affiliates, if the insider does not own the security to be sold). However, the "short position" would be caught by the "economic exposure" test and would be reportable.
Not Restricted to Equity Monetizations
The Multilateral Instrument applies not only to equity monetizations but generally to derivatives transactions with insiders involving "securities" of a reporting issuer, whether equity or debt securities. Accordingly, all other forms of derivatives transactions, such as total return swaps and credit default swaps, involving insiders and securities of reporting issuers will need to be considered carefully to determine whether they trigger reporting obligations (see the exemptions described below).
Application of the Multilateral Instrument to Pre-Existing Monetizations
The Multilateral Instrument will apply to both new derivative-based transactions caught by the Multilateral Instrument, as well as those previously entered into by insiders (or entered into before they became insiders) and remaining in effect after the effective date of the Multilateral Instrument, currently scheduled for February 28, 2004, subject to ministerial approvals.
Exemptions from the Insider Reporting Requirements
The Multilateral Instrument provides a number of exemptions from the reporting requirement (the main area where changes were made to the prior draft). These exemptions include:
(a) arrangements that do not involve, directly or indirectly, an interest in (i) a security of the reporting issuer; or (ii) a derivative in respect of which the underlying security, interest, benchmark or formula is or includes as a material component a security of the reporting issuer;
(b) a compensation arrangement established by a reporting issuer or affiliate if: (i) the existence and material terms are, or are required to be, described in certain public filings; or (ii) the terms are set out in writing and the alteration to economic exposure or economic interest occurs as a result of the satisfaction of certain previously established criteria and does not involve a discrete investment decision by the insider. The CSA note that the disclosure contemplated by this exemption is general disclosure about the material terms of the compensation arrangement applicable to all participants in the compensation arrangement and they do not intend that there be individualized disclosure about a specific insider's individual circumstances;
(c) to the extent that a person or company is exempt from the insider reporting requirements by virtue of an exemption contained in Canadian securities laws, or has obtained exemptive relief in a jurisdiction from the insider reporting requirements of that jurisdiction;
(d) a transfer, pledge or encumbrance of securities by an insider for the purpose of giving collateral for a debt made in good faith, so long as there is no limitation on the recourse (legally or structurally) available against the insider for any amount payable under such debt;
(e) the receipt by an insider of a transfer, pledge or encumbrance of securities of an issuer if the securities are transferred, pledged or encumbered as collateral for a debt under a written agreement and in the ordinary course of business of the insider (this will assist, among others, financial institutions, and was introduced in response to a comment of Stikeman Elliott);
(f) an insider, other than an insider that is an individual, that enters into, materially amends or terminates an agreement, arrangement or understanding which is in the nature of a credit derivative;
(g) a person or company who did not know and, in the exercise of reasonable diligence, could not have known of the alteration to the economic exposure or economic interest;
(h) the acquisition or disposition of a security, or an interest in a security, of an investment fund, provided that securities of the reporting issuer do not form a material component of the investment fund's market value; and
(i) the acquisition or disposition of a security, or an interest in a security of, an issuer which holds directly or indirectly securities of the reporting issuer if (i) the insider is not a control person of the issuer; and (ii) the insider does not have or share investment control over the securities of the reporting issuer.
Moreover, the Multilateral Instrument does not apply to require reports in respect of securities of a publicly offered mutual fund, as the definition of "reporting issuer" for the purposes of the Multilateral Instrument excludes a mutual fund that is a reporting issuer.
Form and Timing of Insider Reports
Reporting of the existence, material amendment or termination of a transaction under the Multilateral Instrument is done generally on-line through the System for Electronic Disclosure for Insiders (SEDI), with the same rules and 10-day deadline as for all other insider reporting for ordinary purchases and sales of securities. See Multilateral Instrument 55-102 - System for Electronic Disclosure by Insiders and www.sedi.ca. Existing derivative-based transactions caught by the Multilateral Instrument would need to be reported by March 9, 2004 (assuming the Multilateral Instrument comes into force on February 28, 2004).
In an effort to provide some guidance, the CSA has undertaken to publish a CSA staff notice containing examples of various types of monetization arrangements, together with examples of completed forms for reporting such arrangements, on or before the Multilateral Instrument takes effect.
Insiders entering into certain derivative-based transactions will have to carefully review the "economic exposure" and "economic interest" tests established by the Multilateral Instrument to determine whether the reporting obligations are triggered.
Of particular note is the application of the Multilateral Instrument to derivative-based arrangements previously entered into by insiders and remaining in effect after the effective date of the Multilateral Instrument, currently scheduled for February 28, 2004.
 Excerpts and examples from Companion Policy 55-103 to the Multilateral Instrument have been used in this update.
 Canadian securities legislation requires "insiders" of public companies (generally, (i) directors and senior officers of public companies; (ii) directors and senior officers of companies that are insiders or subsidiaries of public companies; and (iii) 10% shareholders of public companies) to file insider reports disclosing their ownership of, and trading in, securities of such public companies.
 For the purposes of the Multilateral Instrument, a "derivative" means an instrument, agreement or security, the market price, value or payment obligations of which is derived from, referenced to, or based on an underlying security, interest, bench mark or formula.
 The reference to "material component" is intended to insure that if an insider entered into a derivative arrangement which satisfies one of the tests triggering reporting obligations and in respect of which the underlying interest was a basket of securities or an index which included securities of the reporting issuer, such arrangement would trigger a reporting requirement only if the derivative involved securities of the reporting issuer "as a material component". In determining materiality, similar considerations to those in the concepts of "material fact" and "material change" apply.