Canadian Structured Finance Law : Canadian Structured Finance Law: Securitization/OTC Derivatives Blog by Stikeman Elliot Lawyers & Attorneys

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 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”.

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:
  
  
  1. 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;
      
  2. 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
      
  3.  the percentage of contracts, for each of the latest four quarters, that were profitable for counterparties.

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.

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.

Enforcement

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.

Certain commentators on these proposals strongly objected to the CSA’s “product-centered” approach, maintaining that traditional ABS products (as opposed to higher risk securitization products such as synthetic products and products created under an originate-to-distribute model) are not substantially different from, or have significantly different risk profiles than, other forms of complex debt financing and, accordingly, should not be treated any differently. It appears that the CSA may have taken cognizance of this complaint although their response may trend in the direction opposite from that which commentators may have hoped.

On November 10, 2011, the CSA issued Staff Consultation Note 45-401 in which they announced that they are undertaking a review of the minimum amount (MA) and accredited investor (AI) exemptions (together the “Private Placement Exemptions”). The reason for the review is perhaps revealing: “the global financial crisis and recent regulatory developments have raised questions about the use of [the Private Placement Exemptions].”

In the Consultation Note, the CSA maintains that the Private Placement Exemptions “have been premised on the investor having one or more of:

• A certain level of sophistication,
• The ability to withstand financial loss,
• The financial resources to obtain expert advice, and
• The incentive to carefully evaluate the investment given its size.”

I would enlarge on the foregoing by incorporating the view of the American Securitization Forum (ASF) in their comment letter on the securitized products proposal and apply it to complex exempt products in general: “Complex … products offered without all of the protections of the prospectus-delivery regime should be limited to investors who have the knowledge and experience to evaluate the securities they are considering for purchase and the ability to ascertain what disclosure, reports and other contractual features they require in connection with a prospective purchase”.

For convenience, the CSA premises and the ASF enlargement are together referred to below as investor sophistication. A completely reliable determination of investor sophistication is inherently a factual exercise which should be conducted on a case-by-case basis. In order for capital markets to function efficiently, however, tests of general application have been devised including the eligible securitized product investor test and the Private Placement Exemptions. As alluded to in the Consultation Note, the regulatory trick is to find a balance between a test which is so lax that it will allow unsophisticated, retail investors to participate in the exempt market and one that is so severe that it will close the market to investors who do not need the protections provided by a prospectus offering, thereby adversely affecting the raising of capital, especially by small and medium sized enterprises.

It is also undoubtedly true that investor sophistication is a somewhat relative concept which may vary in relation to the complexity of the investment. A given investor may be considered sophisticated when assessing of a vanilla corporate debt investment but a complex transaction of one sort of another may be beyond his level of sophistication. (Thus the ASF has proposed the concept of “qualified institutional buyer of structured finance products” to the SEC, which could be adapted to other complex products, and under which an investor would have to satisfy a quantitative test as to structured finance products under management as well as certain qualification standards relating to such investor’s knowledge and experience in the purchase and surveillance of structured finance products.) That the CSA recognize that this has implications beyond securitized products is implied in the Consultation Note where the CSA state that “the size of investment alone does not assure investor sophistication or access to information, particularly where the minimum amount is used to sell novel or complex products without any accompanying disclosure. At most, the size of the investment is an indicator only of the investor’s ability to withstand financial loss.”

The determination of the appropriate thresholds to be utilized in the various exemptions and which exemptions are appropriate in respect of which products will be the subject of much debate between the CSA and market participants and, while of crucial importance to the continued functioning of the exempt market, is not the subject-matter of this piece. My point here is a relatively simple, even fundamental, one; once an acceptable test for investor sophistication has been established, whatever the details may be, the one conclusion that necessarily follows is that there can be no public policy argument for requiring the delivery of disclosure to the investor; in other words, to find that the investor is sufficiently sophisticated is ipso facto to find that he is sufficiently knowledgeable and powerful enough to demand, obtain and understand all of the information necessary to allow him to exercise a prudent investment decision without the necessity of regulatory intervention or oversight. It is in superimposing a disclosure requirement (not to mention the certification requirement) on top of revising the exemption in order to better assure investor sophistication that the CSA are guilty of regulatory overkill in the case of the proposed securitized product rules. They are in essence saying that, although an investor may be sufficiently sophisticated to purchase without imposing disclosure, we are going to impose it anyway. But surely this is ultimately to entirely collapse the distinction between the private and the public markets and an attack on the basic right of contract which, in the absence of cogent public policy reasons to the contrary, should be unimpeded by regulatory intervention. It is of particular interest that the Consultation Note does not explicitly include any such requirements in the context of the Private Placement Exemptions (although there are various seemingly innocuous references to the relevance of disclosure which interested stakeholders should not let pass without comment).

It will be interesting to see how the CSA integrates their approach to exempt products in general with their approach to securitized products. That they will take cognizance of the latter is specifically acknowledged in the Consultation Note where they indicate that they will be considering the comments received in response to the securitized product proposals as part of their general review of the Private Placement Exemptions. “We believe it is important that our assessment of those exemptions be informed by the CSA’s proposals concerning securitized products and the comments of stakeholders with respect to those proposals”. It may be overly optimistic to hope that, in issuing Staff Consultation Note 45‑401, the CSA may in fact be signalling a shift in direction away from the previous product-centered approach towards an approach of more general application. If so, it will be difficult for the CSA to justify a differentiated application of the exemptions between securitized products and other complex products. Indeed, logically, it almost seems inevitable that the true differentiation should be between vanilla products on the one hand and complex products of any sort on the other and the real challenge may well be in devising a workable definition of ‘complex’.

Nevertheless, and at the risk of setting up a straw man, the position taken by U.S. regulators in respect of the ABS market appears to be that, while the last crisis may well have occurred as a result of problems specific to the real estate sector, as no one can predict the source of the next contagion, it is best to take vigorous prophylactic measures across the board now. Accordingly, they have been widely accused of, and abused for, taking a “one-size-fits all” approach pursuant to which they have crafted rules of universal application.

This approach has attracted vociferous criticism the main line of which generally goes as follows: The financial crisis occurred as a result of poor asset quality due to the application of the originate-to-distribute model characteristic of the RMBS/CMBS sector. The other, non-mortgage-backed sectors, do not use this model and investors in these sectors experienced no spike in losses during the crisis. To apply a solution crafted to address the unique problems of the RMBS/CMBS sectors to these other sectors is both unfair and unnecessary and will lead to the suffocation of those markets.

Despite sympathy for the foregoing, I am not quite sure that it entirely responds to the regulatory position, which is not to say that that position is justified. Perhaps the issue can be better approached from a slightly different angle, one that is based on the proposition that the crisis was symptomatic of a series of faulty credit decisions which made up a chain of events, each link of which was comprised of an aggregation of credit decisions each of which in turn was characterized by a fundamental lack of prudence.

The first link was comprised of decisions made by mortgage originators who advanced loans to borrowers based, in the most extreme cases, on little or no down payment, no documentation, no proof of income and, ultimately, fraud. Whatever the ultimate root-cause of these decisions, it is clear to most, including the regulators, that what stoked them was the enormous demand for product, any product, by investors. Hence, the motivation to originate for the sole purpose of distribution. By not retaining any of the risk, by not keeping any skin in the game, the originators were incentivized to worry less (or not at all) about product quality and more (or entirely) about product quantity, knowing they could pass any losses on.

The next link was characterized by the credit decisions made by purchasers of the mortgages and the issuers of securities backed by the mortgages. The fault with these decisions lay in the lack of proper due diligence on underwriting standards being applied by originators and thus the quality of the purchased mortgages as well as a failure to adequately disclose to purchasers of the securities the problematic underwriting standards and poor asset quality. Their level of imprudence may also in large part be attributable to a belief that they could also pass any problems on to investors. (It has always been a source of some wonder to me that some of the biggest players were nevertheless caught with an enormous amount of these assets/securities when the crisis arose . I am inclined to believe that this was a result of bad timing more than anything else.)

The last link in the credit chain was inhabited by investors in MBS who failed to ensure that they understood the product in which they were investing and their true exposure to faulty underwriting standards, relying too heavily on the credit analysis provided by rating agencies which have subsequently been accused of being hired enablers rather than reliable gate-keepers.

The regulators have consistently maintained that their goals in crafting the ABS proposals were two-fold: to protect investors while at the same time recognizing the importance of maintaining the securitization industry in order not to compromise the availability of credit to consumers. They have been accused, however, of paying little more than lip service to the latter and the solutions evidenced by their proposals would seem to support this accusation.

Accordingly, they have chosen to mandate prudence at each link in the chain. First, they impose prudence on originators by requiring them to have skin-in-the-game and by devising complex and expensive mechanisms to police the accuracy of representations and warranties. Second, they impose prudence on purchasers/issuers by requiring burdensome asset level disclosure and asset reviews. Third, they attempt to impose prudence on investors by attempting to dislodge their reliance on the credit analysis provided by the rating agencies and substituting therefore requirements of doubtful utility or value such as waterfall computer programs and cash-flow certification.

It should, however, have been apparent that the crisis would never have occurred unless each link in the chain of credit decisions leading to it had been faulty. In other words, without all three levels of imprudent credit decisions there would have been no crisis and the final two links are rooted in and totally derivative of (albeit compounding) the original set of credit decisions involving the failure to apply prudent underwriting standards. What necessarily follows from this is that regulators should have been able to achieve their goal of protecting investors by causing a break in the “chain of imprudence” at any single link rather than by taking a shotgun approach which will necessarily involve extensive collateral damage.

For instance, in those sectors, such as autos and credit cards, in which there is no historical evidence of the imprudent application of less than rigorous underwriting standards, and which have historically had both corporate and structural incentives to the exercise of appropriate levels of prudence in the origination of loans,  there is no justification at all for imposing further costs and burdens by the application of rules which have been specifically crafted to address a model and to correct abuses not shared by these sectors. The evil at which the rules are aimed simply did not and does not exist in these sectors. The application of these rules will create no further benefits and will entail only further costs, which should perhaps be viewed as a bright line test for regulatory overkill. Only if and when these other sectors were to evolve in the direction of the RMBS/CMBS sector would the application of similar rules to them be justifiable.

Once the issue of imprudent underwriting standards is satisfied either, in the case of autos and credit cards, by finding no evidence of the application of such imprudent standards, or,  in the case of RMBS/CBMS, by application of the new rules (assuming for present purposes that such rules are adequate and effective for such purposes) the chain of imprudence will have been effectively broken and there is no justification for the imposition of further burdens down the credit chain for the same reason: they will bring no extra benefit but will entail heavy costs. This is especially true for such artificial constructs as the proposed waterfall computer program and cash-flow certification.  (While it may be argued that mandating adequate disclosure (the second link in the chain) should thus be sufficient in the case of RMBS/CMBS, there may be other reasons why it is preferable to instead regulate at the origination link given the levels of malfeasance in the form of predatory lending which seem to have been all too common during the heyday of the crisis.) 

Perhaps a medical analogy is the most fitting conclusion: The regulators have it within their means to neutralize the cancer by the  simple excision of an identifiable tumour; but instead they seem to be insistent upon extensive radioactive and chemical therapy which, while it will certainly eliminate the tumour, may well kill the patient.

European banks have issued covered bonds for hundreds of years, and the product has become increasingly popular in other jurisdictions in recent years. According to the bill’s sponsors, however, U.S. financial institutions have lagged behind due to the lack of a regulatory framework. Senator Hagan indicated that the proposed legislation “would level the playing field for U.S. financial institutions.”

American investors’ demand for this product is high, as such investors have funded over $37 billion of covered bonds issued by foreign financial institutions so far in 2011. Seeking to make the most of such high demand, senators in support of the bill wish to allow American institutions of all sizes to issue the debt instrument.

Not everyone is fully supportive, however. The Federal Deposit Insurance Corporation, a government entity that guarantees US bank deposits, has expressed concerns that the use of covered bonds may reduce the banks’ assets for their deposit funds.

A similar covered bond bill was passed in June by the House of Representatives Financial Services Committee, though it has not been voted on by the full House. Both bills seem to have bipartisan support, which bodes well for the timely implementation of covered bond legislation in the U.S.

In Canada, covered bonds have become a popular source of funding for domestic banks during recent years. Canada, however, also lacks a legislative framework for covered bonds.  The Department of Finance issued a consultation paper on May 11, 2011, setting out the main elements of a proposed legal framework for covered bonds.

The entry point for the application of the Proposals is the definition of securitized product. Given the importance of this definition it is perhaps surprising that comparatively little attention was paid to it by most commentators. Those who did comment on it did little but indicate that they believed the definition to be too broad and cite a few examples of instruments that should not be caught. These included NHA MBS, Canada Mortgage Bonds, over‑the‑counter derivatives, corporate loans secured by pools of assets, innovative Tier 1 capital structures and structured notes.  Apart from our own submission, very little analysis was provided to the CSA to allow it to structure a principle‑based definition. And we do not believe that the solution lies in merely listing the above as exceptions as, unless the definition itself is refined significantly, there will be too many classes of securities on the margins or in the “grey” zone. As illustrated in our submission, there are a number of other types of securities that could unexpectedly be caught by the definition and specifically listing included or excluded securities may not be an effective solution as such lists may result in further interpretive difficulties.

The extreme breadth of the definition will create a trap for the unwary issuer which may only become apparent upon receipt of a comment letter or, more problematically, a claim from an investor in a private transaction who later, being discontented with the outcome of his investment, is casting about for grounds for reimbursement. Indeed any proposed issuance of securities in the “grey” zone will need to be approached cautiously under the proposed definition. If the issuance is to be by way of prospectus, the new rules are tailored almost entirely to fit traditional ABS and a “grey” zone issuer would be hard‑pressed to understand what specific disclosure is required in respect of its issuance. It would be much worse, however, if the issuance is to be conducted in the exempt market since the issuer would be caught between the rock of not complying, and thereby potentially opening itself up to liability for non‑compliance, and the hard place of complying, and thereby voluntarily taking on unwarranted liability by operation of the new disclosure and certification requirements. The uncertainty surrounding the applicability of the definition of securitized product could virtually eliminate all issuances of these “grey” zone securities as it would be difficult to obtain a legal opinion which would give sufficient comfort on the applicability of and compliance with securities laws. It is therefore incumbent upon the CSA to strive for much greater clarity in this area and we believe that they should submit a new proposal on this point for comment.

The CSA Derivatives Committee identified trade repositories, which are centralized facilities for the collection of OTC derivatives data, and the related availability and transparency of transaction and aggregate market data for market and prudential regulators, central banks and the public as one of the most important components of OTC derivatives regulatory reform. 

There are currently no requirements for Canadian market participants to report their OTC derivative transactions and positions. Therefore, Canadian regulators and the Bank of Canada do not have formal access to data regarding the size and composition of the Canadian OTC derivatives market, the activities of Canadian market participants and “Canadian referenced derivatives” entered into by foreign participants.

Trade Repository Requirements

The CSA Derivatives Committee recommends that trade repositories operating in Canada should:

• be required to meet internationally accepted governance and operational standards recommended by the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) including standards relating to legal framework, governance, market transparency and data availability, operational reliability, access and participation, safeguarding of data, timely recordkeeping and communication procedures and standards,
• have boards of directors with appropriate independent representation,
• have a chief compliance officer and robust operational risk management capabilities,
• provide fair and open access to market participants,
• be required to accept all trades for each asset class for which they accept trade data,
• safeguard confidential data, and
• prevent any data use that could represent a conflict of interest. 

The CSA Derivatives Committee also recommends that Canadian provincial securities and derivatives laws should be amended to include approved trade repositories in the definition of market participant. 

What is not clear from the recommendations is whether a trade repository, whether domestic or foreign, would have to become registered or recognized in each province in which it accepts trade data from market participants. Hopefully, registration or recognition in (and regulation by) thirteen different provincial and territorial securities regulators can be avoided, especially for non-Canadian trade repositories.

The comment letter from the Canadian Market Infrastructure Committee (CMIC) submitted that the federal authority over systemic risk and banking means that the Bank of Canada should be at the centre of trade repository regulation (i.e., not the provincial securities regulators) within harmonized federal and provincial approval processes. The framework should be designed to provide federal authorities with the appropriate data for their systemic risk purposes and provincial securities regulators with the appropriate data for their market conduct purposes. The legislative approach that should be followed is the developent by federal authorities of federal legislation that would focus on the Bank of Canada’s trade repository requirements for systemic risk monitoring purposes, albeit in consultation with both provincial securities regulators and industry participants to ensure that the scheme of the federal legislation is consistent with the market conduct responsibilities of provincial securities regulators.

A Made-in-Canada Solution?

The CSA Derivatives Committee recommends studying whether a “made-in-Canada” solution is necessary and the requirements for foreign-based trade repositories. While there are efficiency arguments for a single global trade repository, at least for each asset class, there are of course reasons why Canadian regulators (federal and provincial) may prefer a local trade repository, including the possibility that foreign trade repositories may not develop systems that accept trade data from Canadian market participants for all types of OTC derivatives entered into domestically by Canadian counterparties or that Canadian regulators may not have sufficient access to foreign trade repositories holding trade data in respect of trades by Canadian counterparties or Canadian referenced derivatives or that such access might be interrupted in the future. 

What is clear from the comment letters is that if Canada does pursue a domestic trade repository, the format and parameters of the data that are required must be the same as used by other trade repositories globally so that trade data feeds between market participants and trade repositories work efficiently.

OTC Derivatives Transactions Reporting Requirements

The consultation paper recommends that provincial market regulators mandate the reporting of all OTC derivatives transactions, both cleared and non-cleared, to an approved trade repository. This mandatory reporting includes the reporting of pre-existing OTC derivatives which should be reported within 180 days from the effective date of the new rules except for existing transactions which terminate or expire within one year of the effective date of the new rules. The CSA heard from industry in the comment letters that 180 days from the effective date of the new rules for the reporting of pre-existing OTC derivatives may be too short a period. Not only may it not be practical from an operational perspective for many market participants to meet that timeline, but data does not necessarily exist within organizations in the format that it would be required to be reported.

Who Must Report OTC Derivatives Transactions

The consultation paper proposes that one counterparty to each OTC derivative transaction should be required to report the transaction and any related post execution events to an approved trade repository. However, counterparties should be able to delegate reporting to a third-party service provider including a central counterparty clearing house. Financial intermediaries should bear the reporting onus in transactions with end users. Transaction counterparties should be permitted to elect the reporting party for transactions between two financial intermediaries or two end users. A foreign counterparty may assume reporting obligations provided that the transaction is reported to a trade repository approved in Canada. 

OTC Derivatives Transaction Information Required to be Reported

The consultation paper recommends that the reported data include not only the principal economic terms, but also the full executed legal agreements entered into between the counterparties and should be reported in accordance with international standards for data reporting which would include unique identifiers for legal entities, transactions and product types. In addition, “continuation data” should be reported throughout the life of an OTC derivative transaction. Many comment letters state that the requirement to submit all legal documentation to a trade repository is too onerous for the institutions and in any event would not provide regulators with any additional useful information beyond the principal economic terms of the transaction. Also, the full legal documentation for some trades is often not executed until long after the trade date and, in the case of many bespoke trades, the full legal documentation can be voluminous.   Also, not all parties use FpML confirmations so reporting the transaction documentation electronically is not always feasible. 

Timing of Reporting

The CSA Derivatives Committee proposes that transaction reporting to trade repositories should be completed in real time once feasible for Canadian market participants and within one business day until real time reporting is implemented. Once real time reporting is implemented, large trades meeting a to-be-determined block trade threshold should be subject to a delayed reporting requirement in order to preserve the anonymity of market participants and ensure that there is no detrimental impact on market liquidity or function. 

This real time reporting requirement engendered many comments, as it has in other jurisdictions. The need for real time reporting into a database that is not itself a market is questioned. While timely information is necessary, reporting time frames should depend on the level of data required to be reported, the complexity of the transaction and the availability of the required technology systems on a global basis. 

The question of a block trade threshold is also addressed in many of the comment letters. For example, the International Swaps and Derivatives Association (ISDA) recommends that the analysis to determine appropriate minimum block trade threshold levels should be undertaken separately for the Canadian OTC derivatives market, different asset classes within the market and different products within each asset class as the appropriate threshold levels for different asset classes and products within assets classes in the Canadian market will be different. A uniform block trade threshold is too simplistic and would be damaging to liquidity. Also, all block trade thresholds should be reviewed periodically in light of current market conditions and there should be a mechanism for the immediate reassessment of thresholds during periods of market stress.

An appropriate publication delay for block trades should reflect the time it takes to hedge the exposure without unduly impacting the market and in light of liquidity in the particular market.   Liquidity in many Canadian markets may be quite different from liquidity in some foreign markets. Many large Canadian market participants comment that the publication of block trade data should be delayed for at least a quarter as the public reporting of block trade data runs the risk of inadvertent disclosure of confidential information, potentially enables reverse-engineering strategies and runs the risk that the small number of relatively large participants in the Canadian markets would have the ability to figure out the individual positions of one another.

Access to Confidential Trade Repository Information

The consultation paper also raises a number of concerns relating to access to confidential information, including whether it is necessary for provincial regulators to enact legislation that expressly permits the disclosure of confidential information to and by trade repositories, that amendments to legislation should be enacted to ensure that confidential trade repository data is not made publicly available pursuant to public disclosure laws and that Canadian regulators and the central bank should establish cooperation agreements with foreign jurisdictions that have equivalent legal and supervisory frameworks to facilitate cross border access to trade repository data.

Availability of Information to Public

Another controversial proposal is that trade repositories should make available to the public aggregate data, including information on positions, transaction volumes and average prices. Anonymous post-trade transaction level data should also be made public provided that it would not be detrimental to market liquidity or function. The comment letters urge that the release of data to the public be studied thoroughly, because the publication of such data may compromise the positions of counterparties depending upon the size of the market and the level of aggregation of the data.

Inter-Affiliate Transactions and End User Exemptions

The consultation paper does not deal with the question of inter-affiliate trades. Should inter-affiliate trades be excluded from the reporting requirement (and possibly other aspects of OTC derivatives regulatory reform)? It has been argued that transactions between affiliates merely represent transfers of risk within a corporate group and should not be subject to the same reporting requirements as inter-affiliate transaction data will not provide any valuable information to regulators from either a systemic risk or market conduct perspective. Reporting of inter-affiliate trades will also increase the costs and burden for corporate groups that choose to consolidate their hedging activities in a single entity.

Nor does the consultation paper contemplate exemptions from the reporting requirements for hedging end users.   The CSA will have to consider whether such exemptions should be made available for end users that are hedging risks (particularly in the commodities and energy markets) where they do not pose any systemic risk. Perhaps exemptions of this nature will be discussed by the CSA Derivatives Committee more broadly in its anticipated Consultation Paper 91-405 - Exemptions (Derivatives).

According to IIROC, the CSA and IIROC are proposing to publish a joint notice to solicit feedback on whether additional proposals to enhance disclosure of short sales and failed trades in Canada are required. For example, the joint notice may seek comment on whether "disclosure of short positions by institutional investors may be necessary, similar to 'buy-side' reporting requirements that have been or are being widely implemented in other jurisdictions" as well as the type, level and frequency of public disclosure of failed trades in equity securities traded on all Canadian marketplaces and cleared through CDS.

This subsequent notice on enhanced disclosure, however, has yet to be published. In the U.S., meanwhile, the SEC recently issued a request for comment on the feasibility of requring real-time reporting of short sale positions of publicly listed securities, either publicly or only to the SEC and FINRA. In a sign of what may be to come in Canada, the SEC notice asks specific questions of market participants, including with respect to the benefits and costs of real time reporting of investors' short positions.

Proposed Form 45-106F7 requires identification of each significant party involved in the securitization, namely parties with a significant role in structuring the securitization transaction, the creditworthiness and liquidity of the program, the selection, acquisition, analysis and management of the assets, the distribution of the securitized products and the payment to securitized product holders and requires details in respect of the role and function of such significant party and description of its experience with respect to substantially similar assets. For sponsors, liquidity providers and providers of material program credit enhancement, additional information is required. Where any such significant party is retaining a tranche or portion of a tranche of the issuance, the description of the tranche interest so retained is to be disclosed.

The disclosure must include diagrams setting out the structure of the securitization under the securitization program and simplified diagrams as to the cash flows of the securitization program.

The form requirements include (among other things) a detailed description of the program including a description of the investment guidelines applied to the pool assets, the amount and nature of liquidity support, the amount and nature of program-wide credit enhancement and any other protections afforded to securitized product holders.

In addition, a summary of the pool assets is required. For each series of short-term securitized product to be distributed, the IM is required to disclose the range of asset types that may be included in the pool, the manner in which the issuer will gain access to underlying asset exposure and the due diligence or verification procedures that have been or will be applied in respect of the pool assets. Disclosure is required as to whether any of the pool assets include CDOs or similar obligations, credit default swaps and other credit derivatives, synthetic assets or derivatives or sub-prime assets. If the pool assets include any of the foregoing, enhanced disclosure is required including a description of those assets and the process for obtaining those assets.

The IM will need to describe the short-term securitized product, its distribution and offering including the material terms thereof as well as the flow of funds for the securitization program including payment allocations, payment dates and payment priorities and, vis a vis certain assets, the ranking of the securitization program in priority of payments if it would reasonably be required by a prospective purchaser to make an informed investment decision.

The disclosure document must describe conflicts of interest that exist or may be reasonably anticipated between or among significant parties and a securitized product holder, all fees and expenses to be paid or payable out of the cash flows from the pool assets and the identity of the parties receiving those fees or expenses. This could be problematic to the extent that it means disclosing confidential arrangements or proprietary business terms. In order of significance, the document will need to disclose risk factors to enable the prospective purchaser to make an informed investment decision with respect to the short-term product including credit and liquidity risks, legal risks that may exist (such as true sale and bankruptcy remoteness issues and other claims or contingent claims on the pool assets) and tax risks, among others. The CSA provides only an indicative list of the types of risk factors that should be included. Each issuer preparing an IM will need to consider the distinct risk factors applicable to its own program.

The issuer will need to describe the material terms of the existing program documents and transaction agreements. This may prove to be a challenge. If the information memorandum is to be distributed on or before each purchase and the conduit is a multi-seller, multi-asset ABCP conduit intended to acquire a diverse range of asset interests and to finance and refinance those assets over time with short term instruments, one can expect new transaction-specific or asset-specific agreements to be entered into with some frequency. The ABCP conduit issuer will need to regularly revisit the IM disclosure as a consequence. We’ll revisit this issue in further detail later in this blog entry.

The other prescribed terms (in addition to those terms of general application to short or longer term products) include description of financial leverage and the credit rating of securitized product. Each memorandum (whether for short-term issuances or otherwise) must provide a description of the statutory or contractual rights of action or misrepresentation in favour of the purchaser, the resale restrictions that apply and include certifications from the issuer’s CEO or CFO (or equivalent), promoter and sponsor as well a signed certificate from each underwriter. While the foregoing summarizes the salient aspects of some of the important prescribed terms, this blog entry doesn’t identify every single disclosure term.

I’d like to share some further observations on the foregoing form requirements. After having completed a survey of a selection of ABCP conduit information memoranda, I believe the proposed form requirements will mean that for many ABCP conduit sponsors or administrators the current information memoranda in use will prove to be deficient after the proposed rules come into effect for ABCP conduit information memoranda. By and large, most current ABCP conduit information memoranda describe in general terms and broad language the aspects of the program that existed at the program inception and were not anticipated at the initial preparation of the IM to be reasonably capable of change or at least were described in a manner that such disclosure would remain correct after the passage of time and in particular after the introduction of new assets and originators into the securitization program. I don’t think this manner and approach to IM disclosure will continue to suffice.

I believe that it will no longer be the case that an ABCP conduit administrator will be able to create a series specific IM on the initial creation and issuance of a series of notes and only revise or revisit the IM when there are material amendments to the terms and attributes of the series. The requirement to describe pool assets and transaction terms in particular will require frequent reconsideration of the IM requirements. This means that ABCP conduit sponsors will potentially need to revisit their IMs and enhance the disclosure whenever new deals are originated and transaction documents are finalized and will need to report on related performance of such assets. In addition to the time and expense that may be so associated, the question that I have is whether the requirements imposed by the prescribed terms can practically be achieved.

In the context of short-term securitized product conduits (such as ABCP conduits), I presume that the ABCP conduit is issuing instruments of varying maturities and refinancing or rolling those notes regularly, perhaps as frequently as daily. Given this presumed frequency of issuance and purchase of securitized instruments, is the obligation to deliver an IM (in prescribed from and containing no misrepresentation) to each ABCP purchaser at or before the time of purchase intended to be interpreted such that the ABCP distribution desk of a sponsor of an ABCP conduit is required to issue an IM to a purchaser of the ABCP on any day that a purchaser purchases including the rolling, renewal or refinancing of previously issued and created CP (ie. on the initial creation and each roll date thereafter).   If this is the intention, it will mean each ABCP trader and the associated ABCP conduit administrator will need to confirm that the IM contains no misrepresentation and satisfies the prescribed terms as often as daily. This will then mean that from an operational and practical perspective the ABCP conduit is being asked to maintain current product disclosure virtually at all times – an administrative exercise that places the issuers of short-term securitized product (such as ABCP conduits) in Canada in an arena all by themselves. As it has with the continuous disclosure regime proposed for exempt purchases of securitized products, the CSA has imposed disclosure obligations on the short-term securitized product market that do not exist in any other exempt debt or equity market in Canada.

Accordingly, the CSA have not adopted the more controversial aspects of the U.S. Proposals such as mandatory risk retention, asset-level disclosure and waterfall computer programs. Even in respect of those parts of the U.S. Proposals that have been broached by the CSA proposals, the contrasting regulatory approaches have yielded markedly different results.

Repurchase Requests

The U.S. authorities have devoted much energy to the topic of repurchase requests, in part as a result of lawsuits over the enforcement of covenants to repurchase assets as a result of alleged breaches of representation and warranty and the difficulties encountered by investors in obtaining the necessary information from sponsors. In an effort to identify originators with clear underwriting deficiencies, the U.S. Proposals contain various rules ranging from the requirement to file periodic reports in respect of all fulfilled and unfulfilled repurchase requests to a requirement to obtain a third-party opinion in respect of any unfulfilled repurchase request.

The equivalent CSA proposal is limited to prospectus disclosure requirements. It applies to any offering where the underlying transaction documents contain an obligation to repurchase or replace assets due to a breach of representation and warranty (that is, virtually all ABS transactions). Disclosure is required in respect of each transaction in which (i) the originator under the present distribution or one of its affiliates was the originator, (ii) the assets involved were of the same class as those involved in the distribution and were themselves the subject of a public distribution and (iii) the assets were the subject of a demand to repurchase or replace for a breach of representation and warranty pursuant to the transaction agreements made at any time during the previous three years. In addition, disclosure is required as to the outcome of the demand and, if the demand has been rejected on the basis that the assets did not violate a representation and warranty, “whether an opinion of a third party not affiliated with the originator had been furnished to the trustee or issuer that confirmed that the assets did not violate the representation and warranty”. The requirement that any demand to repurchase be made “pursuant to the transaction documents” is important. In the U.S. much comment has been devoted to whether arbitrary demands not based on the rights afforded under the documents need be reported. The answer seems to have been clarified under the CSA proposal. 

Curiously, a separate but identical provision applies to “each party that is required to repurchase or replace a pool asset for breach of a representation and warranty”.  Given the breadth of this latter provision, the one discussed above, which applies solely to originators and their affiliates, seems redundant. 

Finally, information regarding the financial condition of each party with a repurchase obligation must also be provided if there is “a significant risk that the party’s financial condition could have a material impact on its ability to comply with the provisions relating to the repurchase obligations”. The precise nature of the required disclosure is uncertain and should be clarified unless all that is intended in the traditional statement that there can be no assurances that the party will be able to meet its obligations.

Asset Review

The U.S. Proposals also require issuers of registered ABS to perform a review of the underlying assets and to make disclosure regarding the nature, findings and conclusions of the review. The CSA proposal simply requires disclosure as to (i) “whether the pool assets have been reviewed for compliance with selection criteria or are the subject of a report by a third party to verify the accuracy of the loan or other asset information disclosed in the prospectus” and (ii)”if the pool assets have been reviewed for compliance or are the subject of a report by third party, the identify of the reviewer or third party, the scope of the review or report, and the result of findings of the review or report”. 

Risk Retention

Two days prior to the release of the CSA proposals, the SEC and various other federal banking regulators issued a massive set of proposed rules under the Dodd-Frank Act requiring securitization sponsors to retain an economic interest in the assets that they securitize. The proposed rules apply to virtually all securitizations whether public or private. They provide for several forms in which risk can be retained as well as limited exceptions for pools of assets that satisfy specified credit criteria and restrictions on hedging of the retained interests. The impact of these rules promises to be significant, imposing costs and burdens on the securitization industry which will inevitably be passed on to consumers in the form of a higher cost of credit. In stark contract to the U.S. Proposals, the CSA have chosen not to require minimum risk retention but, in keeping with the general thrust of its proposals, have restricted themselves to merely requiring disclosure as to whether any party to the transaction for whom disclosure has been provided under the prospectus “is retaining a portion of a tranche or tranches, and if so, … the amount retained for each tranche [and] whether that person or company has directly or indirectly hedged, or taken any other action, that seeks to transfer in whole or in part the credit risk associated with a retained portion.”

Although the CSA have not proposed the introduction of Dodd-Frank-style rules, they have asked for comments on certain features of the U.S. Proposals: “We have done so where we think that further feedback and analysis is required to determine (a) whether the proposed requirement will achieve its intended aims and, if so, how to appropriately design the requirement or (b) whether it is appropriate in the Canadian context. In particular, we are seeking comment on the following types of requirements:

• requirements that securitizations be structured in a particular manner, such as requiring that sponsors or other transaction parties retain a minimum tranche or tranches of the securitization (a “skin-in-the-game requirement”);
• requirements for due diligence, such as requiring the issuer to review the pool assets;
• requiring or restricting the involvement of particular parties in a securitization, such as imposing independence requirements or restrictions on conflicts of interest; and
• requirements for new disclosure that we think would be a major departure from what is already being provided pursuant to transaction agreements, such as asset-or-loan-level disclosure, provision of a computer waterfall payment program, and requiring sponsors or originators to file reports on fulfilled and unfulfilled repurchase requests across all securitizations.”

The introduction of any such requirements in Canada should be strongly resisted. The U.S. Proposals were made in response to specific industry conditions which by and large were not present in Canada. Contrary to what is apparently believed by the CSA (see their assertion that the model is “fundamental to securitized products”), the ‘originate-to-distribute’ model of securitization which has attracted so much adverse attention in the U.S. was not in fact prevalent in Canada (or, for that matter, in most asset classes in the U.S.), at least not in the manner or to the degree which is said to have caused so much damage. In transactions involving most asset classes, Canadian sponsors (mostly originators) in fact retained a significant amount of “skin-in-the-game” as a result of underwriting and rating agency requirements and industry standards and expectations. The financial crisis was arguably the product of the radical and unregulated application of this model in the RMBS sector alone and, as recognized by the CSA, there was no the subprime housing bubble in Canada. Nor have Canadian securitizations in general suffered anywhere near the level of losses that were experienced in the U.S. U.S. commentators have forewarned of the danger to the U.S. securitization market represented by the cumulative burdens which would be imposed by the implementation of the U.S. Proposals. Such burdens would be even less tolerable in the Canadian market which is much shallower than its U.S. counterpart. If they were to be imposed in Canada, it may prove fatal to both the ABS industry and any positive effect of the industry on the supply of credit, a benefit cited by the CSA itself.

First in the array of new disclosure documents proposed by the CSA in NI 51-106 is Form 51-106F1 Payment and Performance Report for Securitized Products. This report would be required to be filed within 15 days after each payment date for each series or class of securitized products to which NI 51-106 applies. Generally, Form 51-106F1 would contain information regarding payment distribution and pool performance during the most recent reporting/payment period. This new disclosure requirement is largely derived from the SEC’s Form 10-D. If the reporting issuer concludes that none of the disclosure in Form 51-106F1 is applicable due to the attributes of the subject securitized product or the structure in question, the reporting issuer can file an alternate report that contains all information that would be material to an investor regarding payment distribution and performance of the subject series or class of securitized products.

Second is Form 51-106F2 Timely Disclosure of Significant Events, a form which would be required to be immediately filed (along with a news release) no later than 2 business days after the occurrence of an enumerated event. The list of events that would give rise to such a filing would be contained in Section 5(2) of NI 51-106, including, among others, (i) a failure to make a payment, (ii) a change of servicer, (iii) modification or termination of any material credit enhancement arrangement, (iv) a bankruptcy, (v) a change in credit rating and (vi) any other event that results in a material modification to rights of investors, payments or pool performance. The enumerated events above are, according to the CSA, largely derived from the SEC’s Form 8-K.

The third new requirement is the Annual Servicer Report (Section 6 and Appendix A to NI 51-106), which each servicer whose servicing activities relate to more than 5% of the pool assets must file. This form, which must be audited, would require such servicers to assess their compliance with a set of servicing standards listed in Appendix A to NI 51-106. Going hand in hand with this is a new requirement for an annual servicer certificate, signed by an authorized officer of the servicer, stating that the officer has (i) supervised a review of the servicer’s activities and performance under the applicable servicing agreement during the reporting issuer’s most recently completed financial year and (ii) to the best of the officer’s knowledge, based on such review, the servicer has fulfilled all of its obligations under the applicable servicing agreement in all material respects during the financial year, or if not, states the nature and status of each such failure. This certificate must be filed by the reporting issuer along with its annual information form, financial statements and annual managements’ discussion and analysis in respect of any servicer to which items 1.7(a), (b) or (c) of the new Form 41-103F1 applies (essentially any master servicer, affiliated servicer or servicer servicing 10% or more of the pool assets).

Additionally, while NI 51-106 only applies to reporting issuers, certain proposed amendments to National Instrument 45-106 Prospectus and Registration Exemptions would apply the requirements in respect of Form 51-106F1 and Form 51-106F2 to issuers of non short-term securitized products in the exempt market. Vis a vis the issuance of non short-term securitized products by issuers that are not reporting issuers, the proposed rules would provide that the continuous disclosure obligations generally apply as if the issuer were a reporting issuer subject to certain modifications. Specifically, such issuers would be subject to the same requirements described above: that Forms 51-106F1 and 51-106F2 be completed, filed with the OSC, posted to a website and, in the case of Form 51-106F2 only, delivered to each holder of the affected series of securitized product.

For short-term securitized products, the CSA is proposing amendments to NI 45-106 that would require issuers in the exempt market to prepare a monthly report using the new Form 45-106F8 Periodic Disclosure Report for Short-Term Securitized Products Distributed Under An Exemption From The Prospectus Requirement, which would need to be filed with the OSC and posted to a website no later than 15 days after the end of each calendar month. The content of Form 45-106F8 is generally analogous to the quarterly disclosure requirements applicable to reporting issuers in respect of pool, program and asset information.   The CSA suggests that this Form 45-106F8 was developed by reviewing, among other things, monthly reports already produced by ABCP dealers and credit rating organizations, comment letters on the SEC’s April 2010 proposed ABS and structured finance rules and comment letters on the October 2008 CSA ABCP consultation paper.

Short-term private issuers would also be required to prepare, file with the OSC and post to a website, a timely disclosure report disclosing any (i) change to the information in the most recent Form 45-106F8 report or information memorandum or (ii) event that affects payment distribution or performance of the pool, within 2 business days after the date of the event.

As can be seen, these proposals significantly expand the disclosure required by issuers of public securitized products, as well as essentially extend the requirements of the “reporting issuer” regime to private issuers of securitized products. These amendments would make issuers of securitized products into the exempt market the only Canadian issuers with substantive periodic and timely mandated disclosure obligations.   It appears that the CSA has posited that exempt purchasers of securitized products need protections in the form of periodic and prescribed continuous disclosure not otherwise afforded to private purchasers of other debt and equity securities in Canada.

The foregoing requirements do not apply in respect of pool assets that that are guaranteed by the Government of Canada. One further exception to Reg AB which has  been omitted, however, is that in respect of pool assets backed by the full faith and credit of a foreign government if the pool assets are investment grade securities. By implication disclosure is required under the CSA rules in respect of such assets.

Certain of the other items of disclosure required in respect of significant obligors may involve a somewhat disconcerting degree of reliance upon the obligor. Apart from the requirement to describe the character, history and development of its business, perhaps the most notable example of this is the requirement to disclose “any adverse financial developments since the date of the significant obligor’s most recent financial statements”.

It should be noted there are two other categories of significant obligors: first, a property or group of related properties and, second, a lessee or group of affiliated lessees. It is not immediately clear, at least to me, what the latter category adds to the general obligor category or how exactly a property can be considered to be an obligor and what the implications of doing so are for the required disclosure. Presumably since these categories of the definition are also present in the Reg AB equivalent, the U.S. experience in this respect will be instructive. One implication that is specified for a significant obligor which is a property is that instead of providing the equivalent of MD&A disclosure, only the net operating profit required by such disclosure need be provided.

Credit Enhancers

A significant credit enhancer is an entity (or group of affiliated entities) whose credit enhancement represents 10 – 20% of “the cash flow supporting one or more classes of the securitized products being distributed”.  A very significant credit enhancer represents 20% or more.

Although the wording is derived from that used in Reg AB, the phrase “cash-flow supporting one or more classes of securitized product” could be clarified somewhat. Is it the securitization value of the assets, that is, the discounted present-value of all future expected cash flow? Is it the hedged or unhedged cash flow? In some cases, enhancement supports payments on the issued securities and other obligations of the issuer as opposed to the cash flow of the assets and it would seem more appropriate in such cases to make the calculations on that basis.

Derivative Counterparties

In the case of derivatives, a significant counterparty is an entity (or group of affiliated entities) the maximum probable exposure to whom  represents 10 – 20% of the aggregate principal balance of the pool assets and a very significant counterparty is one the maximum probable exposure to whom represents 20% or more of such aggregate principal balance. 

Once again this rule is modeled on the one in Reg AB. However, certain alterations to the wording used in Reg AB may cause some interpretive difficulties. First, there is the obvious error in the reference to the “exposure of the derivative counterparty” rather than the exposure to the derivative counterparty which is the only relevant consideration. The previous paragraph assumes that this will be corrected.

Second, Reg AB applies to each derivative instrument used “to alter the payment characteristics of the cash flows from the issuing entity.” The CSA rules would apply to each derivative instrument used “to alter the payment characteristics of the payments made on the securitized products.” The payment characteristics of the securities are what they are and would not be not altered by the derivative instrument. Only the payment characteristics of cash flow from the assets is, in a sense, altered.

Finally, the amount used to calculate the percentage of the maximum probable exposure is the aggregate principal balance of the pool assets or, “if the derivative instrument relates only to certain classes of securitized products, of the aggregate principal of those classes.” The phrase “only to certain classes” replaces “only to one or more classes” in Reg AB. This change may raise a certain degree of uncertainty in a case where the derivative instrument relates to all classes of securitized products.

In its request for comments, the CSA indicated that it developed the prescribed form of IM by reviewing, among other things, existing ABCP information memoranda, the information that the Bank of Canada expects when reviewing to accept ABCP as eligible collateral for its standing liquidity facility and comment letters on the October 2008 ABCP Concept Proposal. A typical IM in the market today is basically a very broad overview of the types of assets that will be acquired by the ABCP issuer and a description of the main parties involved in administering and/or providing support to the ABCP issuer and the expected rating of the ABCP to be issued.

While all of this information is required by the prescribed form, it also requires more extensive detail, in particular with respect to specific transactions. For example, the prescribed form requires disclosure of the investment guidelines applied to the pool assets that limit the types and credit quality of assets and asset originators – while a general set of eligibility criteria can be constructed, these will vary somewhat across asset classes and will also vary somewhat from originator to originator. In addition, if the issuer has acquired pool assets, it is required to provide certain disclosure prescribed by Form 45-106F8 (the prescribed form of periodic disclosure for short-term exempt securitized products). This would include disclosure of each asset type acquired by the issuer (expressed as a dollar amount and as a percent of the issuer’s aggregate assets), the industry of the seller (expressed as a dollar amount and as a percent of the aggregate assets) and the percent of assets in the series acquired by each seller. It would also require disclosure describing the assets, including the average remaining term, number of obligors and weighted average life of the assets and detailed performance data, including default and delinquency data. These information requirements would seem to require that an IM be continually updated to reflect the acquisition of new assets, the amortization of existing assets, and to provide an updated performance report. As ABCP issuers are continuously distributing their securities, compliance with these requirements may pose a very significant challenge. Given the periodic disclosure obligations that are proposed to be imposed on ABCP issuers by way of monthly reports (among other things), it isn’t clear why this information would be required to be contained in the IM.

For securitized products that are not short-term, there are no prescribed requirements but, as noted, the IM will need to disclose sufficient information about the securitized product and securitized product transaction to enable a prospective purchaser to make an informed investment decision. This obligation sounds an awful lot like “full, true and plain disclosure” and is clearly a higher standard than applies generally to offering memoranda under existing securities laws (which require that offering memoranda not contain a misrepresentation). Existing disclosure in the exempt term market for securitized products has often been described as “prospectus-like”; and given this heightened standard, coupled with the increased certification requirements discussed below, this is certain not to change.

One of the CSA’s guiding principles in establishing the securitized product rules was that the rules should take into account the particular features of the Canadian securitization market and be proportionate to the risks associated with particular types of securitized products available in Canada and should not unduly restrict investor access to securitized products. Some may question whether the proposed IM rules, which apply irrespective of the type of asset class or issuer involved, are consistent with this guiding principle.

Certification Requirements/Expanded Statutory Civil Liability

One of the more significant aspects to the IM requirements is the requirement that a certificate be signed by the issuer’s CEO and CFO (or individuals acting in a similar capacity), each promoter and each sponsor, stating that the IM does not contain a misrepresentation. In addition, each underwriter will be required to sign a certificate stating that, to the best of its knowledge, information and belief, there is no misrepresentation in the IM. The certifications are required to be true at both the date the certificate is signed and the date the IM is delivered to the purchaser (the latter requirement being further indication that the IM needs to be continually updated). These certification requirements are part of the intended extension of statutory liability for disclosure in information or offering memoranda for securitized products to include third parties such as sponsors and underwriters. The CSA has noted that the statutory civil liability can be achieved in most jurisdictions by prescribing the IM as an offering document to which statutory civil liability rights apply which would then permit a right of action for damages against anyone signing the IM. In Ontario, legislative amendments would be required for statutory rights of action to be available against sponsors and underwriters. Although the standard of disclosure in a private securitized products transaction will not on its face be the same as in a public transaction (which requires full, true and plain disclosure of all material facts), one would expect that underwriters will cease to draw much of a distinction between public and private offerings of securitized products going forward.

A copy of any IM delivered to a prospective purchaser will need to be delivered to the securities regulatory authority and posted on a website within 10 days after a distribution under the IM. A report for the distribution of a short-term securitized product is not required to be delivered if the report is filed not later than 30 days after the calendar year in which the distribution occurs.

Periodic Disclosure Requirements for Exempt Securitized Products

The proposed rules also impose periodic disclosure obligations on issuers of securitized products. These rules would appear to apply not only to new securitized product issuances but also to existing securitized products. As with the IM rules, a distinction is drawn between short-term securitized products and other securitized products. Issuers that distribute securitized products under the securitized product exemption, other than short-term securitized products, will be required to prepare a prescribed form of payment and performance report similar to what is required to be prepared by a reporting issuer and post it on a website within 15 days of each payment date (and deliver a copy to the securities regulatory authority). The issuer is also required to prepare a timely disclosure report upon the occurrence of certain stated events (which are the same events that a reporting issuer is required to disclose). In essence, the continuous disclosure obligations for reporting issuers and non-reporting issuers who issue securitized products maturing more than one year from the date of issuance have effectively been conformed.

Continuous disclosure obligations will be discussed in a future post but would include payment defaults, rating changes, changes in trustees or servicers, certain triggering events such as early amortization events that would materially alter the payment priority or distribution of cash flows and a “difference of 5% or more occurring in a material pool characteristic of an asset pool for outstanding securitized products from the time of issuance of the securitized products, other than as a result of the pool assets converting into cash in accordance with their terms” (one can only imagine the number of ways that this could be interpreted). This report would need to be posted on a website no later than two business days after the occurrence of the event and investors must be provided with a copy or otherwise advised of the report. Query whether all reportable events will be known to the issuer within two business days of the occurrence of the event, in particular asset performance-related events where reporting to the issuer may lag the occurrence of the event.

Issuers of short-term securitized products are required to prepare a periodic disclosure report in the prescribed form dated as of the end of the last business day of each month and within 15 days of the end of each month it is required to delivery a copy to the securities regulatory authority and post a copy to a website. This disclosure report requires a significant amount of information, including very detailed transaction-specific disclosure in regards to asset composition and performance.

If an investor would reasonably require the information to make an informed investment decision, an issuer is also required to provide disclosure of any change to the information disclosed in the most recently delivered report or to the disclosure in the IM as well as disclosure of an event that affects payments or pool performance. This report is required to be delivered to the securities regulatory authority and posted to a website no later than two business days after the date on which the relevant event or change occurred. As noted, for some events there may be a delay between the time when the event occurs and the reporting of that event to the issuer, which would preclude reporting within this timeframe. Also, the requirement to provide timely disclosure of any change to the disclosure in the IM would seem to be a further indication that the IM is intended to be a document that requires continuous monitoring and updating.

Resale Restrictions

The proposed rules would make the first trade of a securitized product that was distributed under the securitized product exemption a distribution, with the effect that the only prospectus exemption that would be available for a resale of a securitized product would be the same securitized product exemption, resulting in a “closed-system” for securitized products.

In the equivalent CSA proposals, the introductory wording is restricted to (a) above while the equivalent of (b), (c) and (d) are left as unqualified line items. As a result, rather than just requiring a description of the contractual provisions, if any, meant to address bankruptcy issues, the CSA seem to be requiring discussion of the substantive issues themselves. These are really the proper subject-matter of the legal opinions provided in the transaction which are lengthy and qualified in various ways in accordance with accepted practice. They are not appropriate subject-matters for prospectus disclosure with its associated liability.

Reg AB requires a description of the “creation (and perfection and priority status) of any security interest in favour of the issuing entity, the asset-backed security holders or others, including the material terms of any agreement providing for such … creation of a security interest.” Although not absolutely explicit, taken as a whole it is fairly clear that this requirement is meant to apply to the creation of security interests pursuant to the transaction in question. This is not so clear in respect of the CSA proposal as the result of the cropping of the language to simply require a description of “the creation, perfection and priority status of any security interest in a pool asset, and each person or company who holds a security asset in a pool asset.” On its face this language could be read so as to extend the scope of the requirement to include security interests in the pool assets given to the originator by the underlying obligors, which of necessity would need to be provided on an asset-level basis. Since such a reading is patently ludicrous and runs contrary to the entire thrust of the CSA proposals which intentionally avoid the asset level disclosure being proposed under Reg AB II, it must be assumed not to have been intended. The issuer relies on the representations and warranties of the originator in respect of these matters.

Servicer

If multiple servicers service the pool assets then, in addition to each master servicer, each servicer that services at least 10% of the asset pool must be identified and more detailed disclosure is required if it services 20% or more of the pool assets. In some transactions, especially RMBS transactions, a sub-servicer may be appointed in respect of the entire pool. It is unclear whether such a sub-servicer is meant to be captured by this requirement but there is at least an argument that it is not, given that one of the specific line items is “the material terms of any relationship or arrangement with another party by which the servicer may subcontract or delegate some or all of its functions to that party.” If the sub-servicer was already caught, such disclosure would seem to be unnecessary given that the material terms of the servicing agreement applicable to each servicer is already required disclosure. On the other hand, the requirement to disclose information about each master servicer and each 10% servicer casts a certain degree of doubt on what is intended here. The servicer primarily obligated is usually the originator who could be said to be a master servicer and the sub-servicer could be caught by the 10% threshold.

If such a sub-servicer is caught there are a couple of line items which might cause some concern, both on the part of the sub-servicer and on the part of the issuer who must rely upon information provided to it by the sub-servicer. First, disclosure is required in respect of the servicer’s “procedures for servicing assets of the type included in the securitized product transaction” and its “process for handling delinquencies and losses”. A servicer’s collection policies are often extremely lengthy and detailed and may, to a certain extent, be considered to be proprietary. Second, information would need to be provided “regarding the servicer’s financial condition to the extant that there is a significant risk that the effect on one or more aspects of the servicing resulting from such financial condition could have a material impact on pool performance or performance of the securitized product”.

In Reg AB, disclosure is required if “any special or unique factors are involved in servicing particular types of assets included in the current transaction, such as subprime assets, and the servicer’s processes and procedures designed to address such factors”. In the CSA proposals, this is rendered as “any factors involved in servicing the types of assets included in the securitized product transaction that are particularly relevant to assets of that type. For example, describe the factors that are particularly relevant to subprime assets and loans with deferred payments, and the servicer’s processes and procedures designed to address those factors”. The deletion of the words “special or unique” is not helpful and only serves to introduce a degree of doubt about what is being required. 

This point also illustrates a general concern deriving from the opening instructions to the form: “This Form sets out specific disclosure requirements relating to securitized products that are in addition to the general requirement under securities legislation to provide full, true and plain disclosure of all material facts relating to the securities to be distributed. Issuers must comply with the specific instructions or requirements in this Form if the instruction or requirement is applicable”. Thus, unless the specific requirement is limited by a materiality threshold, it appears that all applicable facts, however immaterial, are expected to be discussed. As a result, what precisely is being required here has been obscured rather than clarified.

One element of the bankruptcy-related disclosure discussed above in the context of issuers reappears here where a description is required in respect of “whether in the event of a bankruptcy, receivership or similar proceeding with respect to the servicer, any of the issuer’s assets will secure part of the bankruptcy estate or subject to the bankruptcy, receivership or similar control of a third party”. It is unclear in what circumstances the issuer’s assets would ever become subject to a bankruptcy proceeding with respect to servicer.  Nevertheless the wording of this requirement seems to imply that at least a negative statement is expected.

Affiliates and Certain Relationships and Certain Transactions

In both Reg AB and the equivalent CSA proposals, disclosure is required in respect of related party relationships, agreements or transactions which exist at the time of the offering or during the two years before the date of the prospectus between any of the parties discussed in the prospectus. In Reg AB, the types of related-party arrangement which are of interest are (1) those entered into outside of the ordinary course of business or on non-arm’s length terms, apart from the asset-backed securities transaction and (2) those relating to the asset backed securities transaction or the pool assets.

In the equivalent CSA rule, however, the former category is also made subject to the requirement that the relationship, agreement or understanding be “related to the securitized products being distributed or the pool assets”. Accordingly, there does not seem to be any real distinction between the two categories under the CSA rule with the result that, unlike in the U.S., non-arms length dealings among the parties involved in the securitized product transaction which are not related to the securitized products or the pool assets need not be disclosed.

One final line item which may turn out to be the most controversial of all is the requirement to disclose “whether any person described in the prospectus[which includes arrangers or underwriters]or any of its affiliates are engaged in, or have in the 12 months before the date of the prospectus been engaged in, any transaction that would involve or result in any material conflict of interest with respect to any investor in the securitized product being distributed.” The possible implications of this requirement are unsettling to say the least. For instance, just on a practical level, does it really mean that the specific investors have to be identified? Clearly this information would not be available for the preliminary prospectus and may not be known until the prospectus has been finalized or until after it has been issued and receipted. In fact, can it be said that are there really any investors at all until after the final prospectus has been delivered or even until after the rescission period has elapsed? Would an amendment be required after the investors are confirmed and would that be just the start of a vicious circle?

Apart from technical difficulties, this requirement also raises significant substantive issues as it would appear that the obligation to provide the required information presupposes the ability on the part of the issuer to investigate, determine and understand the activities of all other participants, including the underwriters and the investors, over the last 12 months. It is not clear what the original intent here was but it seems safe to assume that there has been somewhat of a failure to translate it effectively. Clearly some further work is necessary here.

 The proposal makes a number of prospectus exemptions currently in NI 45-106 unavailable for distributions of securitized products, specifically:

1. accredited investor (section 2.3);
2. private issuer (section 2.4);
3. offering memorandum (section 2.9);
4. minimum amount investment (section 2.10);
5. financial institution or Schedule III bank specified debt (subsections 2.34(2)(d) and (d.1)); and
6. short-term debt (section 2.35).

These above-listed exemptions would be replaced with a three-part exemption requiring that each investor (i) purchases the securitized product as principal, (ii) fits into the newly proposed definition of an “eligible securitized product investor” and (iii) is delivered an information memorandum on or before their purchase.

An “eligible securitized product investor” is similar in large part to the old definition of “accredited investor” in NI 45-106 and is essentially the same as the definition of “permitted client” in NI 31-03 Registration Requirements and Exemptions, the main differences being the deletion or modification of the asset and income tests applicable to individuals and small investors. Whereas previously, such investors were often able to rely in items (j) through (m) in the definition of “accredited investor” (as set out below), items (k) and (l) have been deleted, and the thresholds in items (j) and (m) have been drastically increased to $5,000,000 and $25,000,000 respectively.

(j) an individual who, either alone or with a spouse, beneficially owns, directly or indirectly, financial assets having an aggregate realizable value that before taxes, but net of any related liabilities, exceeds $1,000,000;

(k) an individual whose net income before taxes exceeded $200,000 in each of the two most recent calendar years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of the two most recent calendar years and who, in either case, reasonably expects to exceed that net income level in the current calendar year;

(l)  an individual who, either alone or with a spouse, has net assets of at least $5,000,000;

(m) a person, other than an individual or investment fund, that has net assets of at least $5,000,000 as shown on its most recently prepared financial statements, and has not been created or used solely to purchase or hold securities as an accredited investor;

Additional amendments have been proposed to the parts of the “accredited investor” definition which are applicable to investment funds. In particular, under the proposed regime investments funds would have to be managed by a person registered as an investment fund manager under the securities legislation of a jurisdiction in Canada, or advised by a person authorized to act as an adviser under the securities legislation of a jurisdiction in Canada. So, for instance, the creation of an investment product by a foreign non-registered entity or even a sophisticated market participant to issue ABS where the investment manager and/or an investment adviser does not have the appropriate securities registrations could be problematic in the exempt space.

The practical implications of narrowing the scope of exempt investors in securitized products remains to be seen. It is possible that the exempt investor rules may not have a material impact on the actual scope of the investor base for securitized products, but time will tell whether that is true. Please contact either of the authors to share your own thoughts on the proposed new regulatory regime for exempt distributions of securitized products.

Apart from identifying each party and describing its role and function in the securitized product transaction, most of the other line items (almost all of which are adopted from the U.S. Securities and Exchange Commission’s Regulation AB (Reg AB) are relatively non-controversial and are not likely to require much more or different disclosure than issuers have been used to providing under the current regime in keeping with their obligation to provide full, true and plain disclosure of all material facts.

However certain of them do raise issues which will be the subject-matter of this and a future piece.

Originator

The required disclosure in respect of originators seems to have been inspired by the proposed amendments to Reg AB (Reg AB II) which require the identification of all originators except where (i) it has originated less than 10% of the pool assets and (ii) the cumulative amount of originated assets by parties other than the sponsor (or its affiliates) comprised less than 10% of the total pool assets. In other words, disclosure is not required in respect of originators of less than 10% of the asset pool if the sponsor and its affiliates have originated 90% or more of the asset pool.

In the CSA proposals, the basic disclosure requirement applies to originators of more than 10% of the pool assets. In addition, disclosure is also required where “the originator has originated as of the cut-off date, or is reasonably expected to originate, assets in respect of a pool in which a sponsor and its affiliates have cumulatively originated less than 10% of the pool assets”. In other words, disclosure is not required in respect of the originators of less than 10% of the asset pool if the sponsor and its affiliates have originated 10% or more of the asset pool.

The original intent of the Reg AB II proposal seems to be that where an originator represents an insignificant proportion of the asset pool when compared to the sponsor, disclosure in respect of the former is deemed to be immaterial and thus not required. This seems to make good sense. It is not clear what the intent of the CSA proposal might be but it is suspected that something simply got lost in the translation.

More detailed disclosure is required in respect of each originator (or group of affiliated originators) which has or is reasonably expected to originate 20% or more of the pool assets. A couple of the disclosure items are worth noting. First is a requirement to disclose the originator’s “credit-granting or underwriting criteria for assets of the type being securitized”. (A similar requirement applies to sponsors as well). It is assumed that only a very general discussion is required here as the details may be proprietary and competitively sensitive and not relevant in any case since, in any transaction, the eligibility criteria of the specific asset pool being securitized will be disclosed.

Second, disclosure must also be made in respect of the originator’s financial condition “to the extent that there is a significant risk that its financial condition could have a material impact on its ability to comply with any obligations to, or fulfill any reasonable expectations that it will, originate assets for the pool.” In any situation involving an amortizing pool of assets, this would not be a material consideration and presumably need not be discussed.

There are two general categories of securitized product:

(a) a security that entitles the security holder to receive payments that primarily depend on the cash flow from self-liquidating financial assets collateralizing the security, such as loans, leases, mortgages and secured or unsecured receivables; and

(b) a security that entitles the security holder to receive payments that substantially reference or replicate the payments made on one or more securities of the type described in (a) but that do not primarily depend on the cash flow from self-liquidating financial assets that collateralize the security.

Following each category of securitized product is a purportedly non-exhaustive list of included examples. 

Listed under paragraph (b) are synthetic asset-backed securities and other synthetic financial instruments (synthetic CDOs, CMOs, CLOs, CBOs, etc). While the term “synthetic” is not defined, it appears that the list of examples is meant to illustrate the meaning of paragraph (b). However, most “synthetic” financial instruments can be said to entitle investors to receive payments that primarily depend upon the cash flows from (i) one or more derivatives that provide economic exposure to referenced debt obligations or defined categories of obligations and (ii) the collateral securing such derivatives. The payments do not necessarily reference or replicate a security referenced in paragraph (a). Many credit default swaps reference corporate or sovereign debt obligations, not just ABSs or CDOs and these do not seem to be captured.

What may be of more concern here is that the definition of synthetic securitized product (paragraph (a) may end up capturing a wider variety of instruments than may have been intended. For instance structured notes such as credit-linked notes that reference a basket of corporate debt could conceivably be caught if the basket can in some way be thought of as including “securities of the type described in paragraph (a)” which includes CDOs, etc. Perhaps the real problem is that the terms CDO, CMO, CBO, etc are not defined and have somewhat amorphous meanings themselves.

Any synthetic securitized products caught by the definition would become subject to the disclosure requirements specified in Proposed NI 41-103. These almost entirely deal with topics applicable to asset-backed securities and would be of doubtful applicability to synthetic securitized products. Thus the supplementary disclosure required in respect of the latter remains unclear. This may not be of great concern since in the past almost all, if not all, synthetic securities were offered in the exempt market. It is probable that this would remain the case in the future and the rules relating to disclosure in information memoranda are flexible enough to accommodate synthetic securitized products.

Paragraph (a) presents its own interpretive issues. First, the list of examples not only includes CDOs, CMOs, CBOs, etc but also includes “asset-backed securities”. The “asset-backed security” definition is the same as the current definition in NI 51-102 and is more or less identical to the Reg AB definition, being “a security that is primarily serviced by the cash flows of a discrete pool of mortgages, receivables or other financial assets, fixed or revolving, that by their terms convert into cash within a finite period and any rights or other assets designed to assure the servicing or the final distribution of proceeds to security holders”.

Unfortunately, the definition is not expanded as it is under Reg AB to clarify the interpretation of the phrase “discrete pool of assets” in the context of master trusts, co-ownership interests, prefunding periods and revolving periods. For instance, in the context of the usual co-ownership arrangement used for revolving assets such as credit cards, a single pool could support multiple series of securities. Similarly the application of the definition to the residual value of lease assets is clarified in Reg AB, presumably due in part to the fact that, by their terms, the underlying automobiles do not necessarily convert to cash within a finite period although the related leases do. Thus, for example, if in an auto lease deal, the residual value of the autos represents more than 50% of the securitization value of the asset pool, can the payments owing to security holders be said to be “primarily serviced by” the cash flow from the financial assets, in this case, the leases? Finally consider the example of a CMBS backed by a single very large mortgage. This would not seem to satisfy the “discrete pool of … financial assets” criteria in the definition.

The example of CMBS further highlights a potentially more serious interpretive difficulty. In a CMBS transaction, the offered security represents a direct ownership interest in the underlying assets. The assets cannot really be said to “collateralize the security” unless this phrase is to be interpreted broadly to mean something like “back or otherwise dedicated to payment of the security”. It is clear from Proposed NI 41-103 that CMBS were intended to be subject to the new rules and, since CMBS clearly satisfy the definition of asset-backed security, it appears that the inclusion of this definition as an example under paragraph (a) should be read as colouring the interpretation of paragraph (a), specifically the meaning of the word “collateralizing the security”.

The real problem arises, however, if this broader interpretation is applied beyond the non-controversial case of CMBS to various securities which, while they share certain characteristics of traditional asset-backed securities, are not generally thought of as true asset-backed securities.

The language of paragraph (a) appears to be derived directly (although somewhat grammatically re-arranged) from the new definition of securitized finance product in Reg. AB II (which, it is interesting to note, unlike the CSA rules, only applies to the safe harbour modifications) and the definition of asset-backed security under the Dodd-Frank Act. Concerns have been raised by various commentators in the U.S. about the untoward breadth of these definitions. Many issuers of securities, including financial institutions, mutual funds and certain income trusts and REITs, depending on their underlying structure and asset mix, may hold various financial instruments and the cash flow to support payments to their securityholders may be primarily derived from the liquidation of these assets. Perhaps in most of these cases it can not be said, in any true sense, that the financial assets “collateralize” the security but if that word is given a broad meaning, uncertainty may begin to creep into the analysis.

This sense of uncertainty is heightened when the exclusions adopted by the CSA are critically examined. Excluded from the scope of the proposed ruling are covered bonds (which are undefined) and securities, other than debt securities, issued by a mortgage investment entity. The latter is defined as a person or company

(a) who invests substantially all of its assets in debts owing to it that are secured by one or more mortgages, hypothecs, or other instruments, on real property; and

(b) whose primary purpose or business activity is originating and administering mortgage loans, with the intent of holding such mortgages for the entire term and of using the revenues generated by holding the mortgages to provide a return for its investors.

For present purposes at least, the exclusions themselves are less interesting than the negative implications that they raise. First, a covered bond is generally considered, in the CSA’s own words, as “a primary obligation of the financial institution with the cover or collateral pool serving as credit enhancement” which seems to support a broad interpretation of the concept of “collateralizing” the security. More troubling though, is  the implication that other securities may be caught provided they are, in some sense, “collateralized” by a pool of self-liquidating financial assets even if they primarily rely on the general credit of another party (i.e., the security bears recourse to a specific operating company or other credit source). 

Second, the exclusion of securities, other than debt securities issued by mortgage investment entities, implies that any security (including equity and corporate debt) issued by an entity whose primary business, and thus source for funding payment to investors, is the originating and administering of financial assets other than mortgages on real property, and any debt security, however structured (or for that matter unstructured), issued by a mortgage investment entity, may be a securitized product.

The foregoing discussion is not meant to imply that the CSA intended to subject, for example, recourse securities issued by finance companies to the enhanced disclosure requirements for securitized products. What it does illustrate, however, is that, when the definitions are subjected to techniques of statutory interpretation, certain ambiguities may emerge giving rise to uncertainty. In the context of transactions generally requiring opinions as to compliance with securities laws, such uncertainty may become problematic.

As indicated above, we will continue to offer our observations on various aspects of the CSA proposals over the next couple of months leading up to the June 30 deadline for the submission of comments. We would like to invite all our readers to consider this to be a forum for introducing and airing your own views and concerns. All you need to do is to post a comment on this piece or, if you would prefer, send one of us an e-mail. We would be happy to collect and consider your comments and may raise some of your points (for attribution or not as you may indicate) in future pieces.

According to the CSA, the Proposal contains four main features:

1. Enhanced prospectus disclosure requirements for securitized products issued by reporting issuers;
    
2. New prospectus exemption rules for securitized products that require, in most cases, the delivery of an “information memorandum” to investors and narrow the class of investors who can buy securitized products on a prospectus exempt basis.
   
   Specifically, the Proposal would make a number of prospectus exemptions currently in NI 45-106 unavailable for distributions of securitized products, including: section 2.3 (the accredited investor exemption), section 2.4 (the private issuer exemption), section 2.9 (the offering memorandum exemption) and section 2.10 (the minimum amount investment exemption). These exemptions would be replaced by a new prospectus exemption for investors who are fit into the narrower proposed definition of “eligible securitized product investor”;
    
3. Prospectus level liability for issuers, sponsors and underwriters, including CEO certification of “information memoranda”; and
    
4. Continuous disclosure and prescribed monthly reporting obligations for both reporting issuers and issuers in the exempt market.

The Proposal contains significant, and in many cases, onerous requirements which will have a material impact on a Canadian industry with a very positive track record of performance.

The CSA is accepting comments on the Proposed Rule until June 25, 2011.

We will be posting detailed future commentary on these proposed rules with a view to creating the broadest possible discussion among market participants. We encourage you to let us know your views. Stay tuned.

The cash collateral had been provided pursuant to a negotiated security agreement under which it was clear that the security interest secured only certain overdraft facilities LBHI had with BOA. LBHI’s guarantee liability was not an obligation secured by this cash collateral. Consequently, the court found that the statutory safe-harbour did not apply, i.e. the protection from the stay for exercising contractual rights under any security agreement forming part of or related to a swap agreement. (While the language in the Canadian safe-harbours is quite different, we’d see the same result here if we were dealing with an insolvency proceeding that involved a stay on collateral enforcement, such as the CCAA. Under the CCAA, the right to set-off the value of financial collateral requires that the collateral have been provided for the eligible financial contract.)

The more interesting legal issue in the case related to whether BOA could rely on a common law right of set-off. The security agreement pursuant to which the cash collateral had been provided that BOA retained the right to exercise any remedy provided by applicable law and stated that the rights, powers and remedies given to BOA by the agreement were in addition to all rights, powers and remedies given by virtue of any statute or rule of law. BOA argued that this meant it retained its state law rights of set-off.

The court disagreed. To give these boilerplate provisions an interpretation that would permit BOA to set-off any other obligation against the cash collateral was inconsistent with the purpose of the agreement, which was to secure the specific obligation relating to intra-day overdrafts.

Granted it is difficult to draw a distinction between a cash collateral set-off arrangement and a set-off agreement or right that does not involve a security interest. However, there are differences. With cash collateral arrangements (as was the case with LBHI) the collateral provider had certain obligations with respect to the cash collateral as it relates to the secured indebtedness. It has to maintain a certain amount on the deposit as a condition of maintaining the overdraft, and it has to give notice if it wants to withdraw the funds or may not be permitted to withdraw the funds. These types of contractual requirements and restraints which apply to the funds on deposit and relate specifically to the indebtedness provide assurance that the set-off opportunity will ultimately be available and in that vernacular sense “secure” the indebtedness. There is no such assurance that other obligations will ultimately be available for set-off since those contractual obligations do not apply to them.  It’s not necessarily inconsistent with the intention of the parties to allow both the specific contractual set-off with respect to the specifically secured indebtedness and the more random, see where we are when the music stops, set-off at common law or perhaps under a general set-off clause, such as the ISDA standard form set-off provision.

Much of the analysis in the case focused on whether the cash collateral account was a special or a general account. Under N.Y. law rights of set-off cannot be asserted against a special account. The court found it was a special account and precluded the set-off on that basis. Canadian common law does not draw a distinction between special and general accounts, at least not expressly. A fund, such as a trust fund, may be created for a certain purpose and only accessible for that purpose, so I won’t say that this type of analysis would never apply. However, it’s more likely that it would be argued as an implied waiver of the set-off right in Canada and that may have been harder to argue given the preservation of rights in the agreement.

In any event, the lesson of the case is that your boilerplate may not be as helpful as you think. With cash collateral arrangements, if the definition of secured indebtedness is narrow, you may want to be clearer about what rights of set-off are retained. The inclusion of the standard form of set-off clause in the 2002 ISDA Master (and in many earlier versions) would have added an interesting dynamic to this case.

Our readers will recall that the Rule provided, among other things, that NRSROs must maintain on a password-protected Internet Web site a list of each structured finance product for which it currently is in the process of determining an initial credit rating and identifying the type of structured finance product, the name of the issuer, the date the rating process was initiated and the Internet Web site address where the arranger of the subject issuance provides information to the hired NRSRO for the subject issuance that can be accessed by other NRSROs.  One of the goals of the foregoing Rule was to provide information accessible to NRSROs that were not hired for a subject structured finance issuance so as to enable such other NRSROs to be able to complete alternate or shadow ratings or review of the issuance.  The Rule is part of the broader U.S. reform initiative that is seeking to manage perceived conflicts of interest in the rating retainer arrangements and processes between asset originators and credit rating agencies. The underlying logic is that by providing access to all interested rating agencies to information about a proposed rated structured finance product, rating agencies might be in an informed position to assess the ratings ascribed to structured finance issuances generated by other rating agencies and thus avoid rating agency determinations that are not capable of review, criticism or confirmation by others.  Whether in fact the rating agencies and their processes (and allegations of conflict of interest) are to blame for the failures in U.S. securitization is a subject that I believe requires a nuanced and careful examination but in any event the U.S. Congress certainly doesn't need to be convinced that the credit rating agencies are at least partly responsible for the excesses and failures in the structured finance market in recent years.  But that's the subject for another blog...

Our anecdotal information suggests that many structured finance arrangers in Canada were not prepared in June of this year to have due diligence and similar information available on dedicated web sites for non-hired NRSROs as required under the Rule and many would not have been ready to meet the previous effective date for the Rule as of this coming December 2nd.  One of the issues that structured finance arrangers were struggling with is how to manage, collect and record exchanges with rating agencies so as to be able to be in a position to effectively populate the required dedicated Internet Web site with information shared with the hired rating agency about the structured finance product in question.  Some commentators have suggested that the requirement to have the information about the rated product available for scrutiny on a dedicated site may have a chilling effect on the tone, manner and scope of exchanges among the arranger, the rating agency and the originator.  We'd see, so the argument goes, less candid and informal exchanges among participants engaged with the proposed issuance to help develop the product criteria or attributes, fewer oral communications and more scripted responses.

The SEC is seeking comments from interested parties on the Rule and particularly its application to non-U.S. structured finance transactions. The extra-territoriality of the US financial reform legislation (including the Dodd-Frank securitization reforms) has been a subject of previous blog posts by my partner, Mike Rumball, and the application of this Rule in the future to Canadian deals is another example of the potential broad application of current US reforms. We will be watching the application of this Rule to Canadian deals and will report back on this blog on future related developments.

The Ontario Securities Commission’s (OSC) nascent focus on investors’ concerns regarding climate change considerations has been apparent for some time. In February 2008, the OSC released Staff Notice 51-716 – Environmental Reporting, which outlined the results of a targeted review to determine the degree to which reporting issuers were adequately disclosing “environmental matters”. Meanwhile, in December 2009, the OSC published Staff Notice 51-717 – Corporate Governance and Environmental Disclosure, which detailed the OSC’s plans to enhance environmental and corporate disclosure requirements of reporting issuers.

In Staff Notice 51-333, the CSA emphasize that the standard (as outlined in NI 51-102) to be met by reporting issuers in determining if environmental matters must be disclosed is whether or not the matter is “material”. The CSA offer several principles to guide the determination of materiality, namely that: (i) there is no bright line test, (ii) materiality is context- and timing-dependent; and (iii) trends, demands, commitments, events and uncertainties depend on the probability that such trend, etc., will occur and the expected magnitude of its effect.1

In the context of a wide range of environmental issues, the CSA focused Staff Notice 51-333 on the following types of disclosure:

1. Environmental Risks and Related Matters. The five key disclosure requirements in NI 51-102 that relate to environmental matters are: environmental risk, trends and uncertainties, actual and potential environmental liabilities, asset retirement obligations and the financial and operational effects of environmental protection requirements, including the costs associated with these requirements.
    
2. Environmental Risk Oversight and Management. Two key sets of disclosure requirements provide insight into a reporting issuer’s oversight and management of environmental risks: environmental policies implemented by the issuer and the issuer’s board governance. A reporting issuer should explain the purpose of its environmental policies and the risks they are designed to address and evaluate and describe the impact that the policies may have on its operations. The reporting issuer should disclose the board of directors’ (or any delegate committee’s) responsibility for the oversight and management of environmental risks.
    
3. Impact of adoption of International Financial Reporting Standards (IFRS). As reporting issuers make the mandatory transition to IFRS for financial years beginning on or after January 1, 2011, issuers may be required to accrue more environmental liabilities at higher amounts and provide more disclosure regarding these liabilities.
    
4. Forward-Looking Information Requirements. Issuers are advised that disclosing goals or targets with respect to greenhouse gas emissions or other environmental matters may be considered forward looking information or future oriented financial information and would be subject to the disclosure regime for such information in NI 51-102.
    
5. Governance Structures Around Environmental Disclosure. Staff Notice 51-333 provides reporting issuers with recommendations regarding governance structures with respect to environmental matters, including reliable internal controls and disclosure procedures. The reliability of these systems is a necessary underpinning for securities regulatory filings, including CEO and CFO certifications under National Instrument 52-109 – Certification of Disclosure in Issuers’ Annual and Interim Filings. Directors and certifying officers need to know that management has implemented systems, procedures and controls to gather reliable and timely environmental information to be able to certify that the reporting issuer’s filings do not contain any misrepresentations.

The CSA’s Staff Notice 51-333 demonstrates that, regardless of whether or not they are subject to greenhouse gas emissions or other environmental reporting requirements, issuers must seriously consider the effect of environmental matters and climate change on their business and ensure that such matters are adequately disclosed to investors.

We will continue to follow the progress of the Canadian securities regulators in their development of a robust disclosure regime for climate change related matters.  Look for further analysis and observation in future bulletins.

1 The CSA derived the guiding principles from National Policy 51-201 Disclosure Standards, decisions of the Canadian securities regulatory authorities, such as the OSC’s decision Re YBM Magnex International Inc. (2003), 26 OSCB 5285, and from a review of discussions of environmental materiality in guidance documents from the Canadian Institute of Chartered Accountants and the U.S. Securities and Exchange Commission.

As a result of these new rules, ISDA published the 2010 HIRE Act Protocol to enable parties to amend the terms of their existing Covered Master Agreements to reflect the new U.S. withholding requirements enacted under the HIRE Act and the increased tax risk associated with IRS audits of equity swap transactions.  Adherence to the Protocol is voluntary.

Because the HIRE Act applies to payments made on certain swaps and other contracts on or after September 14, 2010, regardless of when the contract was entered into, it is important for Canadian market participant to: (1) review existing agreements, (2) consider carefully the impact of the HIRE Act withholding requirements on their transactions and (3) assess the implications of adherence or non-adherence to the 2010 HIRE Act Protocol.

Ultimately, IIROC made a number of findings and recommendations regarding the obligations of dealers to their clients with respect to PPNs, including the following:

1. The dissemination of required disclosure to clients was inconsistent among members. On this point, IIROC reminded dealers that they are required to have a "new product due diligence" policy and are required to implement procedures to ensure that any clients purchasing a PPN receive the required appropriate disclosure.
    
2. The majority of dealers appeared to rely on product issuers to distribute the monetization notices directly to unit holders without the benefit of a contractual agreement requiring issuers to distribute on the dealer's behalf. IIROC stated that all dealers should review their contractual agreements with issuers to ensure that responsibility for the distribution of notices is clearly delineated.
    
3. Most dealer marketing material was inadequate and missed key information. On this point, IIROC reminded dealers of their obligations regarding sales literature under IIROC Rule 29.7(1) regarding the fair presentation of potential risks.
    
4. IIROC found that some dealers' registered representatives did not understand all the features of the PPN products they were recommending to clients. In response, IIROC stated that dealers must take a proactive approach to reviewing and monitoring products, which should include a written policy for the due diligence of new products.
    
5. IIROC found the PPN products to be suitable for the accounts tested.
    
6. There was no uniformity in the level of training to registered representatives regarding PPNs. IIROC stated that dealers must ensure their registered representatives and sales staff are educated and understand the important features of products being marketed to clients.
    
7. IIROC found deficiencies in the information included on monthly statements, which should be clear and informative.

See IIROC Notice 10-0233.

The CSA are proposing an amendment to Part 2 of NI 81-102, which would allow mutual funds to engage in limited short-selling of securities subject to certain conditions. Previously, mutual funds wishing to engage in short-selling were forced to operate under ad hoc relief granted by securities regulatory authorities.

Under the proposed amendments, a mutual fund will be permitted to sell securities short subject to it having borrowed the security being sold short; there being a cap on short-selling of 20% of its net asset value (NAV); there being a limit on its total exposure to any one issuer through short-sales of 5% of its NAV and it holding a cash cover in an amount that is at least 150% of the aggregate market value of all its short positions on a daily mark to market basis. The proceeds of any such short sale may not be used to enter into long positions in securities other than the cash cover, thus eliminating the possibility of long/short strategies.

The proposed codification of exemptive relief eliminates unnecessary regulatory burdens and reduces costs and delays associated with the application for such relief. However, the ability of a mutual fund to engage in short-selling may be hampered by the requirement that it borrow the security being sold short. The proposed amendments do not include any changes to Section 2.12, which only allows mutual funds to enter into securities lending arrangements as lender. Allowing mutual funds to borrow securities through securities lending arrangements could potentially reduce the cost of borrowing securities and provide a mutual fund with greater access to borrowed securities.

The CSA are also proposing the removal of the term limit on specified derivatives. Mutual funds will no longer be limited in the term to maturity of the fixed income securities in which they can invest. As a result, mutual funds will be able to enter into derivatives that match the term to maturity of their fixed income holdings and they will be able to offset their positions at any time by entering into an opposing transaction.  It has been our experience that one area of concern for financial intermediaries and counterparties to mutual funds has been how to manage the risk of early termination or wind-up of the derivative positions given the current term maturity restrictions.

Finally, the CSA are proposing an amendment to the definition of “cash cover” to include: (i) evidence of indebtedness with a remaining term to maturity of 365 days or less and an approved credit rating; (ii) certain floating rates reset no less frequently than every 165 days and the principal amounts of which continue to have a market value of approximately par on each rate reset; and (iii) securities of money market mutual funds. These changes to the definition of “cash cover” will provide mutual funds with greater flexibility in selecting securities for use as cash cover.

We will be watching as the proposals are further developed and introduced and will provide further updates on developments of interest relating to these proposed amendments.

Among other changes, the amended Rule 17g-5 requires that certain arrangers that pay for a credit rating of a structured finance product maintain information on a password-protected web site for the benefit of qualifying NRSROs, whether or not the NRSRO had been hired to determine an initial credit rating or to monitor a credit rating of the structured finance issuer in question and to represent to the hired NRSRO as part of the engagement of such NRSRO that such web site had been established in compliance with the requirements of the SEC Rule. Under Rule 17g-5(a)(3), an NRSRO is prohibited from issuing or maintaining a credit rating when it is subject to certain conflicts of interest (including being hired by an arranger to determine a credit rating for a structured finance product) unless the NRSRO, among other things, (i) maintains on a password-protected  web site a list of each structured finance product for which it currently is in the process of determining an initial credit rating in chronological order and identifying the type of structured finance product, the name of the issuer, the date the rating process was initiated and the web site address where the arranger represents that the information provided to the hired NRSRO can be accessed by other NRSROs; and (ii) obtains from the arranger a written representation that can reasonably be relied upon that the arranger will, among other things, disclose on a password-protected web site the information that it provides to the hired NRSRO to determine the initial credit rating (and monitor that credit rating) and provide access to the web site to other NRSROs. The Rule establishes a compliance date of June 2, 2010, subject to the conditional exemption described in the following paragraph.

In an Order dated May 19, 2010 (SEC Release No.34-62120), the SEC has temporarily exempted NRSROs from the requirements of SEC Rule 17-g-5(a)(3) where certain conditions are satisfied. Under the Order, an NRSRO is not required to comply with Rule 17g-5(a)(3) until December 2, 2010 with respect to credit ratings where (1) the issuer of the structured finance product is a non-U.S. person; and (2) the NRSRO has a reasonable basis to conclude that the structured finance product will be offered and sold upon issuance, and that any arranger linked to the structured finance product will effect transactions of the structured finance product after issuance, only in transactions outside the U.S. The SEC intends that a “U.S. person” for purposes of the exemptive relief will have the same meaning as under Regulation S of the Securities Act of 1933. Whether an NRSRO has a “reasonable basis” to conclude that a structured finance transaction is not a U.S. transaction will be determined on the facts and would presumably involve conversations between the NRSRO and the arrangers and marketers of the structured finance instrument in question as to the intentions vis-à-vis the marketing, trading and re-sale of such instrument.

As background to the Order, the SEC stated that it had learned from certain foreign securities regulators that many foreign arrangers were not prepared to address the requirements imposed by the amended SEC Rule 17g-5 in terms of establishing the requisite web sites and implementing other systems requirements necessary to make the required disclosures in light of local laws that may impact adherence to the SEC Rule. The corresponding effect of imposing on NRSROs the requirements of Rule 17g-5(a)(3) would have been to require conditions to NRSROs’ issuing or monitoring credit ratings of structured finance products that non-U.S. arrangers were not able to address or accommodate. The SEC relief is designed to address those entities that are not U.S. persons within the meaning of the Act and complete non-U.S. transactions. The SEC will be monitoring the use of the temporary exemption to evaluate whether it is being used for transactions that meet the above-described conditions. The SEC is specifically seeking comments as to the application of Rule 17g-5(a)(3) to non-U.S. transactions.

While NRSROs in the structured finance market have temporary relief in respect of non-U.S. transactions, actions will need to be taken to prepare for compliance with the SEC Rule by structured finance arrangers and NRSROs with Canadian activities prior to the end of the temporary relief period.

Derivatives

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:

Prescribed Derivatives

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.

PPN’s

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.

Exchange-Traded Derivatives

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).

Designated Derivatives

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. 

Excluded Derivatives

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.

Remarks

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.

Relevant Links

Draft Legislation - http://www.fin.gc.ca/drleg-apl/csa-lvm-eng.htm
Government Fact Sheet - http://www.fin.gc.ca/n10/data/10-051_2-eng.asp

Current close-out protections for EFCs in CDIC Act proceedings

Under the current law, a Canadian bank that is in financial difficulty could be subject to one of two types of order made under section 39.13(1) of the CDIC Act by the federal Cabinet on the recommendation of the Superintendent of Financial Institutions (“Superintendent”). These are (1) an order vesting the shares of the institution in CDIC and (2) an order appointing CDIC as receiver of the institution. These orders have different effects, but in both cases there is, subject to an exemption for EFCs, an automatic stay on termination or accelerating payments under contracts by reason only of (i) the federal member institution’s insolvency, (ii) a default, before the order was made, by the federal member institution in the performance of its obligations under the agreement, or (iii) the making of the order. With respect to EFCs, however, there is an exemption to allow a counterparty to terminate, net and deal with financial collateral (the “EFC exemption”).

2009 amendments: enabling assignment of EFCs

The 2009 amendments permit EFCs to be assigned to a bridge institution. Section 7.1, the section not yet in force, provided that if an order directing the incorporation of a bridge institution is made, then the counterparty cannot close-out an EFC if CDIC undertakes to unconditionally guarantee the payment of any amount due or that may become due in accordance with the provisions of the EFC by the institution and to ensure that all obligations arising from the EFC will be assumed by the bridge institution. Section 7.1 reads as follows:

(7.1) If an order directing the incorporation of a bridge institution is made, the actions referred to in subsection (7) may not be taken by reason only that the order or an order appointing the Corporation as receiver is made in respect of the federal member institution or that the eligible financial contract is assigned to the bridge institution if the Corporation undertakes to

(a) unconditionally guarantee the payment of any amount due or that may become due – in accordance with the provisions of the eligible financial contract – by the federal member institution; or

(b) ensure that all obligations arising from the eligible financial contract will be assumed by the bridge institution.

Unless and until CDIC makes that undertaking, a party to an EFC is free to rely on the EFC safe-harbour. Unfortunately the 2009 amendments did not make it clear that CDIC cannot assign individual transactions, but must assign all protected transactions between the institution and the party. In recognition that this was not the intention, the proclamation of section 7.1 into force had been delayed.

2010 proposed amendments: no cherry-picking assigned EFCs

The consequential amendments to the CDIC Act introduced by Bill C-9 propose to clarify that either all or none of the eligible financial contracts between the member institution and its counterparty must be assigned to the bridge institution, together with the related credit support. In other words, there is no cherry-picking. In addition, contracts with related parties should also be assigned to the bridge institution. This ensures that structures involving several different transactions among related parties that are contractually connected are not potentially disrupted by the assignment to the bridge institution of the eligible financial contracts.

(7.2) The Corporation may assign to a bridge institution eligible financial contracts - including any claim under such contracts - that are between a federal member institution and an entity or any of the following entities provided that the Corporation assigns all of those eligible financial contracts to the bridge institution:

(a) another entity that is controlled - directly or indirectly - by the entity;

(b) another entity that controls - directly or indirectly - the entity; or

(c) another entity that is controlled - directly or indirectly - by the entity referred to in paragraph (b).

(7.3) If the eligible financial contracts are assigned to a bridge institution,

(a) the undertaking referred to in subsection (7.1) that is provided applies to all the eligible financial contracts that are assigned; and

(b) the federal member institution’s interest or, in Quebec, right in property that secures its obligations under an eligible financial contract that is assigned is transferred to the bridge institution.

We anticipate that section 7.1 will be brought into force together with new sections 7.2 and 7.3.

These bridge bank amendments recognize that where there is an insolvency of a significant financial institution close-out of financial contracts may, in the circumstances, have a destabilizing effect. Granting a power to the relevant regulator to temporarily suspend close-out in order to effect a transfer to a solvent bridge institution enhances market stability. The Canadian amendments are consistent with the recommendations on this topic in the Report and Recommendations of the Cross-border Bank Resolution Group of the Basel Committee (See Recommendation 9 of Consultative Paper September 2009 and final version March 2010). 

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 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.

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. 

Securities-only regime

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.

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."1

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.

¹ 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).

Section 82 of the QDA requires that a person other than a "recognized regulated entity" who "creates or markets a derivative" be qualified by the AMF (under rules which have yet to be prescribed) before the derivative is offered to the public (the Qualification Requirement). The person must also have the derivative authorized by the AMF (the Authorization Requirement). The Authorization Requirement is not currently in force.

In this decision, the AMF exempted the applicant firm from the Qualification Requirement in connection with the "creation and marketing" of CFDs through a proprietary electronic trading platform and through its Canadian affiliate which is registered as a dealer with the AMF and is a member of The Investment Industry Regulatory Organization of Canada (IIROC). The Canadian registered affiliate is responsible for KYC and suitability reviews on prospective counterparties.

The decision states that the applicant firm had previously furnished detailed information to the AMF relating to the terms and conditions of the products and associated risks, trading methods, execution and risk management systems, margin requirements, etc.

The decision is conditional on (1) the applicant firm conducting all CFD-related activities in Quebec through its electronic trading platform or through a registered representative of the Canadian registered affiliate, (2) the applicant firm, the Canadian registered affiliate and its registered representatives carrying on this business in compliance with applicable IIROC rules, requirements applicable to registered firms under the QDA and related regulations and any other derivatives-related rules applicable to their activities, (3) the applicant firm informing the AMF on a timely basis of any material changes to its business and of (4) any disciplinary actions against it, the Canadian registered affiliate or its registered representatives with respect to their CFD-related business, and (5) delivery on an annual basis of the applicant firm's audited financial statements and a statement of the number of CFDs entered into with Quebec counterparties over the preceding financial period.

The exemption is granted retroactively to February 1, 2009 and will expire automatically on the earliest of June 16, 2010 or the date of the coming into force of regulations implementing the Qualification Requirement.

Current close-out protections for EFCs in CDIC Act proceedings

A Canadian bank that is in financial difficulty could be subject to one of two types of order made under section 39.13(1) of the CDIC Act by the federal Cabinet on the recommendation of the Superintendent of Financial Institutions. These are (1) an order vesting the shares of the institution in CDIC and (2) an order appointing CDIC as receiver of the institution. These orders have different effects, but in both cases there is an automatic stay on termination or accelerating payments under contracts by reason only of (i) the federal member institution's insolvency, (ii) a default, before the order was made, by the federal member institution in the performance of its obligations under the agreement, or (iii) the making of the order. With respect to EFCs, however, there is the exemption to allow a counterparty to terminate, net and deal with financial collateral (the EFC exemption).

Amendments

The amendments will limit the ability to rely on the EFC exemption if a "bridge institution" is to be incorporated and the EFCs are to be assigned to the bridge institution. A bridge institution (described in more detail below) is a financial institution that could be established, when CDIC is appointed receiver of an institution, to take over some or all of the assets and liabilities of the member institution for a temporary period, presumably to facilitate a sale of the institution.

The CDIC Act will permit EFCs to be assigned to a bridge institution. If an order directing the incorporation of a bridge institution is made, then the counterparty cannot close-out an EFC if CDIC either (1) undertakes to guarantee unconditionally the payment of any amount due or that may become due in accordance with the provisions of the EFC by the member institution or (2) undertakes to ensure that all obligations arising from the EFC will be assumed by the bridge institution. The proposed language of this limitation on the EFC exemption is as follows:

(7.1) If an order directing the incorporation of a bridge institution is made, the actions referred to in subsection (7) may not be taken by reason only that the order or an order appointing the Corporation as receiver is made in respect of the federal member institution or that the eligible financial contract is assigned to the bridge institution if the Corporation undertakes to

(a) unconditionally guarantee the payment of any amount due or that may become due - in accordance with the provisions of the eligible financial contract - by the federal member institution; or

(b) ensure that all obligations arising from the eligible financial contract will be assumed by the bridge institution.

Unless and until a bridge institution is incorporated and CDIC makes one of those two undertakings, a party to an EFC is free to rely on the EFC exemption. 

It is highly likely that a bridge institution incorporation direction and receivership order will occur at the same time so parties will likely know immediately if the EFC exemption can be relied on or not.  Note also that this provision prevents reliance on the EFC exemption only if the EFC is terminated or accelerated by reason only of the making of the order to incorporate the bridge institution, the appointment of CDIC as receiver or the assignment of the EFC to the bridge institution, and not if the contractual trigger is the institution's "insolvency" or a pre-proceeding default by the institution.

The amendments do not include a provision similar to that in the similar U.S. law to the effect that either all transactions with the counterparty or none of them must be assigned.  Given that the term "eligible financial contract" is defined in the regulations to include individual transactions as well as any master agreements, a literal reading of subsection (7.1) could suggest that CDIC has the power to assign individual transactions under a master agreement, which in turn raises the spectre of cherry-picking.

However, given that the purpose of the bridge institution provisions is to enhance the financial stability of institutions, this cannot be the intention of the provision. CDIC has confirmed to ISDA that it interprets the provision as applying to the master agreement and the underlying transactions as a single contract.

Recognizing that there is an ambiguity in the language, there is a chance that amendments to the Act will be proposed before the provisions come into effect to clarify that assignment of individual transactions is not permitted.

Implications of assignment to a bridge institution

If CDIC is appointed as receiver of the institution, the Cabinet, on the Finance Minister's recommendation, can also direct the Minister to incorporate an institution designated in the order as a bridge institution. This would be a bank if the insolvent institution was a bank, a trust company if the insolvent institution was a trust company, etc. CDIC as receiver can transfer assets and liabilities of the institution to the bridge institution for such consideration as it determines. CDIC can be selective in determining what assets and liabilities are transferred. The protection that the creditors of the member institution have (if the obligations owed to them are not assumed by the bridge institution) is that the Act requires the consideration set by CDIC for the transferred assets to be "reasonable in the circumstances".

If the EFCs are assigned to the bridge institution, then the parties to those contracts should consider the following. The bridge institution will not be an agent of CDIC or the federal Crown even though all the shares are owned by CDIC and it must act on the direction of CDIC.  The bridge institution is intended to be a temporary entity. Its designation as a bridge institution is for two years (subject to possible renewal to a maximum of five years in total). CDIC is required, however, to provide the "financial assistance that a bridge institution needs in order to discharge its obligations . as they become due". Consequently, if CDIC undertakes to have the bridge institution assume the obligations under transferred EFCs (and does not directly guarantee them), there is this assurance that the obligations will be satisfied while the bridge institution exists.

The views expressed in this article are those of the author and may not be representative of those of the firm or its clients.
 

Abitibi, which was insolvent, determined to use the corporate proceeding to restructure not only its relationship with bondholders but also with its term lenders, in the belief that it would be a more expedited procedure than a CCAA proceeding. 

The court has jurisdiction under s.192 of the CBCA to make interim orders to facilitate the plan. The court in the Abitibi proceeding made an interim order that looked very much like the type of order a court would make in a CCAA proceeding.  Included in the order was a temporary stay (until the hearing date for approval of the arrangement) against any person (not just the bondholders and term lenders) accelerating or terminating any contract with any of the Abitibi entities.  Unlike the orders granted under the CCAA, however, there was no exemption for eligible financial contracts with the Abitibi entities.

The Quebec Superior Court in its reasons associated with the order does not deal with eligible financial contracts except to note that the orders requested "exclude from their application swap or derivative transactions or eligible financial contracts". However, the order itself did not exclude all eligible financial contracts from the stay. It only excluded eligible financial contracts with persons "other than the Abitibi parties". The intention here was seemingly not to interfere with the operation of credit default transactions having Abitibi as a reference entity or other eligible financial contracts between third parties where termination may have been triggered by an Abitibi default.

The order made in Abitibi is in contrast to the decision of the Alberta Court of Queen's Bench in Re Enron Canada (2001), 31 C.B.R. (4th) 15 (Alta. Q.B.). In that case, a CBCA plan of arrangement application was brought in which the applicant sought a stay of termination rights under contracts that would have been classified as "eligible financial contracts" under the CCAA.  Parties to such contracts had contractual rights to terminate based on the Chapter 11 filing of the applicant's parent corporation or other credit events affecting the parent corporation, which was the applicant's credit support provider. The applicant argued that it was solvent and that it could remain so if a stay was granted to give it time to renegotiate credit support arrangements with its counterparties. The court rejected the application on the basis that it was not appropriate to interfere with the contractual rights of the parties and that the public policy against interfering with close-out and netting rights in the case of insolvent counterparties applied as well to solvent counterparties seeking to reorganize.

The very fact that the Abitibi order was made raises an issue for close-out netting. It is important to note, however, that the court did not hear arguments from any affected parties regarding the application of the order to eligible financial contracts and it was not the focus of Abitibi's submissions to the court. Also, the Enron Canada decision was not before the court. An appeal of the order, including the stay, was launched by the term lenders, but not parties to any EFCs specifically. The order became moot a little over a month after it was made when Abitibi filed under the CCAA, it having become apparent that the corporate plan would not succeed. Given the circumstances, the precedential value of the order on this issue is not as great as that of the Enron Canada case.

If, as this case suggests, the courts will allow the CBCA plan of arrangement proceeding to be used by an insolvent corporation as an alternative to a CCAA proceeding to deal not only with bondholder claims but also claims of ordinary creditors such as term lenders, then it makes sense to treat the commencement of such a proceeding, at least where creditors' claims are involved, in the same way as other bankruptcy events of default. Parties may want to consult with their Canadian counsel to ensure that the bankruptcy event of default is drafted widely enough to capture this type of corporate proceeding. As noted, corporate plans are used in many situations that do not involve insolvent entities or claims of creditors, so not every plan of arrangement procedure should give rise to an event of default. We suggest that the triggering event be the commencement of a proceeding under corporate law that proposes to deal with the claims of any class of creditors.

Parties will be in a better position to challenge the type of stay order granted in Abitibi where they have a clear contractual termination right. That right does not have to be the commencement of the corporate proceeding of course. Parties could have rights to terminate based on other events. For example, very often the Canadian proceedings will be accompanied by a performance default, a cross-default or the commencement of a U.S. Bankruptcy Code proceeding with respect to the entity or its related entities, which may itself be a termination event or event of default.

The views expressed in this article are those of the author and may not be representative of those of the firm or its clients.
 

Nexen Marketing was a party to a number of agreements with SemCAMS and certain of its affiliates:

1. a Crude Petroleum Purchase Contract with SemCAMS under which Nexen purchased condensate (Condensate Agreement);
2. a GasEDI Base Contract for Sale and Purchase of Natural Gas with SemCAMS under which either party could be purchaser or seller but where Nexen had always been the purchaser (Gas Agreement);
3. a crude oil purchase contract with SemCanada Crude Company (SemCanada Crude) under which Nexen was both the purchaser and seller of crude oil (SemCanada Crude Agreement); and
4. a natural gas purchase and sale agreement with CEG Energy Options Inc. (CEG Energy) under which Nexen was both the purchaser and seller of gas (CEG Gas Agreement).

Nexen had obtained a parental guarantee from SemGroup L.P. (a U.S. parental entity of SemCAMS and its affiliates now subject to Chapter 11 proceedings in the U.S.). Nexen however did not have any contractual rights of set-off in respect of affiliate obligations under any of the agreements and had not entered into a master netting agreement with SemCAMS or any of it affiliates.

SemCAMS (and certain of its affiliates, including SemCanada Crude and CEG) were granted CCAA protection in July, 2008. Based on the July 25 and August 25, 2008 settlement dates, Nexen owed SemCAMS a combined $1.2 million under the Condensate Agreement and the Gas Master Agreement. Nexen had refused to pay SemCAMS on both of the settlement dates. In the first instance, Nexen purported to set-off its obligations against amounts owed to Nexen by SemCanada Crude and CEG under the SemCanada Crude Agreement and CEG Gas Agreement, respectively (and for amounts owing for estimated legal fees incurred in relation to the recovery of debt by Nexen owed by a number of SemCAMS' affiliates, including SemCanada Crude and CEG). In the second instance, Nexen purported to set-off its obligation against amounts owed to Nexen by SemCanada Crude for July 2008 sales under the SemCanada Crude Agreement. SemCAMS brought an application to recover the amounts from Nexen (plus interest).

Nexen asserted that it had an equitable right of set-off, arguing that the SemGroup of companies, headed by the U.S. parent company SemGroup, L.P., operated as a "single enterprise". Madam Justice Romaine of the Court of Queen's Bench of Alberta heard arguments from both parties and granted SemCAMS' application, ordering Nexen to pay the $1.2 million to SemCAMS, plus interest.

In her written reasons1, Madam Justice Romaine set-out the five-part test for equitable set-off from the Supreme Court of Canada's decision in Holt v. Telford, namely that:

1. the party relying on a set-off must show some equitable ground for being protected against its adversary's demands;
2. the equitable ground must go to the very root of the plaintiff's claim;
3. a cross-claim must be so clearly connected with the demand of the plaintiff that it would be manifestly unjust to allow the plaintiff to enforce payment without taking into consideration the cross claim;
4. the plaintiff's claim and the cross-claim need not arise out of the same contract; and
5. unliquidated claims are on the same footing as liquidated claims.

Madam Justice Romaine's reasons largely focused on the third part of this test, noting that the close connection required the claim and the cross-claim to arise either from the same contract or "series of events". Madam Justice Romaine found that neither was present, as SemCAMS' claims arose under separate agreements (i) made with separate corporate entities, (ii) negotiated during separate time periods, and (iii) made for different purposes. The Court also rejected Nexen's argument that the purchase and sale of "similar products" in the same months created a close connection.

 ¹ SemCanada Crude Company (Re), 2009 ABQB 252.

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:

1. 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
2. the activities must relate only to the following categories of derivatives (the “Specified Categories”) currently regulated under the Securities Act (Quebec):
   1. An option or a negotiable futures contract pertaining to securities, or a Treasury bond futures contract;
   2. An option on a commodity futures contract or financial instrument futures contract;
   3. 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.

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.
 

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 U.S. 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:

General Issues

• 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 QDA;
• 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 Quebec counterparties, 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 counterparties" (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 Derivatives Regulation (discussed below));

The Autorité des marchés financiers (the "AMF", Quebec's financial services regulator) had published a draft Derivatives Regulation (the Derivatives Regulation) for comment on October 3, 2008. The final form of the Derivatives Regulation was adopted on January 15, 2009.

The 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", and the prescribed information document to be delivered by derivatives dealers to their clients. The AMF is expected to publish companion policies on certain specific interpretation issues.

The QDA does not include any material transitional provisions, although the AMF is expected to issue guidance on the transitional application of the legislation. Canadian and foreign market participants should 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.

The adoption of the Quebec STA is a highly important development for Quebec participants and their counterparties in the derivatives, structured finance and securities financing markets. As an example, the Quebec STA amends the Civil Code of Quebec provisions regarding the creation and publication (perfection and priority) of security interests in securities and security entitlements. Among its most important features are the following:

• The legislation will adopt a comprehensive definition of "security" that includes not only publicly-traded corporate debt and equity securities, but also government securities, units or other equity securities issued by mutual funds or trusts, equity securities of non-publicly traded corporations and certain securities issued by partnerships.
• The distinction between certificated and uncertificated securities is established with different rules applicable to transfer for each of these categories.
• It will adopt the concept of a security entitlement to identify the interest of a holder in the indirect holding system and the concept of a financial asset to help to define the types of interests or property held in a securities account and to which a security entitlement may relate.
• It includes in the concept of a financial asset certain property held in a securities account, including the cash balances in the account and instruments such as bills and notes.
• A collateral taker may publish its security interest in a security and a security entitlement by taking control of the security or security entitlement, as the case may be. The difficulties associated with having to publish by registration with respect to book-based securities will no longer exist.
• Control will include being the entitlement holder with respect to the securities account as well as lesser forms of control established by means of control agreements. 
• Purchasers, including collateral takers, who obtain control will generally have priority over secured creditors who publish by any other means.
• Protections against adverse claims will also benefit persons who acquire a security or a security entitlement for value without notice of any adverse claim. 
• The Civil Code amendments expressly allow a secured party to rehypothecate collateral that are securities or security entitlements.

The conflict of laws rules for indirectly held securities have been implemented in a liberal manner inasmuch as they allow the parties to designate the applicable jurisdiction. The Quebec STA does not adopt the Ontario STA concept of the securities intermediary's jurisdiction, however, the results of the new rules are very similar. The Quebec STA modifications to the Civil Code private international law rules provide for a series of alternative jurisdictions applied in the following order:

• The jurisdiction that is the governing law of the securities account agreement, unless agreed to otherwise such as in a control agreement,
• The jurisdiction of the office where the securities account is maintained, if that office is designated in the securities account agreement,
• The jurisdiction in which the office identified in an account statement as the office where the account is located, or
• The jurisdiction in which the decision-making centre of the securities intermediary is located.

The Quebec STA amendments to the Civil Code indicate that an individual consumer will not be able to grant security over uncertificated securities or a security entitlement unless authorized by law. Regulations permitting such security are anticipated to be adopted and come into force at the same time as the Quebec STA.

Modifications to the Civil Code and the transitional provisions of the Quebec STA apply to security granted on other movable incorporeal (roughly intangible) property in addition to securities and security entitlements.

Market participants should contact a Stikeman Elliott legal adviser in order to discuss the transitional provisions of the Quebec STA and the necessity to review current and up-coming transactions.

Fast-track adoption

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 entities

Any person other than a recognized "regulated entity" 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 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.

"Accredited 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 20073in 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.

The ASC's response, BO 91-503, extends the definition of "OTC derivative" (and therefore, the exemption to the prospectus and registration requirements of the Securities Act) 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. "Acceptable clearing corporation" is in turn defined as a clearing agency that (i) operates a central system for the clearing of derivatives transactions; (ii) is subject to enabling legislation and oversight by a central or regional government authority in an "eligible country of operation" (i.e. a country that is a member of the Basle Accord and a country that has adopted the banking and supervisory rules set out in the Basle Accord) that provides for compliance and power of enforcement over its members or participants; and (iii) is named in a schedule from time to time published for the purpose of BO 91-503 with the approval of the ASC's Executive Director.

BO 91-503 provides for the same exemption from the prospectus and registration requirements of the Securities Act as did BO 91-502: OTC derivatives transactions and commodity contracts are not futures contracts, as defined in the Securities Act, provided the transactions are made between "Qualified Parties" who each act as principal or as an agent/trustee for accounts that are fully managed by it. The list of Qualified Parties in the Appendix to BO 91-503 is the same as that in BO 91-502, comprising mainly sophisticated, creditworthy entities.

In BO 91-503 (as was the case with BO 91-502), the definition of "OTC derivative" requires that such agreements not be part of a fungible class of agreements that are standardized as to their material economic terms. As such, OTC derivatives that are standardized and are to be cleared by an acceptable clearing corporation do not appear to be exempt from the prospectus and registration requirements of the Securities Act by virtue of BO 91-503. To this extent, further exemptive relief from the ASC may be necessary.
 

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 20071in 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.

1. a derivatives agreement, whether settled by payment or delivery, that 
   1. trades on a futures or options exchange or board, or other regulated market, or
   2. is the subject of recurrent dealings in the derivatives markets or in the over-the-counter securities or commodities markets;
2. an agreement to
   1. borrow or lend securities or commodities, including an agreement to transfer securities or commodities under which the borrower may repay the loan with other securities or commodities, cash or cash equivalents,
   2. clear or settle securities, futures, options or derivatives transactions, or
   3. act as a depository for securities;
3. a repurchase, reverse repurchase or buy-sellback agreement with respect to securities or commodities;
4. a margin loan in so far as it is in respect of a securities account or futures account maintained by a financial intermediary; 
5. any combination of agreements referred to in any of paragraphs (a) to (d);
6. a master agreement in so far as it is in respect of an agreement referred to in any of paragraphs (a) to (e)
7. a master agreement in so far as it is in respect of a master agreement referred to in paragraph (f);
8. a guarantee of, or an indemnity or reimbursement obligation with respect to, the liabilities under an agreement referred to in any of paragraphs (a) to (g); and
   1. an agreement relating to financial collateral, including any form of security or security interest in collateral and a title transfer credit support agreement, with respect to an agreement referred to in any of paragraphs (a) to (h).

The term "derivatives agreement" in paragraph (a) is in turn defined as follows:

"derivatives agreement" means a financial agreement whose obligations are derived from, referenced to, or based on, one or more underlying reference items such as interest rates, indices, currencies, commodities, securities or other ownership interests, credit or guarantee obligations, debt securities, climatic variables, bandwidth, freight rates, emission rights, real property indices and inflation or other macroeconomic data and includes

1. a contract for differences or a swap, including a total return swap, price return swap, default swap or basis swap; 
2. a futures agreement; 
3. a cap, collar, floor or spread;
4. an option; and
5. a spot or forward.

Industry observers will be pleased that the definition now encompasses a full range of products that have become prevalent in the market, including equity, credit and weather derivatives, as well as emerging products such as freight and emissions allowance derivatives. Margin loans have also been included. The relocation of the definition to the regulations will make it easier to add new products in the future as the market evolves further.

The regulation also makes some changes as to how securities loans and repos are described. Notably, commodities loans have also been included to cover such products as gold loans.

It is also now clearer than it was under the previous definition that guarantees of any of the obligations under any type of eligible financial contract are covered.