New Light on Shadow Banking: The FSB's New Report on Rehypothecation of Client Assets

 Margaret Grottenthaler

The Financial Stability Board has been considering the possible harmonization of rules relating to rehypothecation of client assets in securities financing transactions (such as securities loans, repo and margin loans) for several years. On January 25, 2017, it released a report entitled Transforming Shadow Banking into Resilient Market-based Finance, which summarizes the findings of its Rehypothecation and Re-use Experts Group.

Regulatory Approaches to Shadow Banking

Those of you who want to know more about how this aspect of so-called “shadow banking” works will find the new report very informative. Specifically, it explains:

  • What rehypothecation is;
  • Why it is important to the efficient functioning of lending markets;
  • What systemic risks it poses;
  • How those risks are currently addressed by regulation and market practice; and
  • The possibilities for harmonizing regulatory approaches.

The report ultimately concludes that there is no immediate case for harmonizing regulatory approaches. One interesting section of the discussion is the status update on the implementation of Recommendation 7 of an earlier FSB report, Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos (August 29, 2013). Recommendation 7 had three elements:

  1. Disclosure to clients by financial intermediaries with respect to rehypothecated assets so clients can assess their risks.
  2. Restricting rehypothecation to the intermediary to client-related purposes such as financing long positions or covering short ones, not for the intermediary’s own purposes.
  3. Only allowing entities subject to adequate regulation of liquidity risk to rehypothecate client assets.

With respect to these issues, the Rehypothecation and Re-use Experts Group found that:

  • Most jurisdictions require client consent before assets can be rehypothecated;
  • All jurisdictions have reporting mechanisms to track the status of rehypothecation of client assets;
  • No jurisdiction bans the practice outright;
  • Many jurisdictions’ restrictions vary depending on whether the assets are cash or non-cash;
  • Restrictions are laxer for banks/investment firms than for investment funds; and
  • All jurisdictions require adequate regulation of liquidity risk as a condition.

Approaches in the jurisdictions examined diverged on the second element of Recommendation 7 (not permitting rehypothecation to fund intermediary’s own-account purposes). Even where this element was not implemented, however, its underlying rationale was often satisfied by rules preventing intermediaries from funding a material portion of their own account activities with client assets. The FSB is monitoring implementation of this element of the recommendation.

Ultimately, the FSB concluded that there was no immediate case for harmonizing regulatory approaches. The differences in approaches are deeply rooted in national/regional securities laws, bankruptcy laws and other legal regimes that vary significantly across jurisdictions. Moreover, since the 2007-09 financial crisis, firms and clients have made notable improvements in risk management practices associated with rehypothecation, making the entire issue somewhat less urgent from a regulatory point of view.

Collateral Re-use

The report also addresses collateral re-use. This is the practice of secured parties using collateral provided by the debtor party. It overlaps with rehypothecation inasmuch as the financial intermediary may be a secured party and the debtor may be a client. This practice raises similar issues. The risks are addressed in different ways, such as Basel III Leverage Ratio and liquidity frameworks, and clearing requirements. Successfully implementing the global securities financing data collection and aggregation initiative will be an important step in obtaining a clearer understanding of these activities and allow any residual risks not addressed by the current initiatives to be identified and addressed. 

CSA decide not to reduce early warning threshold to 5%

The Canadian Securities Administrators today announced that they will not be moving forward with plans to reduce the early warning reporting threshold from 10% to 5% as previously proposed.

As discussed on our securities blog in March 2013, the CSA last year proposed amendments to the reporting threshold, triggers and related disclosure requirements under Canada’s early warning reporting regime intended to “provide greater transparency about significant holdings of issuers’ securities”. While the most significant change under the 2013 proposal would have been to decrease the reporting threshold from 10% to 5%, the CSA also proposed a number of other significant reforms, including greater transparency through reporting of “equity equivalent derivatives” in order to address issues such as “hidden ownership” and “empty voting”.

In today's release, the CSA note that a majority of the over 70 comment letters received in response to the 2013 proposals expressed concern with the potential unintended consequences resulting from some of the proposed amendments to the early warning regime. In what is sure to be a welcome development for most market participants, the CSA have decided against moving forward with the proposed reduction of the reporting threshold to 5% or the proposed inclusion of equity equivalent derivatives in the determination of the early warning threshold. An equity equivalent derivative would have been defined as a derivative that was referenced to or derived from a voting or equity security of an issuer and that provided the holder, directly or indirectly, with an economic interest that was substantially equivalent to the economic interest associated with beneficial ownership of the security (the examples provided included cash-settled total return swaps and contracts for difference).

Today’s announcement is a status update only with the details to follow when final amendments are published, which is expected to be in Q2 2015.

According to today’s announcement, the final amendments will incorporate a number of other previously proposed reforms, including requiring disclosure of 2% decreases in ownership as well as when ownership falls below the reporting threshold (i.e. “exit” reports). Another significant aspect of the 2013 proposal included proposed amendments to address securities lending arrangements. These will also be dealt with in the final amendments by exempting lenders from disclosure requirements if they lend shares pursuant to a “specified securities lending arrangement” and exempting borrowers from disclosure requirements in certain circumstances. As set out in the 2013 proposal, a “specified securities lending arrangement” required, among other things, that the lender have an unrestricted ability to recall the securities before a meeting of securityholders and/or to instruct the borrower how to vote the securities.

Proposals to expand the circumstances under which eligible institutional investors (EIIs) will be disqualified from alternative monthly reporting (AMR) will also go forward. In the 2013 proposal, the CSA had proposed to make the AMR regime unavailable where an EII solicits, or intends to solicit, proxies from securityholders of a reporting issuer on matters relating to the election of directors of the reporting issuer or a reorganization, amalgamation, merger, arrangement or similar corporate action involving the securities of the reporting issuer. In today’s announcement, the CSA have indicated that they will provide further clarification on the circumstances where such exclusion would apply.

The final amendments will also clarify the application of early warning requirements to certain derivatives as well as enhance disclosure requirements and clarify timeframes for filing.

For more information, see CSA Notice 62-307.

CASLA panel considers proposed developments in securities lending

Margaret Grottenthaler -
 

I spoke at the CASLA conference yesterday about the pending regulatory developments in Canada with respect to the early warning regime and changes to National Instrument 81-102 and prepared a short article on these changes.   Previous items in this blog have covered these developments generally, but the paper focuses on the securities lending aspects of the proposed developments. Other materials from the conference will soon be posted on the CASLA website.  This third annual conference organized by the Canadian Securities Lending Association was very well attended and extremely informative

CSA propose amendments to early warning reporting regime to enhance disclosure

Amanda Linett and Ruth Elnekave -

The Canadian Securities Administrators (CSA) have published for comment proposed amendments to the reporting threshold, triggers and related disclosure requirements under Canada’s early warning reporting (EWR) regime intended to “provide greater transparency about significant holdings of issuers’ securities”.  These amendments could affect the conduct of certain equity derivative transactions and related hedging activities.

Currently, under the EWR regime, prescribed disclosure is required by any investor that acquires beneficial ownership of or the power to exercise control or direction over 10% or more of any class of a public company’s voting or equity securities. Additional reporting is required on each incremental acquisition of 2% as well as a change in a material fact contained in an earlier report. Certain eligible institutional investors (EIIs) can take advantage of relaxed timing requirements for early warning reporting under the alternative monthly reporting (AMR) regime.

As discussed in an earlier post on our securities blog, the key changes under the proposals include:

  • decreasing the reporting threshold from 10% to 5%;
     
  • clarifying that the reporting trigger applies to a 2% decrease in ownership and a decrease below the new 5% threshold;
     
  • expanding the reporting trigger to capture certain types of derivatives that affect an investor’s total economic return in an issuer;
     
  • expanding the scope of required disclosure to include a broader range of interests and require more specific disclosure; and
     
  • making the AMR regime unavailable to investors who actively engage with shareholders on certain corporate matters.

Reporting Threshold and Timing

The proposals provide for a decrease in the EWR threshold from the current 10% to 5% under both the EWR and AMR regimes. Under the “moratorium” provisions of the EWR regime, which prohibit further purchases until one full business day after a report is filed, the cooling-off period would apply at the new 5% threshold.

Under the amendments, the required news release (which is currently required to be filed “promptly”) would have to be filed promptly but no later than the opening of trading one business day following a reportable transaction, and the timing for filing the report would not change. Timing for reporting under the AMR regime would also not change.

The CSA’s stated objectives for lowering the EWR threshold to 5% include addressing the increased prevalence of shareholder activism and the ability of 5% shareholders to influence control of an issuer, requisition a shareholders’ meeting or affect the outcome of significant transactions or the constitution of the issuer’s board of directors, as well as harmonizing Canada’s standard with that of several major foreign jurisdictions. In this regard, a 5% threshold would be consistent with jurisdictions including the United States, the United Kingdom and Australia.

Hidden Ownership and Empty Voting

The CSA are concerned that the current EWR requirements may not capture investors using “hidden ownership” strategies whereby derivatives are used to accumulate substantial economic positions in public companies on an undisclosed basis, and this interest is then potentially converted into voting securities in time to exercise a vote. They have similar concerns with “empty voting” strategies whereby investors may utilize derivatives or securities lending arrangements to hold voting rights in respect of an issuer and possibly influence the outcome of a shareholder vote without having an equivalent economic stake in the issuer.

To broaden the scope of the EWR and AMR regimes to include such interests, the proposals would provide that for purposes of the reporting trigger, a person would be deemed to have acquired beneficial ownership or the power to exercise control or direction where they acquire beneficial ownership, control or direction over an “equity equivalent derivative.” This term is proposed to be defined as a derivative which is referenced to or derived from a voting or equity security of an issuer and which provides the holder, directly or indirectly, with an economic interest that is substantially equivalent to the economic interest associated with beneficial ownership of the security. The CSA note that an equity equivalent derivative would generally include only cash-settled equity total return swaps, contracts for difference or substantially similar derivatives, but not partial-exposure derivatives such as options and collars that provide the investor with only limited exposure to the reference securities.

Securities Lending Arrangements

Under securities lending arrangements, the lender disposes of its securities and the borrower acquires the securities, generally along with the right to vote the securities for the duration of the loan. The CSA state that the current regime requires the lender and borrower to consider the securities disposed of and acquired, respectively, in determining whether the reporting requirement has been triggered, notwithstanding the duration of the loan.

In light of the proposed requirement to report 2% decreases in ownership, the reporting requirement would specifically apply to lenders under securities lending arrangements, absent available exemptions. However, the proposals would exempt the lender (but not the borrower) from reporting securities lent out as a disposition under a “specified securities lending arrangement” that provides an unrestricted ability for the lender to recall the securities (or identical securities) before a meeting of securityholders and/or requires the borrower to vote the securities in accordance with the lender’s instructions. Further, in order to provide the market increased transparency about the use of these arrangements, it is also proposed that securities lending arrangements in effect at the time of a reportable transaction be disclosed, even if such transaction did not involve the securities lending arrangement.

Changes to Scope of Alternative Monthly Reporting

Under the current regime, an investor that qualifies as an EII is entitled to utilize the AMR regime, which only requires them to report an increase in ownership of 2.5% or more within 10 days of the end of the month in which the threshold is crossed and does not require a press release or a trading moratorium. The EII can generally remain in the regime unless and until it makes or proposes or intends to make or propose a transaction in which the EII would obtain a controlling interest in the reporting issuer. Upon this happening, they are required to issue a press release and immediately begin reporting in the EWR regime. However, unlike in some other jurisdictions, a decision to become “active” does not give rise to the same result. In other words, an investor is currently able to accumulate a substantial interest in an issuer’s shares even after deciding to become “active” and is only required to disclose the share purchases 10 days after the end of the month in which they occur. The CSA are concerned that this is inconsistent with the policy rationale underlying the relaxed timing requirements of the AMR regime, being the availability of the regime only to an EII with a passive intent.

Under the proposals, the AMR regime would not be available for an EII that solicits, or intends to solicit, proxies from securityholders of a reporting issuer on matters relating to the election of directors of the reporting issuer or a reorganization, amalgamation, merger, arrangement or similar corporate action involving the securities of the reporting issuer. In practice, the proposals would mean that upon initiating or intending to initiate such activist activity and thus becoming disqualified from accessing the AMR regime, activist investors would be required to immediately file a news release and within two business days file an early warning report containing the proposed enhanced level of disclosure, thereby making their intentions known to the market significantly earlier than under the AMR regime.

Enhanced Early Warning Report Disclosure

To address the CSA’s concerns with respect to the use of boilerplate language and inadequate disclosure regarding the purpose of reportable transactions, the proposals include new EWR forms under both the EWR and AMR regimes with more detailed disclosure requirements as well as instructions on the type of disclosure expected by the CSA. Key additions include disclosure of:

  • “deemed” control (triggered by the ownership of, or control or direction over, an equity equivalent derivative) of the relevant securities by the reporting investor, either alone or together with a joint actor;  
     
  • the material terms of any existing “related financial instrument1 (including an equity equivalent derivative) involving the class of security subject to the early warning report, as well as the number of underlying securities if the reportable transaction involved an equity equivalent derivative;
     
  • the material terms of any existing securities lending arrangement (including duration and recall provisions), as well as whether the reportable transaction involved such arrangement. In the case of a reporting investor that is a lender under any existing specified securities lending arrangement, the material terms thereof;
     
  • whether the consideration paid or received represents a premium to the market price, and a description of method of acquisition or disposition if other than by purchase or sale;
     
  • any plans of the reporting investor or a joint actor which relate to a list of specified actions, including an extraordinary corporate transaction involving the issuer, changes in the issuer’s board or management, material changes in the issuer’s business or corporate structure and any intention to solicit proxies from the issuer’s securityholders; and
     
  • specified information in respect of any agreements or understandings between the reporting investor and a joint actor and any other person with respect to any securities of the issuer, whether or not such agreement relates to the reportable transaction.

Implications of the Proposed Changes

  • Reducing the reporting threshold from 10% to 5% could benefit potential offerors by identifying more broadly (and earlier in the process) securityholders that hold 5% of the target securities (including for purposes of securing lock-up agreements), and allow issuers more time to defend against a potential offeror or activist shareholder. On the other hand, pre-bid accumulation transactions may be hindered, and potential acquirors would need to consider, in some cases, the earlier disclosure to the market of their intentions. 
     
  • Narrowing the scope of the AMR regime would, in certain cases, eliminate the cover offered to activist EIIs under the AMR regime and make their intentions known to issuers they are targeting substantially earlier.
     
  • The proposed changes may result in increased compliance costs, largely to investment managers, mutual funds and other institutional investors, and we would expect the volume of reporting under the EWR regime to increase significantly, particularly among public mutual funds which are subject to a higher portfolio concentration limit of 10% and are not eligible to report under the AMR regime.
     
  • Investors who use derivatives and securities lending as a risk management tool in connection with short and/or long positions in an issuer’s stock and who may not have previously been caught may have to publicly disclose holdings, and at the lower 5% threshold.
     
  • Investors would need to plan early in connection with stock accumulations, consider carefully whether a particular proposed transaction is caught by the EWR regime, and generally assess possible implications in connection with reportable transactions such as the potential dissemination of investment strategies.

The CSA’s proposals would amend the early warning reporting requirements currently found in Multilateral Instrument 62-104 Take-Over Bids and Issuer Bids, National Policy 62-203 Take-Over Bids and Issuer Bids and National Instrument 62-103 The Early Warning System and Related Take-Over Bid and Insider Reporting Issues. As MI 62-104 applies in all provinces and territories except Ontario, the CSA also expect that amendments to the Securities Act (Ontario) and Ontario Securities Commission Rule 62-504 Take-Over Bids and Issuer Bids will be proposed to give effect to the CSA’s proposals in Ontario.

The CSA’s request for comments, which specifically poses a number of questions regarding the thresholds and proposals, is open until June 12, 2013.

We remind readers that June 12, 2013 is also the deadline for submission of comments to the CSA in connection with their proposed new rule to regulate poison pills and to the Autorité des marchés financiers in Québec in connection with its consultation paper advocating a broader overhaul of the take-over bid regime, as discussed in our earlier post.


1"related financial instrument” has the meaning given to that term in National Instrument 55-104 Insider Reporting Requirements and Exemptions and generally refers to an agreement or understanding that affects, directly or indirectly, the relevant person or company’s economic interest in a security of the reporting issuer or economic exposure to the reporting issuer.

 

SCC Decision in Re Indalex not good news for cash collateral arrangements

Margaret Grottenthaler -

Swaps market participants accepting cash collateral from an entity subject to Ontario provincial pension benefits legislation will want to consider the implications of this decision on their priority. Unfortunately and somewhat surprisingly, the Supreme Court of Canada did not overturn a key part of the Ontario Court of Appeal’s decision. Four of seven judges agreed that the deemed trust under the Pension Benefits Act (Ontario) (PBA) and, consequently, the statutory priority conferred on that trust under the Personal Property Security Act (PPSA) applied to the statutory liabilities of an employer to fund certain deficiency payments that arise during the wind-up of a pension plan. The secured creditor with an assignment of the DIP financing ultimately prevailed in its appeal on the basis of other arguments and was found to take priority over the deemed trust, but it did not prevail on this fundamental issue regarding the liabilities covered by the deemed trust. 

In our blog post on the Court of Appeal decision we addressed whether the decision had a negative effect on credit support provided for derivatives transactions and other securities financing transactions, such as securities loans, repo and margin loans. As stated in that post, there is potential for the deemed trust to take priority over cash collateral accounts where Ontario law alone governs priority, because the PPSA gives the deemed trust priority with respect to “accounts”, and cash collateral arrangements are characterized as “accounts”. The priority and deemed trust applies not only to wind-up deficiencies, but also other amounts the employer owes to the pension fund (e.g. delinquent current service costs and remittances on behalf of employees). As a practical matter, the other liabilities subject to the deemed trust tend to be in a less significant amount and, consequently, they get paid from the assets readily available to the insolvency representative if they are in arrears. The wind-up deficiency amount, however, can be extremely large with respect to defined benefit plans, and essentially unascertainable until wind-up occurs. This is what makes the decision particularly concerning. There is no legal requirement to share the pain of the deemed trust among secured creditors, so the most readily accessible assets tend to fund the liability. The deemed trust beneficiaries may be looking further afield, however, when it comes to the deficiency liability and a nice healthy pool of cash collateral may look very attractive. Swap providers may not have the same influence in insolvency proceedings as the employer’s lending syndicate to force the employer into bankruptcy (where the deemed trust is clearly subordinated to secured creditors). I’ll first briefly review the parts of the decision that are relevant to the cash collateral issue. I will then tell you why I think it might affect priority for cash collateral (but not securities collateral) and offer some recommendations for dealing with this issue.

The Decision

Insolvent Indalex Canada commenced a proceeding under the Companies’ Creditors Arrangement Act (CCAA). Essentially it was a sale of the business as a going concern (what’s called a liquidating CCAA) and the dispute was over part of the sale proceeds. A debtor-in-possession financing was put in place, which was guaranteed by a related US company. The sale proceeds were not sufficient to repay the DIP lenders so the guarantor paid out on the guarantee and became subrogated to the rights of the DIP Lenders. By the terms of the court order the DIP loan had priority over “all other security interests, trusts, liens, charges and encumbrances, statutory or otherwise”. 

There were two pension plans involved, one for the company executives and one for the salaried employees. The case revolved around whether a portion of the sale proceeds equal to the unfunded pension liability belonged to the pension funds, based on a statutory deemed trust under the PBA or an equitable constructive trust, or to the holder of the DIP loan, based on the priority conferred on the DIP loan by the court order. 

Employers have a statutory obligation to make certain payments into a pension plan. There are three deemed trust provisions in the Ontario pension legislation; one for amounts collected from employees that were to be contributed but weren’t, one for unpaid current service costs and one for amounts accrued to the date of the wind up but not yet due under the plan or regulations.    The latter deemed trust only arises on a wind-up of the plan. The case related to this third type of deemed trust. An employer must pay (over a five year period) amounts in addition to the current service costs if there are insufficient assets to cover the value of the pension benefits (deficiency liability). The amount can depend on certain elections made after wind-up by the employees and can change over time based on changes in underlying actuarial and other assumptions. The question was whether the amounts that became payable by the employer over the period extending beyond the wind-up date for this deficiency liability were “accrued” obligations at the date of wind-up or not. The executive plan was not in the process of being wound-up so no deemed trust under the PBA arose or it.

Helpfully the SCC confirmed that the deemed trust only arose where a wind-up order was made in relation to the plan and the majority found that a constructive trust over the employer’s assets was not an appropriate remedy for any breach of fiduciary duty on the part of the employer. The salaried plan was in the process of being wound up before commencement of the proceeding so the court did consider the deemed trust issue with respect to that plan.  

The deemed trust provision is in section 57(4) of the PBA. Where a pension plan is wound up, it deems the employer to hold in trust an amount “of money” equal to “employer contributions accrued to the date of the wind-up but not yet due under the plan or regulations”. The PPSA provides that the PBA deemed trusts have priority over a security interest in “accounts” and “inventory”. Because of the reference to “accrued” liabilities, the majority of the SCC judges (4 of 7) agreed with the Court of Appeal that it included all the liabilities, including the unfunded deficiency liability that would otherwise be paid over the period following the wind-up. One can easily criticize the majority’s interpretation of the PBA, but what would be the point! What is positive news, however, is that unlike the rather incoherent approach in the Court of Appeal reasoning, the majority made it clear they were relying on the priority granted by the PPSA and not simply on the creation of the deemed trust. 

Justice Deschamp (with whom Moldaver J. agreed), before dealing with the issue of priority of the DIP charge, addressed the issue of whether the PPSA priority for the deemed trust would apply in a CCAA proceeding. She first considered the argument that the PBA deemed trust did not apply in a CCAA proceeding because the priorities must be determined under the federal insolvency scheme, which does not include provincial deemed trusts. There is a disappointing lack of analysis on this point by the court. Deschamp J. noted that in order to avoid a “race to liquidation under the BIA. Courts will favour an interpretation of the CCAA that affords creditors analogous entitlements.” She then stated, apparently to contrary effect, that this does not mean that courts may read bankruptcy priorities into the CCAA at will.

Provincial legislation defines the priorities to which creditors are entitled until that legislation is ousted by Parliament. Parliament did not expressly apply all bankruptcy priorities either to CCAA proceedings or to proposals under the BIA. Although creditors of a corporation that is attempting to reorganize may bargain in the shadow of their bankruptcy entitlements, those entitlements remain only shadows until bankruptcy occurs. 

Deschamps J. concluded that the PBA and PPSA priorities continue to apply in CCAA proceedings, subject to the doctrine of federal paramountcy.

The case then focused on whether the DIP financing charge primed the deemed trust on the basis of the federal paramountcy doctrine. The court was unanimous in its decision that the DIP charge did prevail. It is not entirely clear how much of Deschamps J.’s analysis with respect to the survival of PBA and PPSA priorities in a CCAA proceeding was adopted by the other justices. While Cromwell J. (giving the judgment for two others) seems to adopt these paragraphs of Deschamps J.’s analysis, he does so in a very cryptic fashion.

What this reasoning suggests is that the deemed trust on the basis of the super-priority conferred by the PPSA would prevail over all other secured creditors with an interest in accounts or inventory outside of a CCAA or BIA proceeding and in a CCAA proceeding as well, unless the federal paramountcy doctrine could be invoked. This, however, was an issue that was not before the court and which none of the judges were expressly considering. They were focused on the priority of the DIP charge. 

Collateral for Derivatives

In a typical credit support arrangement for derivatives, the collateral is securities or cash. Securities are delivered through the book entry system to the secured party (or transferee in the case of a title transfer arrangement) and in Securities Transfer Act terms, the secured party becomes the entitlement holder. Cash is also typically transferred directly to the account of the secured party. Cash collateral is an “account” in PPSA terms so the question is whether the deemed trust’s priority over accounts could apply to that cash collateral account. Based on that other questionable SCC decision in Caisse Drummond even absolute transfer and set-off arrangements with respect to cash may be characterized as security interests subject to statutory priorities. 

Doesn’t apply to securities or securities accounts. An important point to note is that priority for this deemed trust (or others) would not extend to securities, securities entitlements or securities accounts or other forms of collateral such as precious metals, and futures contracts. The statutory priority for the deemed trust conferred by the PPSA applies only over “accounts” and “inventory” and their proceeds, and investment property is specifically excluded from the definition of “account”. The Securities Transfer Act also protects a purchaser for value (which would include a secured party under a Credit Support Annex) from adverse claims of which it has no notice and as an entitlement holder, secured parties should not be subject to these provincial law claims that arise after the transfers. 

(There is also a statutory lien under the PBA (not discussed in the case) for the same amounts, but the same STA protection against adverse claims would apply in favour of a secured creditor with control.)

Deemed trust may not apply to cash collateral accounts. The PBA deemed trust requires the employer to hold “money” in trust for the beneficiaries. The PPSA priority only applies if the deemed trust itself attaches to the assets in the first place. This suggests that the contemplated assets are ones that the employer has a property interest in. If the account is itself a cash collateral account and the account debtor is the secured party, then any money the employer will realize from that account is only the net amount after payment of the secured obligation. In other words, a flawed asset analysis and right of set off may prevail in this circumstance. If funds are wired to a secured creditor for its own account (even if intended as a collateral arrangement), then the funds are no longer property that the employer can hold for itself or anyone else. The property which the employer has is the rights against the secured party with respect to the cash collateral account and those rights are limited by the credit support agreement. While this argument may be attractive, there is no assurance it would prevail. 

In CCAA proceedings protections for cash collateral for eligible financial contracts may prevail. The CCAA provides that no order made in the proceeding can have the effect of subordinating financial collateral for an eligible financial contract. If a DIP charge can defeat a deemed trust but a DIP charge cannot defeat financial collateral for an eligible financial contract, it logically should follow that it would be inconsistent with the CCAA for the deemed trust to prevail over the cash collateral arrangement if it was securing derivatives exposures or securities financing arrangements.   Of course, this does not help with priorities outside of insolvency.  

Payment Clearing and Settlement Act may help. Where the PCSA applies, it also provides for enforceability of credit support arrangements involving cash collateral securing eligible financial contracts, which may also create a conflict between federal law and the PPSA super-priority. The PCSA says that a party to an eligible financial contract may deal with its financial collateral. This is a reflection of the policy (based on concerns about systemic risk in the financial system) that laws, including insolvency laws, should not interfere with these rights. While it overrides insolvency laws, it is not restricted in its application to insolvency laws. It could be considered as a paramount federal law. It only applies, however, where the agreement is between two financial institutions (as defined) or between a participant in a clearing house and its customer with respect to the cleared transactions.

Windup only. The deemed trust only arises on wind-up of the plan. Wind-up very often occurs after an insolvency proceeding has already commenced. By that time, a derivatives counterparty, not being subject to the normal insolvency stays, will have realized on its cash (or securities collateral) and, therefore, the deemed trust cannot attach to that property for that reason alone.   In other words, collateral holders should not sit on their rights.    

To be clear, the Indalex reasoning would not apply to federally regulated pension plans such as those provided by banks for their employees or under provincial legislation. While the federal and other provincial legislation provide for deemed trusts, the priority of those trusts is not clearly given priority by a provision similar to s.30(7) of the PPSA. 

Some Recommendations

I continue to believe that parties should use the ISDA English law Transfer Annex CSA or amend the NY Form of CSA to provide for title transfer of cash where that is possible. While there is no assurance it will defeat the problematic Caisse Drummond analysis, there is certainly a good basis for that position. If the set-off is effective, the only property the deemed trust could attach to is the excess collateral value.

If you are taking cash collateral, it would be prudent to determine whether a counterparty has a defined benefit pension plan, to monitor its funding status and to include a termination event triggered by any step taken by the employer or regulator to wind-up the plan. 

Where possible, hold cash collateral outside of Ontario in a jurisdiction that would not apply Ontario law to priority issues. If the collateral is held outside of Canada by a non-Canadian entity (which is often the case), the deemed trust claimants would have to assert the claim in a foreign jurisdiction. That may be a tough case to make in a foreign court, especially in jurisdictions like the U.S., which apply the law of the depositary intermediary to priority issues. 

At the end of the day, there is a risk that this statutory deemed trust could take priority over cash collateral accounts. Hopefully the Ontario legislature will accept the strong recommendation of the OBA PPSL Committee as part of its cash collateral proposal to clarify that section 30(7) does not apply to cash collateral accounts over which a secured party has control. Industry participants may want to take this opportunity to communicate to the government the importance of this point and generally of moving forward quickly with its promise to make the cash collateral amendments as soon as we have a working Legislature again in Ontario.   If the law is not clarified secured creditors may not have confidence that they prime this deemed trust when dealing with entities subject to the PBA with defined benefit plans. There is no point in implementing reform designed to reduce systemic risk (requiring collateral for uncleared swaps for example) if it ends up creating more of it or limits the access of Ontario entities to important swaps markets.   

'We are all Macro-Prudentialists now': the brave new world of systemic risk

Michael Rumball  -

A specter is haunting the financial markets – the specter of systemic risk’                                           (with apologies to Karl Marx)

 

It wasn’t long after the immediate, frenzied response to the financial crisis that governments and regulators began to turn their minds to the fault lines that had been exposed in the financial system as a whole and to ways in which these could and should be addressed. The phrase which has come to be used to describe these fault lines is ‘systemic risk’.

Systemic risk has been defined as “the threat that a material event (whether an unexpected crisis, the failure of proper risk management, or the result of public policies) would result in the failure of either financial markets or a significant number of financial firms and cause significant harm to the [U.S.] economy because of the interconnections between such markets and firms” (The Financial Services Round Table, Systemic Risk Implementation: Recommendations to the Financial Stability Oversight Council and the Office of Financial Research, September 10, 2010) or, more simply, “the risks that cumulate across institutions, markets and even countries to levels that could have serious effects on the real economy “(Paul Jenkins and Gordon Thiessen, Reducing the Potential for Future Financial Crises: A Framework for Macro-Prudential Policy in Canada, May 2012).

To date, financial sector reforms have primarily focused on the micro-prudential level (Jenkins & Thiessen), in other words, on specific, large systemically important institutions and the incentives they faced. As indicated by Daniel K. Tarullo, Governor of the Board of Governors of the Federal Reserve System in his prepared statement before the Committee on Banking, Housing and Urban Affairs of the U.S. Senate on June 6, 2012, “This effort reflects the prominence of both the Dodd Frank Act and international regulatory initiatives which were motivated largely by the failure or near failure of a number of major financial firms and the significant public policy problems created by the market perception that such firms are ‘too big to fail’.” Thus numerous measures, which perhaps can best be described as restraints, dampeners or governors on activities that could lead to the formation of asset or credit bubbles, are now winding their way towards implementation: higher capital ratios, enhanced liquidity standards, more intensive supervision, limits on trading activity, pre-designated resolution and recovery plans, enhanced disclosure requirements, measures intended to readjust incentives, predatory lending regulations, etc.

In April 2009, the G-20 leaders recommended that regulatory frameworks be reinforced with a macro–prudential overlay that promotes a system-wide approach to financial regulation and oversight, mitigates the build-up of systemic risk and thus reduces the occurrence of financial crises in the future. Behind this recommendation was the belief that a focus on structural problems caused by systemically important institutions may not be sufficient to address “inherent problems with any system of credit extension through fractional reserve banking, or inherent problems with liquid financial markets … [or] macroeconomic volatility induced by volatile credit support, first supplied too easily and at too low a price, then severely restricted”.  (Adair Turner, Economics, Conventional Wisdom and Public Policy, Institute for Economic Thinking, Inaugural Conference, April 2010). In Turner’s view, the roots of credit volatility lie at a more fundamental level:

“The essence of the problem appears to lie in the specific character of credit demand and credit supply. Hyman Minsky – in his distinction of hedge finance, speculative finance and Ponzi finance – highlights that in the exuberant phase credit demand is significantly driven not by entrepreneurs seeking to finance new investment which they hope will generate profits enough to service the debt, nor by householders seeking to smooth consumption across their life cycle in a sustainable fashion, but by companies or households using credit in the anticipation of short to medium-term capital gain, in particular in real estate markets. And that demand is in turn met by banks, institutions which have evolved in a specific institutional form – with liquid resources very small relative to their short-term liabilities and with capital reserves very small relative to total assets. That combination – Minsky and others have argued – creates the potential for self-reinforcing cycles, which are not just one potential cause but the essential cause of macro volatility, both in the upswing and in the downswing: and which could arise as much in a system of multiple small banks as in one of large Too Big to Fail banks.”

His conclusion is that the policy response to systemic risk needs to be more radical than what we have so far seen: “discretionary through-the-cycle policy tools of a countercyclical nature to offset the risks of self-reinforcing credit and asset price cycles.” There must be:

“new economic thinking to ensure that in our response to the financial crisis we are adequately radical in addressing the fundamental drivers of instability, not just the symptoms … new tools to take away the punch-bowl before the party gets out of hand, and even perhaps to take it away from the already drunk but not from the still sober. All of which would take us far away from the dominant conventional wisdom of the last several decades, where optimal results are achieved provided financial regulators identify and correct specific market failures, while central banks use one instrument alone to pursue one unchanging inflation objective. But inevitably so given the large and inherent procyclicalities against which we need to lean”.

Such policy tools have come to be described as ‘macro-prudential’. The provenance of this concept has been described by Claudio Borio in his July 22, 2010 report to the Bank for International Settlements, entitled “Implementing a Macro-prudential Framework: Blending Boldness and Realism”:

“Paraphrasing Milton Friedman, “We are all macro-prudentialists now”. With breathtaking speed, in the wake of the crisis the concept has risen from virtual obscurity to currency in the policymaking world. The notion had been around for some time. It had been evolving quietly in the background from its first appearance in the late 1970s at BIS meetings. It was known only within a small, albeit growing, circle of cognoscenti. Once the crisis broke out, the concept helped policymakers frame their efforts to strengthen regulatory and supervisory frameworks.“

According to Borio, macro-prudential is

“an orientation or perspective of regulatory and supervisory arrangements. It means calibrating them from a system-wide or systemic perspective; rather than from that of the safety and soundness of individual institutions or a stand-alone basis. It means following a top-down approach, working out the desirable safety standard for the system as a whole and, from there, deriving that of the individual institutions within it.”

The critical feature of this concept which I wish here to highlight is that, by its very nature, it must be universal, applying to the financial system as a whole as opposed to its individual components (see Progress Report of the FSB, IMF, and BIS to the G20 of October 27, 2011, Macro-prudential Prudential Policy Tools and Frameworks). This impetus towards universality has manifested itself by seeking to erase boundaries between financial sectors, jurisdictions and even regulators.

Thus, “because of its system-wide perspective, macro-prudential policy requires an ability to capture the build-up of systemic risk also in the shadow banking system – defined broadly as the system of credit intermediation that involves entities and activities outside the regulated banking system.” The shadow banking system embraces money market funds, hedge funds, securitization and securities lending and repos (See the report by the IOSCO Technical Committee Task Force on Unregulated Financial Markets and Products, March 2011).

In “Emerging from the Shadows: Market-Based Financing in Canada”, a report to the Bank of Canada published in its Financial System Review of June 2011, Chapman, Lavoie and Schembri describe market-based financing (MBF, their term for shadow banking) as follows:

“MBF refers to credit-intermediation activities similar to those performed by banks. Like bank intermediation, these activities involve maturity or liquidity transformation, possibly with some degree of leverage, but they are conducted primarily via markets rather than within financial institutions (although) in many instances a bank is involved at some point in the intermediation chain). The MBF sector is often referred to as the “parallel,” “shadow” or “unregulated” banking sector, because MBF intermediation activities are subject to a different regulatory framework and typically are not prudentially regulated and supervised to the same extent as the traditional intermediation activities performed by banks.”

According to the FSB, “the shadow banking system can also be used to avoid financial regulation and lead to build-up of leverage and risks to the system. For example, securitization was unduly used by banks during the pre-crisis period to take on more tasks and facilitate the build-up of leverage in the system, while avoiding the regulatory capital requirements” (Strengthening the Oversight and Regulation of Shadow Banking, Progress Report to G20 Ministers and Governors, April 16, 2012). Indeed, FSA chairman Adair Turner has laid the bulk of the blame for the financial crisis on the shadow banking system, calling it

“inherently dangerous….Any macro-level counter factual analysis of the impact of the whole package of innovations which contributed to shadow banking would, I think, clearly illustrate that if we had to choose between having the whole package and none of it, we would have been better off with none of it – no [structured investment vehicles], no [collateralized debt obligations], no credit derivatives … Even if it could be proven, which is still unclear, that in some way this package did deliver the market completion and allocative efficiency benefits ascribed to it ahead of the crisis, there seems no possibility that the scale of that benefit – measured at the macro level as an increase in the obtainable level of income across the economy – could be more than a small fraction of the harm produced by the induced financial instability effect … it is difficult to think of any wave of innovations in any other sector of the economy about which we would be likely to reach such a negative judgment.” (As reported in mortgagestrategy by Gary Jackson on April 20, 2012.)

Several prudential regulators have noted that the tightening of regulations in respect of financial institutions may encourage the migration of activities to the shadow banking sector. According to Federal Reserve Governor Daniel Tarullo,

“A set of effective regulations in one area can produce arbitrage opportunities, which lead people to create new instruments or look for new channels to engage in similar kinds of activities that may produce similar kinds of risks. Indeed the possibility of such arbitrage [in the shadow banking system] has increased as the regulation of already regulated financial institutions has strengthened in the wake of the crisis” .

This has been reiterated by Mark Carney of the Financial Stability Board: “Particularly in boom periods, non-regulated institutions tend to take on an increasing share of intermediation and cross-border credit provision.” Such a state of affairs is obviously incompatible with a universal regulatory approach. “This is why enhanced supervision and regulation of shadow banking will be one of the top priorities for the Financial Stability Board in the coming months”. 

Indeed, at the request of the G20 leaders, the FSB, in collaboration with standard setting bodies is developing regulatory recommendations (to be issued by the end of the year):

“(i) to mitigate the spill-over effect between the regular banking system and the shadow banking system; (ii) to reduce the susceptibility of money market funds to “runs”; (iii) to assess and mitigate systemic risks posed by other shadow tanking entities than money market funds; (iv) to assess and align the incentives associated with securitization to prevent a repeat of the creation of excessive leverage; and (v) to dampen risks and pro-cyclical incentives associated with securities lending and repos that may exacerbate funding strains at times of shocks to confidence” (Macro-prudential Policy Tools and Frameworks).

The danger of regulatory arbitrage is not restricted to financial sectors. In its Progress Report to the G20, the FSF, IMF and BIS made the following observation:

“Because of the close integration of global capital markets and the high risks of spillovers and regulatory arbitrage, it is important to consider the multilateral aspects of macro-prudential policymaking. Cooperation on macro-prudential policies requires (i) strong institutional mechanisms to promote a common understanding of threats to global financial stability and adequate policy actions; and (ii) steps to ensure that macro-prudential frameworks in individual countries are mutually consistent.”

This is echoed by Chapman et al:

“Thus, a coordinated global response is needed to establish clear principles for the monitoring, assessment and regulation of MBF that allows for differences in the MBF sector across countries and limits unintended consequences and opportunities for cross-country regulatory arbitrage.”

This fear of cross-jurisdictional regulatory arbitrage has been of primary concern for various international regulatory task forces (See, for example the Implementation Report of the IOSCO Technical Committee Task Force on Unregulated Financial Markets and Products, March 2011) and has been the primary motivating factor towards the convergence of several initiatives including for example, those related to enhanced disclosure, risk retention and OTC derivatives.

Finally, universality demands cross-regulatory co-ordination.  Thus, as reported in the Globe and Mail on June 7, 2012 in an editorial piece by Jenkins and Thiessen:

“Other major countries have put in place formal macro-prudential arrangements. In the United States, a Financial Stability Oversight Council has been established. In the United Kingdom, the government has created a Financial Policy Committee in the Bank of England. And in Europe, they have set up the European Systemic Risk Board.”

In their view, in order to reduce the risk of future crises, Canada must also move in this direction:

“We believe that macro-prudential regulation is so important in reducing the risk of potential future crises that a formal legislated assignment of responsibility to a committee that would exist for this sole purpose is required … After examining a number of alternative governance arrangements for macro-prudential policy in Canada, our conclusion is that legislation should be enacted to assign formal responsibility for macro-prudential policy to a committee made up of the Governor of the Bank of Canada, the deputy minister of Finance Canada, the superintendent of Financial Institutions and, in the absence of a national securities commission, someone nominated by the federal government to deal with potential systemic risk in securities markets.”

The role of securities regulators in any such committee has been the subject of several reports and articles. In February 2011, the Technical Committee of IOSCO published a discussion paper entitled “Mitigating Systemic Risk; A Role for Securities Regulators”, in which they adopt the following principle: “The Regulator should have or contribute to a process to monitor, mitigate and manage systemic risk, appropriate to its mandate”.

“the role of securities and market conduct regulators in monitoring and addressing systemic risk in capital markets should also be recognized. Such regulators, through their traditional focus on transparency and disclosure, are well placed to work towards an appropriate flow of information to market participants, investors, and other regulators, and can also play a role via their direct authority over a wide cross-section of market participants (especially in terms of business conduct), financial market infrastructures, and trading venues via their market surveillance function.”

Indeed, according to Jenkins and Thiessen,

“the absence of attention to system-wide risks in securities markets (and their interconnections to other parts of the financial system) would represent a serious shortcoming in any framework for macro-prudential policy in Canada.”

Anita Anand of the Faculty of Law of the University of Toronto, in her February 23, 2010 paper entitled “Is Systemic Risk Relevant to Securities Regulation?”, recognized that currently Canadian securities regulators’ mandates do not expressly extend to the reduction of systemic risk, notwithstanding that the contrary argument could be made on the basis that systemic risk may undermine market confidence.  In any case, she feels that, in “adopting a broad view of systemic risk, we would be short-sighted to maintain strict lines between our understanding of prudential regulation and securities regulations”. The reason for this is that (although she doesn’t use the term) the largely private shadow banking segment of the market has demonstrated a propensity to give rise to systemic risk and is outside the purview of provincial regulators. In essence this is an argument based on the universality principle noted above: if we are going to be serious about tackling systemic risk, our policies need to embrace the entire financial system and securities regulators are best placed to deal with certain aspects of it.

In a recent blog posting occasioned by the Supreme Court of Canada decision which found the federal government’s proposal for a national securities regulator to be unconstitutional, Anand noted that the Court specifically observed that the provinces would be incapable of enacting legislation to effectively address systemic risk and expressly stated “the need to prevent and respond to systematic risk may support federal legislation pertaining to the national problem raised by this phenomenon”. Taking her cue from that suggestion she wrote:

“With its more ambitious scheme deemed unconstitutional, the federal government should now move to enact a federal regime in areas that are clearly within federal jurisdiction. Taking the lead from the Supreme Court, the federal government should create a Financial Markets Regulatory Agency (FMRA) and mandate such a national regulator specifically with the oversight of systemic risks in securities markets, investing it with powers to intervene where particular products or activities threaten financial stability.”

Thus, in regulatory circles, the drive towards implementing macro-prudential policies to deal with systemic risk is well under way: and not only at the theoretical level, as revealed by the Technical Committee of IOSCO in their February 2011 paper which discusses in some detail the sources of systemic risk in the securities market place, approaches to identification of systemic risk and the development of systemic risk indicators. (It is particularly interesting to note that the working group which authored this report was co-chaired by the Autorité des marches financiers of Quebec and the Ontario Securities Commission.) In their summary of the issues for securities regulators, they “recognize that the pre-crisis practices that emphasized market discipline and transparency remain essential but need to be strengthened and complimented by stability focus on the challenges presented by systemic risk”.

“This focus will require changes in the approach to securities regulation and will require enhanced access to information for regulators (e.g. through trade repositories) and better surveillance systems that are able to cope with the greater integration of markets and technological developments. It will also require a significant increase in supervisory resources and enhancements in securities regulators’ capabilities for risk analysis. The resulting increase in costs for market participants and regulators will need to be balanced with the benefits of more intensive oversight. Lastly, it will also require regulators together with the responsible body (in some jurisdictions, the central bank or the systemic risk oversight body) to mitigate any emerging systemic risk before they can crystallize and threaten the financial system, as well as to reduce the impacts of any risks which, for whatever reason, happen to materialize”.

Thus, the “new direction implies not only monitoring the emergence of potential risks in the system, but also ensuring that financial markets are working efficiently and contributing positively to the real economy”. The issues that arise from this are many and complex. A key area of concern is the lack of data:

“closing all the gaps will take time and resources, and will require coordination at the international level and across disciplines, as well as strong high-level support. The legal framework for data collection might need to be strengthened in some economies. … there needs to be an internationally coordinated effort for data collection and sharing in order to better assess risks emanating from various regions of the world …”

How this information is to be assessed is also an issue which is acknowledged:

“There will be considerable trial and error in coming to an assessment, on an aggregate basis, of the extent of systemic risk prevailing in the financial system. This assessment of systemic risk is a new task for most securities regulators and those that have the capacity to undertake the tasks should share their expertise and outcomes with others”.

“Additionally, the lack of technical resources for systemic risk analysis is an obstacle in effectively monitoring and mitigating systemic risk and is encountered by securities regulators worldwide. Securities regulators have traditionally focused on market conduct and could lack some of the skilled professionals such as economists and statisticians as well as financial analysts with market experience that are needed to develop systemic risk analysis frameworks. Similarly, many regulators will need to build the IT infrastructure needed to store and analyse large volumes of data. These are important factors that influence the ability not only to develop new methods to measure systemic risk, but also to better use the existing data, information and expertise needed to monitor and mitigate systemic risk”.

It should be recalled here that the proposed IOSCO principle embraced not only the monitoring but also the mitigation and management of systemic risk:

“Under an expanded mandate, securities regulators may for example need to issue early warnings that alert financial market stakeholders to the build-up of systemic risk in certain types of securities transactions or hedge fund activities. Such assessments may require that securities regulators seek disclosure from market participants and private issuers. … securities regulators may need to prohibit certain types of securities transactions or permit them only with certain conditions.” (Anand)

“Transparency is crucial but is not always in and of itself sufficient to limit the development of risks. For example, transparency alone will not ensure that incentives are appropriately aligned. From the regulators’ perspective, access to information is not enough. Regulators must also use that information and act, as necessary … In some cases, regulators should be able, together with the systemic risk bodies in their respective jurisdictions, to restrict certain activities which might threaten the overall stability of the financial system” (IOSCO Technical Committee)

This has already been addressed in certain jurisdictions. The European Securities Markets Authority “may temporarily prohibit or restrict certain financial activities that threaten the orderly functioning and integrity of financial markets or the stability of the whole or part of the financial system in the Union (…) or if so required in the case of an emergency situation (…)”. In the United States, the Financial Stability Oversight Council’s response to “grave threats” includes the power to restrict the ability of companies to offer a financial product or products or to conduct one or more activities.

In Britain, Martin Wheatley of the Financial Services Authority, suggested product regulation would be a core focus of the new regulator. Regulation under the FCA will be about “following the money” to understand what lies behind firms’ profitability, he said. The FCA will look at whether firms have product development and approval processes that can “weed out harmful or inappropriately-marketed products”. Wheately said the approach will be to spot products where the risks are likely to outweigh the benefits the products will bring. He said the FCA would build on the work the FSA has already done on product regulation, adding that intervention could mean a product ban, but that “there are other things we can do behind the scenes with firms”. (IFAonline, May 4, 2012).

The financial crisis of 2007-2008 was a rather extreme example of the volatility to which modern financial markets are prone, occasioned by the confluence of multiple factors including a protracted low interest rate environment and the deliberate erosion of the regulatory safety net premised upon an axiomatic belief in the efficiency of free, unregulated markets and the benefits of increased liquidity and the increased financial speculation required to deliver it. These beliefs proved to be chimercial and could be and have been rather cynically viewed as simply justification for economic rent seeking and extraction on an industrial scale.

So now, as always, the pendulum has swung back and opposing forces (which were always present albeit temporarily cowed by the apparent ability of the other side to deliver the economic goods) have re-emerged with a vengeance sensing, in the words of Claudio Bario, that “the window of opportunity to put in place a fully-fledged macro-prudential framework should not be missed”. I had entitled an earlier piece “Regulatory High Tide” which now seems to have been somewhat premature. As reported by Reuters on April 29, 2012, according to Mark Carney,

“I would say we’re a little more than half way along this process of financial reform and this is really the tough bit because this is where, you know, momentum could flag.”

In various reports delivered a couple of weeks ago by the Financial Stability Bond to the G20 leaders on progress in the implementation of financial regulatory reforms and next steps, the FSB summarizes the reforms which are currently underway. The foregoing discussion is meant to give some notion of the main features of what a “fully-fledged macro-prudential framework” might look like, including:

  1. an unprecedented level of disclosure from virtually all market participants in order to provide a comprehensive picture of market risks. This would concentrate, and be especially onerous, on the largely private shadow market, the first indication of which we saw in the proposed securitized product regulations requiring disclosure in respect of private placements to even sophisticated investors, in contradiction of established principles distinguishing between public and private transactions;
     
  2. a tremendous growth of bureaucratic resources necessary to gather, collate and analyze such disclosure and identify systemic risks which may be present; and
     
  3. a significant degree of discretion necessarily granted to macro-prudential agencies in order to effectively address these risks, possibly (probably?) transforming them into gatekeepers of the financial system performing functions similar to those previously allocated to credit rating agencies.

That deregulation in the last years of the prior century and the first years of this century was a contributing factor to the financial crisis is undeniable. That increased regulation may hamper growth is also undoubtedly true as one of its primary purposes is, on one hand, to slow the growth of potential bubbles and, on the other hand, to provide some weight, in the words of Adair Turner, to “lean against the inherent procyclicalities” characteristic thereof. Nevertheless, we should resist calls to abandon or dramatically scale back the regulations currently under discussion (see, for example, the article in the National Post of June 21, 2012 by Steve H. Hanke who argues that to scale back the regulations would “alleviate financial repression, allowing the banking system to increase the privately produced portion of the broad money supply”). Rather, we should give the proposed regulations time to work and revisit them in a few years to see what adjustments need to be made in order to get the balance right. It is, or at least should be, a matter of trial and error. I do not believe that such an incrementalist approach exhibits a lack of vision but rather a fundamental belief that public policy should be constrained by an acknowledgement and acceptance of the limitations on our ability to predict or shape the future as well as an acceptance of the observation that financial markets are by their nature volatile and must always be so if they are to properly function as expressions and conduits of creative economic energy. This, it seems to me, is squarely within the tradition of the common law and is nothing about which to be embarrassed. That is not to say that certain macro-prudential policies that are designed to “dampen the magnitude and duration of excessive swings in key asset markets” would not be useful. As argued by Frydman and Goldberg in “Beyond Mechanical Markets”, “as long as interventionalist measures are aimed at dampening excess in market fluctuations, rather than at pricking the bubble early, the state can help markets function better without presuming that it knows more than they do.”

Whether or not the proponents of a “fully-fledged macro-prudential framework” intend it, their approach contains within it the possibility of a degree of intervention in market decisions which could drift intentionally or unintentionally into credit allocation policies and the substitution of the judgment of regulators for that of market participants; in other words, towards some degree of central planning. This possibility alone is enough to condemn it. Or as expressed by Adair Turner, “if new economic thinking rejects the idea that the market will naturally deliver perfect equilibrium, it should equally be wary of believing that public policy can achieve it”.

CSA Staff concerned with U.S. exempt market dealers carrying out brokerage activities

The Canadian Securities Administrators released a staff notice today communicating their concern regarding firms that carry out brokerage activities registering as exempt market dealers. The notice describes such firms as being primarily U.S.-based broker-dealers that are members of FINRA.

According to CSA staff, the EMD category of registration was not intended for firms that conduct brokerage activities (trading securities listed on an exchange in foreign or Canadian markets), and the notice states that permitting such activity would result in differing levels of regulatory oversight between EMDs and those firms subject to IIROC requirements and supervision.

In light of their concerns, the CSA will instead "consider" registering these broker-dealers in the restricted dealer category with terms and conditions, including a requirement that such broker-dealers only deal with permitted clients. Such registrations would also be temporary while the CSA engage in a consultation process to ensure that "appropriate regulatory requirements" apply to all firms undertaking brokerage activities. According to the notice, the consultations will "likely" result in changes to the registration rules.

For more information, see CSA Staff Notice 31-327.

Does Re Indalex affect credit support priorities for derivatives and securities financing transactions?

Margaret Grottenthaler -

The Ontario Court of Appeal decision in Re Indalex released on April 7 is certainly the talk of the town in secured financing circles. Unless overturned, it will almost certainly have a significant negative impact on the availability of asset backed loans for entities with defined benefit pension plans given that it conferred priority over secured creditors (including the creditor subordinated to the rights of the super-priority DIP lender) for unfunded employer liabilities to the company’s defined benefit pension plans. As many appreciate, this liability is potentially a huge whack of dough for some companies. But does it have the same negative effect on credit support provided for derivatives transactions and other securities financing transactions, such as securities loans, repo and margin loans? I’m going to refer only to derivatives in this note, but similar comments apply to the collateral for securities financing arrangements. If you’re holding your breath, you can relax a bit because there are reasons why the decision is not likely to have the same impact on the typical collateral arrangement for derivatives transactions as it will have in the commercial finance context. It is problematic though with respect to cash collateral.

The Decision

If you haven’t yet read 20 law firm newsletters on this case, here’s a short description focusing on the aspects potentially relevant to derivatives markets and leaving out some of the details and my more colourful thoughts about the court’s analysis. You have to buy me lunch if you want those!

Insolvent Indalex Canada commenced a proceeding under the Companies’ Creditors Arrangement Act (CCAA). Essentially it was a sale of the business as a going concern (what’s called a liquidating CCAA) and the dispute was over part of the sale proceeds. A debtor-in-possession financing was put in place, which was guaranteed by a related company, Indalex U.S. The sale proceeds were not sufficient to repay the DIP lenders so Indalex US paid out on the guarantee and became subrogated to the rights of the DIP Lenders. By the terms of the court order the DIP loan had priority over “all other security interests, trusts, liens, charges and encumbrances, statutory or otherwise”. 

There were two pension plans involved, one for the company executives and one for the salaried employees. The case revolved around whether a portion of the sale proceeds equal to the unfunded pension liability belonged to the pension funds, based on a statutory deemed trust under the Ontario Pension Benefits Act (PBA) or an equitable constructive trust, or to Indalex US (or more accurately its senior secured creditor), based on the priority conferred on the DIP loan by the court order. The Court of Appeal held that the salaried pension fund had priority based on the statutory deemed trust under the PBA and the priority conferred on the deemed trust by the PPSA and for both funds based on an equitable constructive trust over the employer’s assets (in this case the proceeds of sale of the business). 

One important point to note at the outset is that the statutory deemed trust under the PBA for accrued but not yet due employer pension plan contributions only arises on a wind-up of the pension plan by either the employer or on order of the Superintendent of Financial Services. Employers have a statutory obligation to make certain payments into a pension plan. There are three deemed trust provisions; one for amounts collected from employees that were to be contributed, one for unpaid current service costs and one for amounts accrued to the date of the wind up but not yet due under the plan or regulations.    The latter applies only on a wind-up of the plan and the case related to this third type of deemed trust. An employer must pay (over a five year period) amounts in addition to the current service costs if there are insufficient assets to cover the value of the pension benefits (deficiency liability). The question was whether the amounts that would have been payable by the employer over the period extending beyond the wind-up date for the deficiency liability were “accrued” obligations or not. The executive plan was not in the process of being wound-up at the date of the sale so no deemed trust under the PBA arose. The salaried plan was, however, in the process of being wound up before commencement of the CCAA proceeding. The commercial list judge had held that the deemed trust did not apply to the deficiency liability. 

The deemed trust provision the case was dealing with is found in section 57(4) of the PBA. Where a pension plan is wound up, it deems the employer to hold in trust an amount “of money” equal to “employer contributions accrued to the date of the wind-up but not yet due under the plan or regulations”. Under the PPSA, the PBA deemed trusts have priority over a security interest in accounts or inventory. Because of the reference to “accrued” liabilities, the appeal court held that it included all the liabilities, including the unfunded deficiency liability that would otherwise be paid over the period following the wind-up. Until this case, it was thought that the deemed trust applied to current contribution liabilities that were accrued due but were not yet payable at the wind-up date, but not the deficiency liability, at least in the context of an insolvency proceeding such as the CCAA or bankruptcy. The deficiency liability was considered to be an unsecured claim (as the commercial list judge had held). The court agreed that a DIP financing charge could be given priority over this deemed trust, but held that the Indalex order didn’t do so because the court was not alerted specifically to the issue and there was some suggestion on the affidavit material that the deemed trust would not be affected.

For various reasons I won’t get into the court also found that the employer, as administrator of the plans, had breached its fiduciary duty to the plans in not managing the CCAA so as to take into account the interests of the plan beneficiaries and that an appropriate remedy was a constructive trust over its assets to fund the deficiency. Consequently, even though the executive plan was not being wound-up and, therefore, did not benefit from the deemed trust, effectively the employees received the equitable equivalent (or even better since the deemed trust has priority only with respect to accounts and inventory and the constructive trust was applied to the proceeds of the sale without regard to the source of the proceeds - although the court didn’t limit the statutory trust to those types of proceeds either). 

This case focused on priority over a DIP financing charge. However, it also has implications for other secured creditors as all secured creditors with a security interest in accounts and inventory (and proceeds) are subordinated to the deemed trust by virtue of section 30(7) of the PPSA. In a bankruptcy proceeding, however, the deemed trust would be ineffective as a constitutional matter based on its interference with the scheme of distribution in the BIA (and a host of deemed trust case law). The CCAA itself says that a court cannot sanction a restructuring plan unless it provides for payment of the employer’s current liabilities to the plan. The legislation very deliberately does not include that requirement for unfunded deficiency liabilities, but as this case demonstrates the court may require it in any event.    

If the Court of Appeal decision is not overturned, then, other than in a BIA proceeding, all employer liabilities to company pension plans, including unfunded deficiencies in a defined benefit plan, could take priority over secured creditors with a security interest in accounts and inventory and if justified on the facts a constructive trust analysis could provide a priority for the pension liabilities over the assets of the debtor generally.      

Collateral for Derivatives

In a typical credit support arrangement for derivatives, the collateral is securities or cash. Securities are delivered through the book entry system to the secured party (or transferee in the case of a title transfer arrangement) and in Securities Transfer Act terms, the secured party becomes the entitlement holder. Cash is also transferred directly to the account of the secured party. To the extent it matters to the analysis, the charge which the secured party has is in the nature of a fixed charge. 

An important point to note is that, whether based on the statutory deemed trust or some constructive trust remedy, the priority should not extend to securities, securities entitlements or securities accounts. The statutory priority for the deemed trust conferred by the PPSA applies only over “accounts” and “inventory” and their proceeds. And, even if there was a case where the facts supported some sort of equitable trust arising from a breach of fiduciary duty, it seems unlikely it would or could apply to property that is no longer in the possession or control of the employer. Nor should equitable remedies such as constructive trusts deprive third parties of their interests in property. In Indalex the court was influenced in the context of the constructive trust analysis by the fact that Indalex was the administrator of the plans, but was being controlled by Indalex U.S., which later become the holder of the DIP charge (although query how this was relevant given that it became holder of the DIP charge after the wind-up order). The Securities Transfer Act also protects a purchaser for value (which would include a secured party under a Credit Support Annex) from adverse claims of which it has no notice and as an entitlement holder, secured parties should not be subject to these provincial law claims that arise after the transfers. 

There is also a statutory lien under the PBA (not discussed in the case) for the same amounts, but again it should not have priority over a fixed charge type security interest, which the typical security interest in securities is. 

Cash collateral may be an “account”, however, and the deemed trust could defeat a security interest in cash if the set-off under the creditor support arrangement is not effective (because of a Caisse Drummond  type analysis). An argument could be made that “accounts” as used in the relevant section of the PPSA means accounts receivable and not the broader concept of any monetary obligation owing to the debtor such as would cover the cash collateral account. Also, there are some ameliorating factors that may defeat the deemed trust in the particular circumstances, but one can’t necessarily rely on them in all cases.

First, the CCAA provides that no order made in the proceeding can have the effect of subordinating financial collateral for an eligible financial contract. Hopefully, that provision would prevent a court from relying on any express or inherent CCAA jurisdiction to confer priority on the deemed trust in an initial order or preventing realization on the collateral.

Second, if the collateral is held outside of Canada by a non-Canadian entity (which is often the case), the deemed trust claimants would have to assert the claim in a foreign jurisdiction. That may be a tough case to make in a foreign court, especially in jurisdictions like the U.S. which apply the law of the depositary intermediary to priority issues. 

Third, the statutory deemed trust under s.57(4) of the PBA only arises on wind-up. That wind-up very often occurs after an insolvency proceeding has already commenced. By that time, a derivatives counterparty, not being subject to the normal insolvency stays, will have realized on its cash (or securities collateral) and the deemed trust or constructive trust cannot therefore attach to that property for that reason alone.   If, however, there was a pension plan wind-up prior to an insolvency proceeding with respect to the employer (as was the case in Indalex), the deemed trust could have priority over cash collateral.   

Those of you paying close attention, might be asking – doesn’t the deemed trust still apply to current service costs and special payments that were owing at wind-up? Yes, it does, but as a practical matter, these amounts tend to be in a less significant amount and consequently they get paid from the assets readily available to the insolvency representative. There is no requirement to share the pain of the deemed trust among secured creditors so the most readily accessible assets tend to fund the liability. The deemed trust beneficiaries may be looking further afield, however, when it comes to the deficiency liability and a nice healthy pool of cash collateral may make a pretty target. 

Some Recommendations

I continue to believe that parties should use the ISDA Transfer Annex CSA or amend the NY Form of CSA to provide for title transfer of cash. While there is no assurance it will defeat the problematic Caisse Drummond analysis, there is certainly a good basis for that position. If the set-off is effective, the only property the deemed trust could attach to is the excess collateral value.

If you are taking cash collateral, it would be prudent to determine whether a counterparty has a defined benefit pension plan, to monitor its funding status and to include a termination event triggered by any step taken to wind-up the plan. 

Canadians already face enough challenges in explaining the priority issues with respect to cash collateral to their creditors without the added impediment of priming deemed trusts. Let’s hope the Supreme Court of Canada hears the appeal and reverses the decision. 

U.S. legislation to add withholding tax to certain swap transactions

Jonathan Willson and Roanne C. Bratz

The Hiring Incentives to Restore Employment Act (or HIRE Act) has now come into effect in the United States and it will likely be relevant to Canadian participants in the OTC derivatives and securities lending areas. 

By way of background, the HIRE Act added a new U.S. withholding tax provision for certain equity-related swaps, sale-repurchase transactions and securities lending transactions. The HIRE Act applies to dividend equivalent payments made on or after September 14, 2010.  Dividend equivalent payments include payments that are contingent on, or determined by reference to, U.S.-source dividends in sale-repurchase and securities lending transactions, including certain equity swap transactions where a non-U.S. counterparty buys or sells the underlying U.S. security from or to its counterparty.  After March 18, 2012, cross-border dividend equivalent payments made under all equity swap transactions will be treated as U.S.-source dividend income, unless the U.S. Department of the Treasury issues regulations exempting any particular equity–related swap from its application.  As a result, any U.S. source dividend equivalent payment received or paid by Canadian parties, for example, generally will be subject to U.S. withholding tax even if there is no U.S. counterparty to the transaction.  The withholding tax is imposed on the “gross amount” of any dividend-equivalent payment used in computing any net amount paid to the non-U.S. counterparty in connection with the transaction.  The U.S. withholding tax generally will be imposed at a 30% rate, unless the applicable withholding rate is reduced under the terms of an income tax treaty and proper documentary evidence is timely provided to the appropriate counterparty.

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.