- New regulatory regime creates dual approval requirements for the offering of derivatives to the public in Quebec:
- a person seeking to offer the derivative must be qualified by the Quebec Autorité des marchés financiers (the Authority)
- product being offered must also be authorized by the Authority
- Affects persons desiring to market derivatives outside recognized trading platforms and outside the exempt market
- Pre-existing regulatory framework continues to accommodate:
- offering of listed products through exchanges that have been recognized or exempted by the Authority
- for exchanges whose trading platform is not accessible in Quebec, offering of specified listed products (most options and futures) to accredited investors
- offering of OTC products to accredited counterparties
On April 13, 2012, provisions of the Derivatives Act (Quebec) (QDA) enacted late last year governing "qualified persons" were brought into force. Together with concurrent amendments to the Derivatives Regulation (Quebec), these changes implement a new regulatory regime setting out the conditions for qualification of persons in connection with the offering of derivatives to the public, as well as the conditions for authorization of the particular derivatives sought to be offered (the Qualification Regime). By doing so, Quebec and its financial markets regulator, the Autorité des marchés financiers (Authority), are once again taking the lead in an important area of derivatives regulation in Canada.
The Qualification Regime creates dual qualification and authorization requirements with respect to the offering of derivatives to the public. Specifically, the Qualification Regime requires (1) that a person, other than a recognized regulated entity, who creates or markets a derivative, be qualified by the Authority before offering the derivative to the public and (2) that such person have the marketing of the derivative authorized by the Authority. Thus, both the person seeking to offer the product and the product itself are subject to approval by the Authority. The Qualification Regime is separate and distinct from the derivatives dealer and adviser registration requirements of the QDA. We discuss the interaction between the Qualification Regime and the dealer registration requirement later in this bulletin.
Up until the introduction of the Qualification Regime, the Authority had granted discretionary relief on a handful of occasions in order to exempt registered dealers from the qualification requirement, thereby allowing them to market derivative products, principally over-the-counter (OTC) products such as forex contracts and contracts for differences (CFDs), to the public. The Qualification Regime builds on that experience and, in theory at least, goes further by also capturing the offering of standardized derivatives (i.e., derivatives that are traded on a published market and cleared and settled through a clearing house).
Scope of QDA and Key Exemptions
Prior to discussing the Qualification Regime, it will be useful to summarize the scope of the QDA as well as the key exemptions afforded by the QDA which permit activities to be conducted without the need for qualification and authorization.
Hybrid Products that are Securities
While the QDA regulates both standardized derivatives and OTC derivatives, it does not regulate hybrid products having the predominant features of a security. For example, principal-protected notes and principal-at-risk notes whose return is based on underlying interest such as an index, will typically be considered securities and as such will be subject to the securities regime and not the QDA.
Exemption for Recognized Regulated Entities and their Listed Derivative Products
Listed products of recognized regulated entities (RREs) such as the Montréal Exchange, may continue to be offered to the public through registered dealers without regard to the Qualification Regime. By virtue of being recognized by the Authority, RREs and their products are already subject to regulatory oversight, and thus are exempt from the qualification and authorization requirements.
Exemption for Non-Recognized Regulated Entities and their Listed Derivative Products
Listed products of certain other exchanges, such as ICE Futures and NGX, that have not been recognized by the Authority and therefore do not qualify as RREs, benefit from exemption decisions of the Authority, including exemptions from recognition as an exchange. The Authority exempts such exchanges on the basis of their being recognized by, and subject to the regulatory oversight of, the securities regulatory authority of their home jurisdiction.
Exemption for Specified Standardized Derivatives
A blanket decision of the Authority adopted in 2009 (the Blanket Decision) exempts the offering of specified derivatives (namely certain kinds of options and futures) from the qualification requirement (and also from the derivatives dealer registration requirement) where the activities are conducted exclusively with accredited investors. The Blanket Decision was rendered in order to maintain the status quo for products that were treated as securities prior to the adoption of the QDA. This exemption therefore covers listed products of an exchange, alternative trading system or other derivatives market that is not carrying on activities in Quebec, (i.e., Quebec dealers do not have direct access to its trading platform), and applies if trading in Quebec is solely with accredited investors.
See our October 2010 Blakes Bulletin on Securities Regulation: Update – Quebec Blanket Order Affording Relief for Activities Involving Specified Derivatives to Remain in Effect for further details on the Blanket Decision. Guidance of the Authority indicates that the Blanket Decision is not specifically affected by the Qualification Regime, and that any changes thereto in the future will provide market participants with the benefit of a transition period in order to allow such participants to "reassess their situation".
We discuss the Blanket Decision further below under "Going Forward".
Exemption for OTC Derivatives
Somewhat similarly to the Blanket Decision, the QDA exempts the offering of OTC derivatives from the qualification and authorization requirements (and also from the derivatives dealer registration requirement) where the activities are conducted exclusively with accredited counterparties (the person doing the marketing and/or entering into OTC derivatives must also be an accredited counterparty). See our January 2009 Blakes Bulletin on Securities Regulation: Quebec Derivatives Legislation in Force as of February 1, 2009 for further details on the OTC exemption.
Persons desiring to market derivatives outside recognized trading platforms and outside the exempt market as described above are subject to the Qualification Regime, meaning that they must follow a process of becoming qualified and having the derivative proposed to be marketed authorized by the Authority.
Becoming a Qualified Person
To become qualified, applicants must provide prescribed information to the Authority in order to demonstrate that they meet the qualification requirements of the QDA, including with respect to:
- having an effective corporate and organizational structure;
- having appropriate business policies, procedures and good governance practices; and
- taking the necessary measures to ensure the security and reliability of transactions and activities.
The prescribed information to be provided covers such matters as the regulatory regime applicable to the applicant in Canada or elsewhere, product distribution methods, disclosure to be given to clients, details of the electronic platform used and financial information.
In the absence of participating in a contingency fund that protects the property entrusted to them by the counterparties to the derivative that they are marketing, qualified persons must meet the following financial requirements:
- for qualified persons who are not members of the Investment Industry Regulatory Organization of Canada (IIROC), excess working capital may not be less than zero for two consecutive days; for qualified persons who are members of IIROC, the same rule applies, but calculated in reference to risk-adjusted capital;
- and qualified persons must have minimum capital of C$20‑million plus 5% of the amounts due to counterparties to a derivative that the qualified person is marketing which exceeds C$10-million. This minimum capital requirement is consistent with the requirement of IIROC, and applies to both IIROC and non-IIROC members.
Obtaining Authorization for the Derivative
The Qualification Regime also requires qualified persons to obtain the authorization of the Authority in order to market a derivative. To do so, the person must provide prescribed information to the Authority with respect to the derivative, including:
- a detailed description of the product;
- its trading method;
- a description of the intended clientele;
- outline of risks related to the derivative; and
- costs and fees.
Together with the risk disclosure statement prescribed by the QDA, the foregoing information must be provided to clients trading in the derivative by the dealer through whom the qualified person will be offering the derivative. While the QDA makes it an offence to make a misrepresentation in information provided to clients, it does not create a prospectus-type liability regime for such disclosure.
The process of having the derivative authorized is analogous to the prospectus clearing process for securities, in that the Authority (which has 21 days within which to make a decision), will have the opportunity to comment on the information provided and, if necessary, request that changes be made in order to satisfy the Authority's concerns, having regard to the stated purpose of the QDA to protect the public and ensure that the public has access to "adequate, true and clear information, tailored to the level of financial knowledge and experience of those for whom the information is intended."
Timely and Periodic Reporting Requirements
The Qualification Regime provides for a number of timely and periodic reporting requirements for qualified persons, including giving the Authority:
- prompt notice of excess working capital/risk adjusted capital being less than zero or of any material failure, malfunction or delay of systems or equipment;
- notice of any change that could affect the trading of the derivative, at least 10 days prior to the change;
- notice of any material change in respect of the qualified person or the derivative, within seven days of the change; and
- notice of any other change in information provided in the application materials, within 30 days of the end of the quarter in which the change occurred.
The updated information that is provided to the Authority in a timely manner can then be used in connection with a public offering of derivatives.
In addition, qualified persons are required to provide the following information to the Authority on an annual basis, within 90 days after the end of their fiscal year:
- audited financial statements (Canadian GAAP compliant);
- the number of contracts entered into in Quebec and their notional value for all derivatives offered to the public during the year; and
- the percentage of accounts, for each of the latest quarters, that were profitable for counterparties.
Interaction with Dealer Registration Requirement
The QDA provides that unless the qualified person is already registered as a dealer under the QDA, such person is required to conduct the offering of the derivative through a dealer. In this regard, the QDA imposes a registration requirement on derivatives dealers which is a separate regime from the Qualification Regime. Questions have arisen as to the interaction between these two regimes.
As mentioned, prior to the creation of the Qualification Regime, a number of registered dealers obtained an exemption from the qualification requirement by means of a decision of the Authority in order to be able to market forex contracts and CFDs to the public.
With the Qualification Regime in place, a registered dealer that wishes to offer derivative products to the public through its own electronic trading platform will need to become qualified and have the marketing of the products authorized by the Authority. On the other hand, a registered dealer that is offering an authorized derivative on behalf of a qualified person (or trading either a listed product of a recognized or exempt exchange or an OTC product that is offered only to accredited counterparties) is not subject to the Qualification Regime.
Although many of the requirements of the Qualification Regime were foreshadowed in decisions of the Authority providing discretionary relief from the qualification requirement, the creation of the Qualification Regime provides certainty to stakeholders as to the rules of the game applicable to the non-exempt derivatives market in Quebec. However, it remains to be seen just how much this market will be tapped beyond the kinds of OTC products that have been approved in the past. While the Qualification Regime also regulates the offering of standardized derivatives, the pre-existing regulatory framework in Quebec already accommodates, and will continue to accommodate, the offering of such products to the public through RREs, exempted non-RREs as well as, by virtue of the Blanket Decision, the indirect offering of specified standardized derivatives (most options and futures) to accredited investors through non-exempted non-RREs that do not carry on activities in Quebec.
Importantly, for persons who were exempt from the qualification requirement of the QDA pursuant to an exemption decision of the Authority that specified a sunset date tied to the adoption of the Qualification Regime, the Qualification Regime provides a grace period of 30 days within which to file an application for qualification.
In the notice of publication with respect to the Qualification Regime, the Authority indicates that the Blanket Decision remains unchanged for the time being, and that the Authority will publish notice of any proposed amendments to such decision and at that time allow persons who are relying on the Blanket Decision to benefit from a grace period in order to "reassess their situation". Thus, persons relying on the Blanket Decision should be mindful of possible changes to such decision that may be forthcoming.
For one thing, guidance would need to be provided with respect to the Blanket Decision affording an exemption from both the qualification and the authorization requirements of the Qualification Regime (at the time the Blanket Decision was rendered, only the qualification requirement existed, and so the decision naturally only provides an exemption from that requirement, although from a reading of the QDA it would appear plausible to conclude that an exemption from qualification entails a co-extensive exemption from authorization).
With the adoption of the Qualification Regime in Quebec, it will be interesting to see how other Canadian regulators will develop an approach to this area of the law, and whether efforts to harmonize will be made.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.