Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Securities Regulation, July 2008
The Quebec National Assembly recently adopted comprehensive legislation to regulate derivatives. While not yet in force, it is expected that the Derivatives Act, S.Q. 2008, c.,24 (QDA), will come into force by the end of the year, with the provisions governing dealers and advisers possibly timed to come into force at the same time as the dealer registration reforms contained in National Instrument 31-103 – Registration Requirements.
The adoption by Quebec of the QDA is a first in Canada. As Quebec's Autorité des marchés financiers (Authority) is the lead regulator for derivatives in Canada, specifically by means of its oversight of the Montreal Exchange, the Canadian derivatives exchange of the newly created TMX Group, Quebec is staking its position to be at the vanguard of derivatives regulation in Canada.
Currently, the Securities Act (Quebec) (QSA) governs certain forms of derivatives to the extent that they are securities. Thus, derivatives traded over-the-counter are not governed by any specific system of regulation except to the extent that they would be considered "investment contracts" and thus "securities". In such instances where a derivative would constitute a security and therefore be subject to the scheme of regulation created by the QSA, statutory exemptions could be relied upon although, even in the case of so-called exempt trades, reporting requirements could still apply.
A discussion paper published in 2006 by the Authority underscored the fact that derivatives were not comfortably regulated by the QSA, and that the provisions of the QSA which did regulate derivatives were outdated. According to the discussion paper, the development of the financial markets and products since the 1980's, when the QSA's provisions pertaining to derivatives were first enacted, highlighted a fundamental distinction between securities and derivatives, namely that whereas securities are investment products, derivatives are risk management products. The discussion paper led to a request for comments on a proposed derivatives framework in August 2007, the result of which is the newly adopted QDA.
The QDA defines derivative as an option, a swap, a futures contract or any other contract or instrument whose market price, value, or delivery or payment obligations are derived from, referenced to or based upon an underlying interest. The notion of underlying interest is not defined, although a non-exhaustive definition had been proposed in the draft legislation. The government may determine other types of derivatives that are subject to the QDA by regulation. A hybrid product, being a product that embodies elements of derivatives and securities, is subject to the QDA unless it has the predominant features of a security. In this regard, the QDA provides that a hybrid product is presumed to be predominantly a security if:
- the offeror receives payment of the purchase price on the
delivery of the hybrid product;
- the purchaser is under no obligation to make any
additional payment beyond the purchase price as a margin
deposit, margin, settlement or other such amount during the
life of the hybrid product or at maturity; and
- the terms of the hybrid product do not include margin
requirements based on a market value of its underlying
The QDA carves out investment contracts from its application, meaning that such products will continue to be regulated exclusively by the QSA. Also excluded are warrants or subscription rights, insurance or annuity contracts issued by licensed insurance companies, as well as options or other non-traded derivatives whose value is derived from, referenced to or based upon the value or market price of a security, granted as compensation or as payment for a good or service.
So-called "regulated entities" may not carry on derivatives activities in Quebec without having been recognized by the Authority as such. A regulated entity is defined by the QDA as an exchange, an alternative trading system not registered as a dealer, another published market, a clearing house, an information processor, a self-regulatory organization or any other person designated by the Authority. The QDA contains provisions with respect to the operating rules, activities, governance and disclosure requirements of regulated entities, which are subject to oversight and monitoring by the Authority and the Bureau de décision et de révision en valeurs mobilières (Board), which is the independent quasi-judicial arm of the Authority. Regulated entities will be subject to a self-certification process with respect to their rules and products.
The QDA specifically deems dealers engaged in over-the-counter trading of standardized derivatives as operating a published market, and therefore subject to registration by the Authority as a regulated entity, unless such trading is compliant with the operating rules of such published market. The QDA defines "standardized derivative" as a derivative that is traded on a published market whose intrinsic characteristics are determined by that market and whose trade is cleared and settled by a clearing house.
Regulated entities which have already been recognized by the Authority or which have been given an exemption by it under the QSA or under the Act respecting the Autorité des marchés financiers (Quebec) are grandfathered under the QDA and therefore can continue to carry on their activities in accordance with the conditions of the Authority's pre-existing recognition or exemption, subject to the Authority being able to impose new conditions at a future date.
Furthermore, the QDA requires that, subject to the exemption pertaining to accredited counterparties described below, a person other than a regulated entity who creates or markets a derivative must be qualified by the Authority prior to such derivative being offered to the public, and the Authority must also authorize the derivative product.
DEALERS AND ADVISERS
Subject to the exemption pertaining to accredited counterparties and the deemed registration process described below, the QDA also creates a separate registration regime for dealers and advisers engaged in derivatives trading or advising. The general rules of conduct for dealers and advisers registered under the QDA are similar to those of the QSA (e.g., rules such as "know your client" or acting with diligence and in the client's best interest). The QDA also specifically prohibits dealers or advisers from acting on behalf of a client if they have reasonable grounds to believe that the trade in question is unlawful or likely to bring the derivatives market into disrepute.
Subject to the exemption pertaining to accredited counterparties described below, the QDA requires dealers to provide their clients with prescribed disclosure material, consisting of a risk information statement and, in the case of a derivative created and marketed by a qualified person, the qualification information, prior to the first trade on behalf of such client. Like the QSA, the QDA mandates that such material and any other material communicated to a client be in French or in French and English.
Dealers and advisers who are already registered under the QSA, who meet the conditions for registration under the QDA and who pay the required fee will be deemed to be registered under the QDA and will then become subject to the QDA's requirements.
Importantly, the requirements of the QDA pertaining to qualified persons and dealers and advisers do not apply to over-the-counter derivatives activities or transactions involving "accredited counterparties" only. Accredited counterparties include the following entities, whether Canadian or foreign:
- governments and their agencies and wholly-owned
- financial institutions and their wholly-owned
- registered dealers and advisers and their
- pension funds; and
They also include:
- Canadian or Quebec registered charities;
- persons who establish, in a "conclusive and
verifiable manner", that they are knowledgeable of
derivatives and who meet prescribed minimum asset
- publicly offered investment funds which invest in
- private funds offered to accredited investors under the
QSA or investors meeting the minimum amount investment
exemption under the QSA; and
- other investment funds that are advised by a Canadian or
foreign registered adviser.
Furthermore, while a dealer or adviser acting on behalf of a discretionary account is considered to be acting on behalf of an accredited counterparty, the various rules of conduct incumbent upon registrants under the QDA nonetheless apply to such dealer or adviser, except that such dealer or adviser is not required to provide prescribed disclosure material to its non-accredited counterparty client which it otherwise would have to do if the client were not a discretionary account.
Interestingly, the QDA provides that a derivative cannot be invalidated on the basis that a counterparty does not qualify as an accredited counterparty, although a person in breach of the QDA will remain subject to sanction.
The Authority is given a broad range of enforcement powers under the QDA, similar to those afforded to it under the QSA, including the power to investigate, the power to compel disclosure of information, the power to issue administrative monetary penalties where permitted by regulation, and the power to request the Board to render so-called "freeze" or cease trade orders, which specifically comprises the power to request the Board to order a person to liquidate a contract and retain the proceeds of liquidation.
Except for the power of investigation or unless there is fraud or other deceptive practices involved, the Authority and the Board do not have enforcement powers with respect to over-the-counter derivatives activities or transactions involving accredited counterparties only.
TRADING PROHIBITIONS AND REPORTING REQUIREMENTS
Similar to the QSA, the QDA prohibits a person who has access to information on the investment programs of an investment fund or portfolio manager from using such information for its benefit by trading derivatives included in the program. The QDA also amends the QSA in order to harmonize it with the changes brought forward by the QDA. In particular, the insider reporting requirements of the QSA are broadened to apply to trades in a derivative having securities of a reporting issuer as its underlying interest. As well, the QSA's prohibition against insiders and others in a special relationship with a reporting issuer from indirectly using privileged information which they have in respect of the issuer will be extended to ban trading in derivatives whose underlying interest is securities of the issuer.
As the QDA sets forth legislative core principles, regulations and policy statements will form an integral part of the overall regulatory scheme. In this regard, draft regulations are expected to be published in the fall of 2008.
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.