On June 20, 2008, the Québec government adopted the Derivatives Act (the Act), which provides a legislative framework to govern derivatives activities within the province. This legislative action follows the publication by the Autorité des marchés financiers (the AMF) in August 2007 of the Proposed Framework for Regulation of Derivatives Markets in Québec (the 2007 Proposal).
Once in force, the Act will govern derivatives offerings, as well as trading and related activities in Québec. The Québec government intends to oversee and regulate the activities of derivatives market professionals and other market participants in Québec so as to control systemic risk in derivatives trading and provide for mechanisms for client complaints and investor protection in derivatives-related matters.
By adopting a principles-based approach that will be complemented by regulations and policy statements, the Québec government has established a legal framework designed to adapt to the ever-evolving derivatives market in Canada. The AMF expects to publish draft regulations and policy statements that reflect the principles established in the 2007 Proposal later this fall. The Act and the AMF regulations are not expected to come into force prior to 2009. It is highly likely that the provisions relating to registration of dealers and advisers will be timed to come into force at the same time as proposed National Instrument 31-103 Registration Requirements (NI 31-103).
Since the Montréal Exchange became an equity option market in the late 1990s, the Québec Minister of Finance wanted to provide a modernized regulatory scheme for derivatives activities conducted within Québec and to increase the functionality of the derivatives markets. By adopting the Act, Québec becomes the third Canadian jurisdiction (along with Ontario and Manitoba) to adopt specific legislation governing derivatives activities and the first to legislate a modern scheme for derivatives markets.
In addition to the registration requirement imposed by the Act for dealers and advisers conducting derivatives activities, the Act also requires that exchanges, published markets, alternative trading systems not registered as dealers, clearing houses, self-regulatory organizations as well as information processors carrying on derivatives activities in Québec must be recognized by the AMF. Investment management industry participants, including international service providers, will want to carefully review the Act and ensuing regulations in order to determine if the requirements to register or to be recognized apply to their activities in Québec
Derivatives Covered By The Act
The Act defines a "derivative" as an option, swap, futures contract or any other contract or instrument whose market price, value, or delivery or payment obligations are derived from, referenced to, or based on an underlying interest, or any other contract or instrument designated by regulation or considered equivalent to a derivative on the basis of criteria determined by regulation. This definition is intentionally a broad definition. The Act does not contain a list of derivatives that are subject to the legislation, although it does contain some clarity on financial instruments that will not be considered derivatives, such as conventional warrants or rights.
The Act will apply to "standardized derivatives" (essentially derivatives traded on a published market) as well as over-the-counter derivatives.
In addition, "hybrid products" will be subject to the Act unless circumstances of their offering or issue demonstrate that these products are predominantly a security within the meaning of the Securities Act (Québec) (the QSA). A hybrid product will be considered to be predominantly a security if (i) the offeror received payment of the purchase price of the hybrid product on the issue of the product; (ii) the hybrid product has a maturity date and the purchaser is under no obligation to make any additional payment at maturity, and (iii) the offeror is not subject to any margin requirements based on a market value of the underlying interest of the hybrid product.
Financial products offered by banks and other financial institutions are not excluded from the application of the Act, although the legislature may respond to industry pressure and exclude these products via regulation.
Qualified Persons
A person, other than a recognized regulated entity, who creates or markets a derivative will have to be qualified by the AMF before offering standardized derivatives or over-the-counter derivatives to the public (a Qualified Person). The derivative will also have to be authorized by the AMF.
Qualified Persons will have to file annually, specified information with the AMF. The requirements for such qualification, as well as the applicable disclosure requirements are expected to be provided by regulation, which are yet to be published.
Registration Of Dealers And Advisers In Derivatives
Pursuant to the Act, no person will be permitted to act as a dealer or adviser in derivatives unless registered with the AMF in this capacity. Every individual dealing or advising in derivatives on behalf of a firm registered pursuant to the legislation will also be required to register with the AMF.
The AMF has indicated that it intends to harmonize its administration of the Act, including its regulations and policy statements made under the legislation, with proposed NI 31-103.
The Act provides for certain general obligations of registered firms and individuals including requirements for these registrants to meet accepted standards of integrity and fairness, as well as standards of diligence and competence governing their conduct. Registrants will also be required to maintain an appropriate level of knowledge relating to derivatives and act with honesty and loyalty and exercise all the care that may be expected of a knowledgeable professional placed in similar circumstances.
In addition, the Act sets out conduct rules for registrants, including requirements to:
- establish the client's identity and profile
- determine the client's needs and recommend
derivatives that are suitable
- provide clients with the risk information document
prescribed by regulation
- avoid or, if unavoidable, disclose conflict of interests
to clients and take measures to ensure the clients'
interests are not affected
- segregate client property
- supervise the conduct of accredited counterparties to
whom they provide direct trading access to a published market
and
- provide equitable resolution of complaints by adopting
policies dealing with the examination of complaints and the
settlement of disputes.
We expect that firms and their representatives currently registered with the AMF to provide advice or to trade in derivatives will be grandfathered under the Act. The AMF has indicated that the status quo will continue concerning the regulation of representatives of dealers and advisers in derivatives. This means that the Investment Industry Regulatory Organization of Canada (IIROC) will regulate derivatives dealers' representatives and the AMF will regulate derivatives advisers' representatives.
Exemptions
Certain provisions of the Act will not apply in the case of over-the-counter derivatives where accredited counterparties are involved. Advising and dealing activities in OTC derivatives with accredited counterparties will not trigger the requirement to register as dealer or adviser under the legislation and issuers of these derivatives will not be required to obtain qualification from the AMF.
The exemptions are based on the status of an "accredited counterparty". These include governments, municipal administrations, financial institutions (or subsidiaries thereof), dealers or advisers registered under the Act, dealers or advisers registered under securities legislation, pension funds regulated by the Office of the Superintendent of Financial Institutions, the Régie des rentes du Québec or a pension commission, certain investment funds and hedgers. In addition, an entity that establishes that it has the requisite knowledge and experience and has assets in excess of the minimum amount specified by regulation (the 2007 Proposal suggested $5 million) would also qualify as an "accredited counterparty".
Recognition Of Regulated Entities
No regulated entity will be authorized to carry on derivatives activities in Québec unless it is recognized by the AMF. Pursuant to the Act, a "regulated entity" is an exchange, an alternative trading system not registered as dealer in derivatives, or another published market, a clearing house, a regulation services provider, an information processor, a self-regulatory organization or any other person designated as such by the AMF.
The Act proposes a regime for regulated entities that covers governance practices, risk management procedures, financial and regulatory reporting and conduct rules. Additional requirements to be met by applicants requesting the status of regulated entity will be determined by regulation.
As adopted, the Act will capture all entities providing services in Québec, including those not based in Québec, that fall within the services of a "regulated entity" in the province. We expect that additional guidance will be provided by the AMF as to the circumstances under which the AMF would consider non- Québec-based service providers as carrying on business in Québec.
Next Steps
The Act provides the framework for the regulation of derivatives in Québec; however much of the detailed derivatives marketplace regulation will only be known once the AMF publishes its draft regulations and policy statements later this fall. We expect that once those instruments are published, market participants operating in Québec will need to determine what structural, legal, operational and contractual changes are necessary in order to be compliant with the new regulations.
We note that the Ontario government has not yet explained what it intends to do with the recommendations contained in the final report of the Ontario Commodity Futures Act Advisory Committee published in January 2007. We expect that the Ontario government will wait to see how the regulation of the derivatives market-place in Québec proceeds before taking any concrete action to act on the recommendations contained in that final report.
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.