Bill 77, the Derivatives Act, received royal assent on June 20, 2008 and will come into force on dates to be set by the Government. The Bill, which was introduced on April 9, 2008 by the Québec Minister of Finance, Monique Jérôme-Forget, establishes a broad legislative framework that specifically regulates derivatives in Québec. Québec is the first Canadian province to implement such a framework.
Whereas only certain derivatives are currently governed by the Québec Securities Act (QSA), the new Derivatives Act applies to all derivatives activities in the province. The decision to adopt legislation covering all derivatives appears to have been motivated, in part, by the presence of the Montréal Exchange – Canada's principal derivatives exchange – in Québec and the recent launch of the Montréal Climate Exchange, on which environmental futures contracts will be traded.
The Derivatives Act regulates derivatives trading and establishes mechanisms to monitor the activities of regulated entities, derivatives market professionals and market participants to protect the public from unfair, improper or fraudulent practices and market manipulation. As recommended by the Autorité des marchés financiers (AMF), the Act is based on core principles which are intended to provide greater flexibility in its application and allow the regulator to respond quickly and efficiently to market evolution. The Act will be complemented by regulations and policy statements to be submitted by the AMF to the Minister.
Scope of the Derivatives Act
Under the Act, "derivatives" include options, swaps, futures contracts and other contracts or instruments whose market price, value, or delivery or payment obligations are derived from, referenced to or based on an underlying interest. This broad definition likely will evolve to include contracts or instruments designated by regulation or considered equivalent to a derivative on the basis of criteria determined by regulation.
The Act regulates "standardized derivatives", which are derivatives traded on a published market whose intrinsic characteristics are determined by that market and whose trade is cleared and settled by a clearing house. It also applies to a limited extent to derivatives which are traded over-the-counter (OTC Derivatives). Although over-the-counter derivatives activities and transactions involving "accredited counterparties" are exempt from most requirements of the Derivatives Act, the Act is designed to ensure that the AMF can assert jurisdiction over market manipulation and fraud in all derivatives markets, and puts the AMF in a position to monitor offerings of OTC Derivatives to retail investors.
"Hybrid products," which combine elements of derivatives and securities, are also governed by the Act, unless the terms of such products demonstrate that they are predominantly a security within the meaning of the QSA. Subscription rights or warrants, investment contracts, insurance and annuity contracts, and certain options and other non-marketable derivative instruments linked to securities granted as compensation or as consideration for goods and services are excluded from the application of the Act. This list could be expanded through regulation.
It appears that the Act is not intended to regulate principal protected notes, guaranteed investment certificates and other deposit instruments, even though these instruments could fall within the Act's scope given the broad definition of "derivatives." The AMF may clarify this position, if need be, in a policy statement or otherwise.
Object of the Derivatives Act
The Derivatives Act governs regulated entities (such as exchanges, alternative trading systems not registered as dealers and other published markets, clearing houses, information processors and self-regulatory organizations), regulation services providers, intermediaries who carry on business as dealers or advisers, and other persons who trade derivatives.
Recognition of Regulated Entities
To carry on derivatives activities in Québec, regulated entities must be recognized as such by the AMF and on the conditions as set by the AMF. Recognized exchanges or other published markets or recognized clearing houses may monitor or supervise the conduct of their participants or members and their respective representatives without being recognized as self-regulatory organizations (SROs) under the Act; however, the AMF may decide to make derivatives activities of such entities subject to their prior recognition as SROs.
The Derivatives Act allows the outsourcing of certain functions, such as market regulation; but, regulation services providers are subject to the same recognition requirement as regulated entities, even though the recognized regulated entity retains full responsibility under the Act for any outsourced activities.
Self-Certification of Rules and Products
A regulated entity is required to demonstrate that proposals for new operating rules, rule amendments or new products comply with the core principles set out in the Derivatives Act. While proposals will come into effect shortly after they are filed with the AMF, the AMF will retain the discretion to examine new rules, rules amendments or new products and to intervene, as needed. Regulated entities may ask the AMF to approve a rule amendment if they are uncertain about compliance with the core principles. This self-certification process, which is a key feature that currently exists under U.S. legislation, is intended to accelerate and facilitate the amendment of rules of regulated entities and the introduction of new derivatives. The terms and conditions of such process will be set out in the regulation.
Registration of Dealers and Advisers
No person may carry on business as a dealer or adviser with respect to derivatives (other than OTC derivatives) unless it is registered as such with the AMF or is relying on the exemption from the registration requirements for dealings with accredited counterparties as discussed below. Core principles addressing competence, integrity and sufficiency of financial resources for registered dealers and advisers are set out in the Act; but, categories of registration, conditions to be met by applicants for registration, the duration of registration and the rules governing the activities of registered dealers, advisers and their respective representatives will be determined by regulation by the AMF. Similarly, proficiency requirements for representatives of registered dealers and advisers engaged in the business of trading derivatives or advising others about derivatives trading are yet to be determined.
The Derivatives Act does contain transitional provisions for dealers and advisers already registered in accordance with the QSA to be deemed registered for the purposes of the Act as long as they remain registered under the QSA.
Transactions involving only persons or entities who qualify as "accredited counterparties" under the Derivatives Act are exempt from a wide range of requirements because the status, resources and/or knowledge of these counterparties demonstrate that they do not need protection under the Act. Note that "hedgers" are included in the definition of "accredited counterparties" under the Act. A "hedger" is a person who, because of his or her activities, is exposed to one or more risks attendant upon those activities, and seeks to hedge that risk by engaging in a derivatives transaction, or a series of derivatives transactions, where the underlying interest is that which is directly associated with that risk or a related underlying interest. This definition takes into consideration not only risks related to fluctuations in the price of an underlying interest but also risks relating to supply, credit, exchange or environmental factors.
A person may also qualify as an accredited counterparty on the basis that the person has a specified minimum amount of assets (to be determined by regulation) provided that the person establishes, in a "conclusive and verifiable" manner, (i) that he or she has the requisite knowledge and experience to evaluate the derivatives information provided; (ii) the appropriateness of his or her need of proposed derivatives strategies; and (iii) the characteristics of the derivatives to be traded on his or her behalf. It will be helpful if the AMF provides guidance on the methods for establishing these criteria.
The definition of "accredited counterparty," which could be expanded through regulation, includes any person specifically designated as such by the AMF if it considers this person's business, level of financial knowledge and experience and asset level equivalent to those of an accredited counterparty.
Broad Powers Granted to the AMF
The Derivatives Act grants the AMF the power to: exempt a derivative, a person, an offer or a trade from any or all of the requirements or obligations under the Act; designate a person as an accredited counterparty; request the communication of certain documents; make policy statements relating to the carrying out of the Act; impose administrative monetary penalties; and take remedial measures.
Under the Act, the AMF may, on its own initiative, issue freeze orders on the property of a person, whether in view of or in the course of an investigation. Under the QSA, the AMF must first apply to the Bureau de décision et de révision en valeurs mobilières (BDRVM). The BDRVM is an administrative tribunal created under the Act respecting the Autorité des marchés financiers (AMF Act) which is completely independent of the AMF and responsible for exercising several of the administrative powers set forth in the QSA.
Recognizing that persons may be subject to the QSA, the Derivatives Act and the AMF Act, the Derivatives Act does not duplicate provisions in existing securities legislation. The Derivatives Act makes numerous cross-references to the AMF Act, including provisions concerning inspection and investigation powers.
French Language Requirements
All documents required to be communicated to clients under the Derivatives Act must be drawn up in French only or in French and English. This requirement likely will have limited practical consequences as the Act or the regulation will only prescribe the form or substance of communications to clients in limited circumstances, and these prescribed communications should not apply to transactions between accredited counterparties.
The Derivatives Act contains numerous cross-references to regulations to be adopted under it. In developing regulations to complement the legislative framework under the Act, the AMF needs to specify certain obligations, set out exceptions, determine requirements, supplement definitions and draft policy statements to provide substantive answers to practical issues raised by market participants. Consequently, it is still early to fully assess the impact and consequences of this new legislation.
As a result of the Derivatives Act, consequential amendments will be made to the QSA (which currently governs certain parts of the new legislative framework), the AMF Act, the Consumer Protection Act, the Act respecting insurance and the Act respecting the transfer of securities and the establishment of security entitlements.
Ward Sellers is a partner in the firm's Business Law Department and Managing Partner of the Montréal Office. His practice is principally a transactional practice, covering many areas of corporate and securities law, with a particular emphasis on domestic and cross-border corporate finance, and on mergers and acquisitions. Josée Kouri is an associate in the Business Law Department of the firm's Montréal office. Her practice is mainly focused on mergers and acquisitions, corporate finance, securities and other general corporate matters. Mark DesLauriers is a partner in the firm's Toronto office where he practises in the area of corporate and securities law, with particular emphasis on cross-border corporate finance, public company law, and the regulation of securities dealers and advisers. Jacob Sadikman is an associate in the Business Law Department in the firm's Toronto office where he practises corporate and securities law, with an emphasis on corporate finance, the regulation of investment dealers and advisers and derivatives trading.
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