LEGISLATIVE FRAMEWORK SPECIFICALLY FOR DERIVATIVES
On February 1, 2009, most of the provisions of the Québec Derivatives Act1 came into force by government decree. The Derivatives Regulation and three policy statements came into force on the same date.
This legislation results from a need identified by a group of specialists from the Autorité des marchés financiers (the "Authority") for modern legislation to provide oversight of the derivatives sector given the remarkable growth of derivatives transactions worldwide, an example of which is provided by the Montréal Exchange (a member of TMX Group), which is the Canadian national exchange for all derivatives trading and related products and the sole operator for trading of carbon and other emission credits in Canada.
PURPOSE AND SCOPE OF THE DERIVATIVES ACT
The purpose of the Act is to govern derivatives offering and trading and related activities. The definition of a derivative is broad and includes any contract or instrument designated by regulation and further provides for future derivatives products consisting of any contract or instrument that is equivalent to a derivative on the basis of criteria determined by regulation. A derivative, as defined in the Act, includes 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 on an underlying interest. A derivative is either over-the-counter or standardized. A standardized derivative means 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, such as the CDCC.2 An over-the-counter derivative means any derivative other than a standardized derivative. For example, an institutional financial contract, such as an interest rate swap, is an over-the-counter derivative that involves, for example, a financial institution, a dealer, an adviser or an accredited counterparty. The Act defines accredited counterparty to include several categories of persons whose resources, situation or knowledge are such that the legislator has seen fit to exempt their transactions from certain provisions of the Act.3 The Regulation prescribes the minimum asset thresholds of an accredited counterparty while the Policy Statement respecting Accredited Counterparties is intended to specify certain components of the definition of an accredited counterparty and to clarify how to determine whether certain counterparties qualify. In addition, the Act provides that a dealer or an adviser who trades derivatives for a discretionary account is considered to be acting on behalf of an accredited counterparty.
Finally, the Act also governs hybrid products, meaning an instrument, contract or security that combines elements of derivatives and securities. Examples of such products include principal protected and non-principal protected notes whose return at maturity is linked to a portfolio of securities, an index or a basket of indexes. The Act provides a test to determine whether the Securities Act or the Derivatives Act applies to a given hybrid product and the Policy Statement respecting Hybrid Products explains how to apply the test. A hybrid product will be subject to the Derivatives Act unless it can be shown that the product is predominantly a security.4 The Policy Statement respecting Hybrid Products sets out some examples taken from SEDAR of hybrid products that will continue to be governed by the Securities Act, given that they are predominantly securities, such as principal protected equity index-linked "booster" notes and interest coupons and notes without coupons based on debt securities of an issuer.
The Act specifies that it does not apply to warrants, subscription rights, investment contracts or insurance or annuity contracts issued by an insurer or to options or other non-traded derivatives whose value is derived from, referenced to or based on the value or market price of a security and which are granted as compensation or as payment for a good or service. Thus, it is clear that securities issued pursuant to an issuer's compensation plan, such as options, stock appreciation rights, phantom stocks and deferred share units are not subject to the Act.
The Act provides that in order to carry on derivatives activities in Québec a regulated entity must be recognized by the Authority as an exchange, a published market, a clearing house, an information processor or a self-regulatory organization.
As is already the case for exchanges, clearing houses and self-regulatory organizations, the recognized regulated entity must make operating rules to govern its activities and the activities of its members or of market participants. It must also, in its internal by-laws, include appropriate procedures for making and amending those rules. In establishing its rules, the entity must consider the costs to its members and to market participants that may result from application of the rules. A recognized regulated entity must comply with certain other principles, in particular concerning cooperation with the Authority, governance and control.
What is novel is the self-certification process for rules and products. The Act provides that the regulated entity must file a notice together with the supporting documents with the Authority confirming the adoption or amendment in accordance with the Regulation of the operating rules established by the regulated entity. Under the self-certification process, the proposed rule or rule amendment must be submitted for public consultation for not less than 30 days. However, new derivatives that have not been listed or cleared by the entity are not subject to public consultation, primarily to avoid placing the entity at a competitive disadvantage.
Since activities or transactions involving over-the-counter derivatives between accredited counterparties benefit from an exemption and derivatives offered by regulated entities will be self-certified by those entities, this leaves only derivatives distributed by persons other than regulated entities and that are traded by persons who do not benefit from an exemption. For these persons, the Act provides a derivatives qualification and authorization procedure.
The trading of derivatives does not require the filing or delivery of a prospectus. However, a person who creates or markets a derivative must be qualified by the Authority. The conditions respecting qualification will eventually be included in the Regulation. The coming into force of the provisions relating to the authorization of derivatives and the obligations of qualified persons has been deferred since, under the leadership of the Authority, the Canadian Securities Administrators have launched initiatives to harmonize implementation of the derivatives framework in Canada. To address this situation, the Authority has issued a blanket decision5 granting a qualification exemption for persons creating or marketing derivatives to the extent that they carry on business only in derivatives currently governed by the Securities Act6 and with accredited investors within the meaning of and in accordance with the conditions set out in Regulation 45-106 respecting Registration and Prospectus exemptions.
DERIVATIVES DEALERS AND ADVISERS
The Act provides registration conditions for derivatives dealers and advisers, but specifies that securities dealers and advisers who are duly registered under the Securities Act are deemed to be registered under the Act provided they carry on derivatives activities and comply with the principles set out in the Act. The coming into force of the registration requirements has been deferred to take into account the reform of Regulation 31-103 respecting Registration Requirements which is still under way. In the meantime, since only dealers who are currently registered will be able to carry on derivatives activities, the Authority has preserved the status quo by issuing its blanket decision granting a registration exemption to dealers and advisers, as well as to any physical person acting on their behalf7 on the same conditions as the exemption for persons creating or marketing derivatives, i.e, such dealers and advisers must limit their derivatives activities to derivatives currently governed by the Securities Act and dealings with accredited investors within the meaning of Regulation 45-106 respecting Registration and Prospectus exemptions.
The Government of Québec has implemented a regulatory framework for derivatives that is unique in Canada and distinct from the regulatory framework for securities. The approach is broadly based on core principles that will permit adjustments to keep pace with market changes in this sector. Great efforts were made in drafting these regulatory materials to ensure compatibility inter alia with all relevant standards of the International Organization of Securities Commissions and the Bank for International Settlements.
1. S.Q. 2008, c.24).
2. The Canadian Derivatives Clearing Corporation (the "CDCC") is the issuer, clearing house, and guarantor of exchange-traded equity, index, and interest rate derivative contracts traded on the Montréal Exchange.
3. These categories include governments, public bodies, municipalities, financial institutions, securities dealers and advisers as well as their registered representatives, regulated pension funds, certain investment funds, registered charities that use the services of a securities adviser, entities held by accredited investors within the meaning of the Securities Act (or within the meaning of the definition provided in section 1.1 of Regulation 45-106 respecting Registration and Prospectus Exemptions), hedgers (a person who, because of the person's 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 the underlying interest directly associated with that risk or a related underlying interest), persons designated as such by the Autorité des marchés financiers and persons who have the requisite knowledge and experience to evaluate the proposed derivatives and who have net financial assets worth more than $10,000,000 in the case of entities and more than $5,000,000 in the case of individuals and who have sufficient assets to fulfill their obligations under the terms of their derivatives.
4. The conditions to consider include i) payment of the purchase price on delivery of the product, but the price may be paid in several payments, ii) the absence of an obligation to make any additional payment whatsoever during the life of the hybrid product or at maturity (the purchase of a security does not entail any payment other than the purchase price, whereas derivatives are subject to margin calls) and iii) the terms of the hybrid product do not include margin requirements based on the market value of its underlying interest.
5. Decision No. 2009-PDG-0007.
6. An option or a negotiable futures contract pertaining to securities, or a Treasury bond futures contract; an option on a commodity futures contract or financial instrument futures contract; and a commodity futures contract, a financial futures contract, a currency futures contract and a stock index futures contract.
7. These persons have currently received a registration exemption pursuant to section 2.3(1) of Regulation 45-106 respecting Registration and Prospectus Exemptions, provided their activities are limited to accredited investors. The purpose of this document is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of Ogilvy Renault LLP or any member of the firm on the points of law discussed.
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