Canada: The Business Conduct Rule In Canada's Over-the-Counter Derivatives Market: Principles And Framework

On September 28, 2023, the regulatory authorities of the Canadian Securities Administrators ("CSA") announced the adoption of Multilateral Instrument 93-101 Derivatives: Business Conduct (the "MI") and the Companion Policy 93-101 Derivatives: Business Conduct (the "CP", and together with the MI, the "Instrument"), slated to come into effect on September 28, 2024.¹

The Instrument sets out a "comprehensive regime for regulating the business conduct of dealers and advisers" in the over-the-counter ("OTC") derivatives market, meeting the international standards of the International Organization of Securities Commissions.² OTC dealers and advisors will be subject to a new regulatory framework imposing requirements on conflicts of interest, fair dealing, reporting non-compliance and recordkeeping. The Instrument is intended to protect OTC derivative market participants from unfair, improper and/or fraudulent practices to promote increased confidence in Canadian financial markets.³

CSA staff intends to turn the MI into a National Instrument upon the adoption by the British Columbia Securities Commission of substantially similar rules at a later date.⁴

The following is a summary of the framework established by the Instrument:

APPLICATION OF THE INSTRUMENT TO DERIVATIVE ADVISORS AND DERIVATIVE DEALERS

The Instrument applies to a person or company meeting the definition of "derivatives adviser" or "derivatives dealer", applying to a person or company engaging in or holding themselves out as engaging in the business of advising others or trading as principal or agent in respect of derivatives, regardless of whether they are registered or exempt from being registered as a derivatives advisor or dealer in the applicable jurisdiction.⁵ A business trigger test is employed to decide if the person or company is in the business of advising or trading in OTC derivatives.

In Québec, companies or persons falling within the defined term of "advisor" or "dealer" under the Derivatives Act (Québec) are captured by the Instrument.

DERIVATIVE ADVISORS AND DEALERS ARE REGULATED USING A PRINCIPALS-BASED APPROACH

The Instrument sets out obligations that apply to derivative advisors and dealers using a principles-based approach. Many of the requirements are comparable to those applicable to registered dealers and advisors pursuant to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations ("NI 31-103"). Those in the Instrument have been revised to reflect the distinct operation of the derivatives markets.

Among other requirements, the following are key obligations that derivative parties must comply with:

• Fair dealing: derivatives firms and individuals acting on behalf of a derivatives firm must "act fairly, honestly and in good faith with a derivative party"⁶;
• Conflicts of interest: derivatives firms must "establish, maintain and apply reasonable policies and procedures to identify all material conflicts of interests" and respond to any conflicts of interests discovered⁷;
• Know your derivatives party ('KYDP'): other than a registered firm or a Canadian financial institution, derivatives firms must develop reasonable policies to appropriately verify the derivative party's identity, make reasonable inquires as to the reputation of the derivatives party, determine whether the derivatives party is an insider of a reporting issuer or if they would "reasonably be expected to have access to material non-public information related to any interest underlying the derivative" and establish the creditworthiness of a derivatives party. Additional requirements exist for establishing the identity of a derivatives party that is a trust, partnership or corporation⁸;
• Handling complaints: derivatives firms must document all complaints made about any "product or service offered by the derivatives" advisor or dealer, and must respond to each complaint promptly in a manner a "reasonable person would consider fair and effective"⁹;
• Tied selling: derivatives firms or individuals acting on the firm's behalf are prohibited from coercing a person or company to obtain derivatives-related products or services from a particular person or company (which includes the derivatives firm or an affiliate thereof)¹⁰;

If the derivatives firm is in business with a (i) non-eligible derivatives party or (ii) an individual or an eligible derivatives party that is either an individual or commercial hedger that has not waived the protections, additional obligations will be required:

• Suitability: derivatives firms must take reasonable steps to ensure the derivative and the transaction are suitable for the derivative party prior to making any recommendations to or transacting in a derivative¹¹;
• Permitted referrals: unless a set of exceptions apply, a derivatives firm and any individual acting on behalf of it is prohibited from participating in a referral arrangement in respect of a derivative with another person or company.¹²

Depending on the circumstances, other obligations can include additional relationship disclosure information¹³, pre-transaction disclosure¹⁴, valuation reporting¹⁵, and notice to derivatives parties by non-resident derivatives dealers.¹⁶

RECORD RETENTION REQUIREMENTS

Record retention requirements under the Instrument are more aligned with the timeframe in NI 31-103. Before transacting in a derivative, a derivatives firm must enter into a derivatives party agreement with the derivatives party that sets out the relationship between the derivatives firm and party.¹⁷ It must keep records of its derivative transactions and advising activities in accordance with the guidelines set out in the Instrument.¹⁸ With the exception of Manitoba, all records must be kept seven years from the date the record is created.¹⁹ In Manitoba, the record is kept for eight years.²⁰

Footnotes

1. Multilateral Instrument 93-101 Derivatives: Business Conduct.

2. https://www.securities-administrators.ca/news/canadian-securities-regulators-adopt-business-conduct-rule-for-derivatives-dealers-and-advisers/.

3. Ibid.

4. Supra, note 2.

5. Supra note 1, Section 1(1).

6. Ibid, Section 9.

7. Ibid, Section 10.

8. Ibid, Section 11.

9. Ibid, Section 12.

10. Ibid, Section 13.

11. Ibid, Section 15.

12. Ibid, Section 16.

13. Ibid, Section 19.

14. Ibid, Section 20.

15. Ibid, Section 21.

16. Ibid, Section 22.

17. Ibid, Section 34.

18. Ibid, Section 35

19. Ibid, Section 36.

20. Ibid.