On June 11, 2008, new regulations entitled Principal Protected Notes Regulations (the "New Regulations") under the Bank Act (Canada) (the "Bank Act") regarding principal protected notes ("PPNs") were published which will become effective July 1st, 2008.

Background

PPNs are currently regulated by the Index-linked Deposits Interest Disclosure Regulations (the "Current Regulations") under the Bank Act. PPNs are characterized in most Canadian jurisdictions as "evidences of deposits" and, accordingly, are carved out from the definition of "securities" under the securities laws of those jurisdictions. In some jurisdictions where PPNs are considered "securities" under the securities laws of the province, they are exempt from prospectus and registration requirements. Consequently, the contents of PPN disclosure are not prescribed by securities regulation.

The Current Regulations provide for certain minimum disclosure requirements for PPNs. For instance, there is a requirement to provide a statement in "plain language" which includes information with respect to the way in which interest is to be determined, a description of the underlying index or reference point used in relation to the determination of interest, a description of any limitations in respect of the interest payable, the frequency of payments and other circumstances that may affect the payment of interest, and any rights of withdrawal prior to maturity.

The Canadian Securities Administrators (the "CSA") expressed concerns about PPNs in July 2006 in CSA Notice 46-303 (the "2006 Notice"). Specifically, the CSA were concerned that disclosure documents produced in respect of PPNs were too lengthy, complex and difficult to understand and did not provide sufficient disclosure (or sufficiently prominent disclosure) regarding fees and the ability or impact of selling a PPN prior to maturity. They were also concerned about registered firms' compliance with their "know-your-client" ("KYC") and "know-your-product" ("KYP") obligations when selling PPNs, the "retailization of alternative investment products" (i.e. the use of PPNs to enable unregistered entities to indirectly distribute non-prospectus qualified products to investors who are not "accredited investors") and compliance with securities laws regarding referral arrangements.

In March, 2007, the federal government indicated that it would develop new principles-based regulations for PPNs. Proposed regulations were published for comment in November 2007 following consultations with securities regulators, the Canadian Bankers Association, the Financial Consumer Agency of Canada, the Office of the Superintendent of Financial Institutions and the Canada Deposit Insurance Corporation ("CDIC"). The New Regulations reflect many of the comments submitted and, when they come into force on July 1, the Current Regulations will be repealed.

Impact Of New Regulations

Impact On Issuers Of PPNs

Scope: In the Current Regulations, the "index" referred to in the definition of "index-linked deposit contract" (the term used to describe PPNs) includes (i) the market price of a security, commodity or financial instrument, (ii) the exchange rate between two currencies, (iii) a rate determined by reference to such prices or rates, or (iv) any other kind of variable index or reference point prescribed by the by-laws of the CDIC. The definition of "principal protected note" in the New Regulations more broadly refers to any index or reference point. The change in the definition reflects the growth of the number and type of PPNs. Although the New Regulations significantly enhance the disclosure required of all products that meet the definition, they do not appear to prohibit links to any particular index and, accordingly, issuers can continue to link PPNs to alternative investment products.

Manner of Disclosure: The Current Regulations require "plain language" disclosure of certain terms of the PPN. Any disclosure required by the New Regulations must be made in language that is "clear, simple, and in a manner that is not misleading". This new approach is indicative of a shift from a more rules based regime to one that is more principles-based and, with the introduction of the "misleading" concept, starts shifting the disclosure standard closer to that required under securities legislation.

Disclosure Before Purchase of the PPN: Generally, at least two days before entering into an agreement to issue a PPN, the institution must provide the investor orally and in writing a synopsis of the following terms of the PPN:

  • the term of the PPN, and how and when the principal is to be repaid and the interest, if any, is to be paid;

  • any charges and their impact on the interest payable;

  • how interest is accrued, and any limitations in respect of the interest payable;

  • any risks associated with the PPN, including, if applicable, the risk that no interest may accrue;

  • the distinction between PPNs and fixed-rate investments with respect to the levels of risk and return;

  • the circumstances in which a PPN could be an appropriate investment;

  • if the PPN relates to a deposit that is not eligible for deposit insurance coverage by the CDIC, the fact that it is not eligible;

  • whether the PPN may be redeemed before its maturity and, if so, that redemption before maturity may result in the investor receiving less than the principal amount;

  • the terms and conditions of any secondary market offered by the institution;

  • whether the investor may cancel their purchase of the PPN and, if so, how the purchase may be cancelled;

  • whether the PPN provides that the institution may amend the PPN and, if so, in what circumstances;

  • whether the manner in which the PPN is structured or administered may place the institution in a conflict of interest;

  • any other information that could reasonably be expected to affect an investor's decision to purchase the PPN;

  • that full and complete disclosure of the foregoing information is available on the institution's website and will be provided in written format upon request; and

  • that current net asset value of the PPN and other information relating to interest payable under the PPN will be available upon request after the PPN is issued.

Although the New Regulations do not specify what is meant by a "synopsis", it is likely an abbreviated form of the disclosure typically contained in a PPN information statement. The specific items that must be included in the synopsis are comparable to, and in some respects exceed, the information that the Joint Forum of Financial Market Regulators have proposed be included in the "Fund Facts" point-of-sale disclosure document for mutual funds and segregated funds. For example, the requirements to include a description of different levels of risk and return between a PPN and a fixed-rate investment and to provide a discussion of the circumstances in which a PPN issuer can amend the terms go beyond the disclosure contemplated for the Fund Facts documents.

Additional Disclosure: The New Regulations also require issuers to post full and complete disclosure of the terms of the PPN on the institution's website and make such information available in written form upon request. In addition, upon request from an investor, the institution must disclose the net asset value of the PPN, how that value is related to the interest payable and the last available measure of the index or reference point on which the interest is determined and how that measure is related to the interest payable under the PPN.

The institution must also disclose certain information if the investor requests it prior to an early redemption or sale of a PPN prior to maturity. The information to be disclosed includes the value of the PPN (either on the day before the day that the investor requests the redemption or purchase, or based on the last available measure of the index or reference point on which interest is determined), any penalty or charge, the timing and manner of the valuation of the PPN and the fact that the value of the PPN when it is redeemed or sold may differ from the previously provided value. Finally, the disclosure required for advertisements has been expanded from the Current Regulations.

Impact On Distributors Of PPNs

In July 2007, the CSA published CSA Notice 46-304 (the "2007 Notice"), in which they indicated that approximately 88% of all issued and outstanding linked notes had been issued by banks, 42% of linked GICs had been issued by banks and trust companies and another 53.5% of linked GICs had been issued by caisses populaires and credit unions. In addition, the 2007 Notice indicated that approximately 70-80% of all PPNs were being distributed through investment dealers and a further 10% were being distributed through mutual fund dealers. Accordingly, while the CSA have limited authority to regulate issuers of PPNs and disclosure standards, they have significant authority to regulate those who sell them.

As indicated above, the CSA expressed concerns in the 2006 Notice about (a) disclosure and marketing materials, (b) KYC and suitability obligations, (c) "retailization" of alternative investment products and (d) referral arrangements.

Disclosure: The New Regulations' emphasis on disclosure, particularly risk and fees disclosure, and marketing materials appear to address the concerns the CSA expressed in the 2006 Notice regarding disclosure.

KYC and Suitability: In the 2007 Notice, the CSA indicated that the Investment Industry Regulatory Organization of Canada ("IIROC", formerly the Investment Dealers Association of Canada) takes the view that its members' KYC and suitability obligations extend to the sale of PPNs. The Mutual Fund Dealers Association of Canada (the "MFDA") takes a similar view as expressed in its Member Regulation Notice 48 – "Know-Your-Product", issued in December 2005, and Member Regulation Notice 69 – Suitability Guidelines, issued in April 2008, which contains a section that specifically addresses MFDA members' suitability obligations with respect to PPNs. To the extent that the New Regulations give more prominence to important information regarding PPNs in their synopses, they should help registered investment dealers and mutual fund dealers more easily satisfy their KYC, KYP and suitability obligations by making it easier to compare one PPN to another and to explain their features to clients.

Retailization: Since the New Regulations do not directly address the CSA's concerns about the "retailization" of alternative investment products, dealers should ensure that their KYC, KYP and suitability policies and procedures regarding PPNs specifically address PPNs that are linked to alternative investments.

Referral Arrangements: Similarly, since the New Regulations do not specifically address referral arrangements, dealers should ensure that their policies and procedures regarding the distribution of PPNs take into consideration their securities law obligations with respect to referral arrangements, particularly those regarding disclosure of the payment of referral fees.

The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.

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