Canadian Structured Finance Law

SE at ASF 2012

Stikeman Elliott LLP — Thu, 02 Feb 2012 11:46:29 -0500

The American Securitization Forum returned to its old haunt in Las Vegas this year for the first time since 2009. With north of 4,500 delegates in attendance, it was hardly an intimate gathering but the facilities at the ARIA City Centre were first class and there was certainly ample opportunity for participants to re-connect with their industry colleagues. The mood of the conference was similar to last year’s conference in Orlando which I would describe as “cautiously optimistic”. While there are encouraging signs in some sectors (in particular in the auto space), it would be difficult to conclude that the industry at large is close to regaining its old form.

So what did I take out of this year’s conference? Here are a few of my observations:

Auto ABS in the US market appears to be alive and functioning quite well
RMBS continues to be dormant while CMBS has a very faint pulse (the RMBS market is hampered in part by the uncertainty surrounding GSE reform and what the future holds for Fannie Mae and Freddie Mac)
The regulatory reforms that have been put into effect (including mandated issuer review of assets and reporting on issuer representations and buyback history) don’t appear to be having any material adverse impact on the level of issuance activity
There remains concern over pending regulatory reform including in particular the proposed rules on risk retention and whether the next phase will be the publication of final rules or a re-proposal of revised draft rules; many observers are hoping for the latter and an asset class-specific approach (as opposed to a one size fits all solution across all asset classes)
The proposed Volcker rule could have unintended consequences when it comes to the trading of securitized products; in particular it may limit the ability of banks to provide liquidity or other support to their bank-sponsored ABCP conduits; it could also have an adverse effect on the ability of banks to hold or make a market in ABS – there is a push from market participants to exempt ABS transactions from the Volcker rule entirely
The Eurozone debt crisis may actually be a positive for the European securitization market as investors flock to securitization as opposed to senior unsecured debt
There is little harmony between the regulatory reform approach taken by regulators in the U.S. and Europe which is leading to a rising level of frustration for global players with a presence in both markets

Stay tuned for further developments on these issues and future developments affecting the Canadian ABS market.

Quebec adopts material housekeeping amendments to derivatives legislation

Stikeman Elliott LLP — Fri, 13 Jan 2012 14:56:26 -0500

Alix d’Anglejan-Chatillon

On November 30, 2011, the Quebec Government passed omnibus amendments to financial services legislation under Bill 7, An Act to amend various legislative provisions mainly concerning the financial sector. Bill 7 amends various Quebec statutes regulating the provision of financial services across a broad range of areas such as whistleblower immunity, electronic communications with regulatory authorities, the receivership process for regulated firms, insider trading rules, fraudulent trading and the disclosure of false information to the Autorité des marchés financiers (AMF), Quebec’s financial services regulator.

Bill 7 also includes various housekeeping amendments to the Derivatives Act (Quebec) (QDA), as well as the following:

Incorporating contracts for difference in the definition of a “derivative” regulated under the QDA.
Additional requirements (not yet in force) governing the initial and ongoing business conduct of “qualified persons” as described in our other post dated today.
Amendments in respect of the use of set-off related to cash posted as credit support, as more fully described in our blog post of November 18, 2011.
Provisions governing the regulation of “trade repositories” as “regulated entities” subject to recognition by the AMF, consistent with the high level recommendations of the Canadian Securities Administrators in their CSA Consultation Paper 91-402 Derivatives: Trade Repositories.
Changes to the exemption for over-the-counter (OTC) derivatives transactions. While activities or transactions in OTC derivatives involving “accredited counterparties” only will continue to be exempted from the derivatives registration and qualification requirements under the QDA, those transactions are no longer generally exempt from the application of various market supervision, enforcement and other procedural remedies available to the AMF and the Québec Bureau de décision et de révision.
Specifying that a derivative cannot be invalidated for the sole reason that a counterparty is not an “accredited counterparty” or the derivative “otherwise departs from the Act”, unless the cause of the invalidity is set out in the terms of the derivative.
Additional provisions governing the ability of the AMF to inspect market participants or compel the production of documents.
Provisions governing liability for misrepresentation “about the offering or trading of a derivative”.

AMF tables proposed rules on the derivatives qualification requirement in Quebec

Stikeman Elliott LLP — Fri, 13 Jan 2012 12:40:29 -0500

Alix d’Anglejan-Chatillon

On December 16, 2011, Quebec’s financial services regulator, the Autorité des marchés financiers (AMF), tabled proposed amendments to the Derivatives Regulation (Quebec) (QDA) which are intended to implement the provisions of the Derivatives Act (Quebec) governing “qualified persons” (the Proposals) In addition to the derivatives dealer and adviser registration requirements applicable to dealers and advisers in derivatives (the “derivatives registration requirement”), the QDA requires that a person, other than a regulated entity¹ who “creates or markets a derivative” must be qualified by the AMF, as prescribed by regulation, before the derivative is offered to the public (the "qualification requirement"). Under an amendment not yet in force, the qualified person must also have the marketing of the derivative authorized by the AMF, as prescribed by regulation (the “authorization requirement”).

As outlined below, the Proposals would, among other changes, significantly increase the disclosure, compliance and reporting requirements applicable to Canadian and foreign intermediaries offering listed derivatives products in the Quebec market to any person, or OTC derivatives to persons other than “accredited counterparties”, unless a discretionary exemption can be obtained. The Proposals are published for a period of 30 days after which the AMF may submit the Proposals to the Minister of Finance for approval, with or without amendments. The AMF is accepting written comments on the Proposals until February 1, 2012.

Market participants conducting derivatives-related activities in the Quebec market should carefully review their product lines, and seek detailed advice as to whether the new qualification/authorization requirements will impact this business and what actions should be taken in contemplation of these new rules.

Impact of the Proposals

The Proposals are significant for several reasons.

First, the Proposals, if adopted, would round out the basic framework governing the regulation of both OTC and standardized derivatives first introduced in Quebec in 2009. They follow on the enactment of more detailed amendments to the “qualified persons” provisions of the QDA effective November 30, 2011, as described in our other post dated today.

Second, the Proposals represent an innovative means of regulating the offering of derivatives to persons other than eligible counterparties outside of the conventional prospectus-based framework of securities regulation which has generally been employed by regulators in other Canadian jurisdictions to regulate trades in all or certain categories of derivatives. The basic mechanics of this new qualification requirement are outlined below.

Third, and more importantly, upon the adoption of these rules, material transitional relief issued by the AMF in conjunction with the implementation of the QDA would lapse.² The effect of this change is that:

OTC derivative transactions involving eligible “accredited counterparties” in Quebec would continue to be exempt from the derivatives registration and the qualification/authorization requirements.
Market participants offering OTC derivatives to Quebec-resident persons other than qualified “accredited counterparties” would now be subject to the derivatives registration and the qualification/authorization requirements.
Market participants offering standardized (listed) derivatives to any Quebec-resident person (including to “accredited counterparties”) could no longer rely on blanket and other transitional or discretionary relief previously issued by the AMF. These market participants would have to apply to the AMF for qualification/authorization within 30 days of the coming into force of the new rules and, as the case may be, comply with the derivatives registration requirement (unless an exemption is available)³, or obtain separate discretionary relief from the AMF.

The Proposals do not specify how much time, if any, will be given to the market to transition to the new “qualified persons” regime. The QDA came into force in 2009 with a six-month transition period. It is to be hoped that, in this period of intense regulatory change (particularly in the major derivatives markets outside Canada), the final rules will include a transition period at least that long.

Key Features of the Qualification Process

As noted above, the Proposals build on recent amendments to the QDA made under Bill 7, An Act to amend various legislative provisions mainly concerning the financial sector which further flesh out the cornerstones of the qualification/authorization requirements (the “qualified persons amendments”).

The qualified persons amendments, once in force, would introduce general provisions governing the initial and ongoing business conduct of “qualified persons”, including requirements that a qualified person have an effective corporate and organizational structure with adequate personnel, financial and technological resources and appropriate business policies and procedures and governance practices; that it take the necessary measures to ensure the security and reliability of its transactions and activities; that it offer derivatives to the public through a registered dealer or register as a dealer; that it comply with initial and periodic reporting requirements; and that it comply with safekeeping and segregation requirements.

The Proposals would further provide that:

A qualified person must participate in a contingency fund that protects the assets entrusted to it by its counterparties, or comply with minimum working capital requirements as calculated on Form 31-103F1 Calculation of Excess Working Capital⁴ or under the Joint Regulatory Financial Questionnaire and Report of the Investment Industry Regulatory Organization of Canada (IIROC). The minimum required capital would be C$20 million plus 5% of amounts due to counterparties to a derivative that a qualified person is marketing which exceed C$10 million.
A qualified person must maintain proper books and records to ensure efficient operations and demonstrate compliance with the QDA.
A qualified person must have an emergency and contingency plan in place to ensure business continuity.
An applicant for qualification must provide documents in support of its compliance with specified requirements of the qualified persons amendments, a completed Schedule B Application for Qualification (including background organizational, business and regulatory compliance information on the applicant, and information on distribution methods, client disclosure, electronic systems and operations and audited financial information). The Schedule B application must be accompanied by a completed Form 33-109F4 Registration of Individuals and Review of Permitted Individuals for each of its “permitted individuals”(e.g., directors, the chief executive officer, the chief financial officer, the chief operating officer and individuals having beneficial ownership of, or direct or indirect control or direction over, 10% of the voting securities of the applicant) unless the Form 33-109F4 information is already on file with the AMF (e.g., as in the case of applicants which are already Quebec-registered firms).
An applicant for authorization must provide a completed Schedule C Application for Authorization to Market a Derivative, including a detailed description of the derivative, and associated trading methods, prospective clients, risks and costs and fees. The AMF must make any objection to an application for authorization within 21 days after submission of the application.
Designated information set out in the Schedule B and Schedule C applications must be included in the risk information document that a derivatives dealer must provide to its clients before the first trade in a derivative.
A qualified person must notify the AMF “without delay” if its excess working capital or risk adjusted capital calculated as described above is less than zero or in the case of “any failure, malfunction or material delay of [its] systems or equipment”.⁵
A qualified person must notify the AMF of any material change to the information provided in its applications for qualification or authorization, within 7 days of the change. The rules provide definitions of what constitutes a “material change” in respect of a qualified person or a derivative. Other changes to such information would have to be notified within 30 days following the end of the quarter in which the change occurred.
A qualified person must also notify both the AMF and “the counterparties to a derivative that [it is] marketing, including counterparties waiting to trade such a derivative” of “any change that could affect the trading of such a derivative or the transactions under way in respect of such a derivative at least 10 days prior to the change”. This 10-day prior notice requirement raises a number of conceptual and practical issues, including the absence of any materiality threshold, the absence of any guidance as to the type of change that would trigger the notice requirement and the issue of changes that may arise over which a qualified person has no reasonable ability to give a 10-day prior notice, particularly in the case of a qualified person that is part of a global financial services group and in a dynamic financial markets environment. Hopefully, this requirement will be modified or further clarified through additional guidance.
A qualified person must, within 90 days after the end of its financial year provide to the AMF:
1. audited financial statements prepared in accordance with Canadian GAAP applicable to publicly accountable enterprises (there would appear to be no provision for the delivery of financial statements prepared in accordance with IFRS, U.S. GAAP or other accounting principles as contemplated in Regulation 52-107 respecting Accounting Principles and Auditing Standards), an adjustment to the Proposals which should be contemplated given the number of foreign stakeholders potentially affected by these rules;
2. the number of contracts entered into in Quebec and their notional value for all derivatives offered to the public during the latest fiscal year; and
3. the percentage of contracts, for each of the latest four quarters, that were profitable for counterparties.

Interested stakeholders should consider submitting comments on these proposals by February 1, 2012.

¹ The term “regulated entity” includes exchanges, alternative trading systems, clearing houses, trade repositories and self-regulatory organizations that are subject to the requirement to be recognized by the AMF.

² In connection with the adoption of the QDA on February 1, 2009, the AMF issued a discretionary blanket decision on January 22, 2009 (the “AMF Blanket Decision”) by way of broad transitional relief (AMF decision No. 2009-PDG-0007 (January 22, 2009), as supplemented and extended by AMF notices of October 2, 2009 and September 24 2010). The AMF Blanket Decision sets out a temporary exemption from the derivatives registration requirement and the derivatives qualification requirement for specified derivatives activities carried out solely with “accredited investors” as defined under Regulation 45-106 respecting Prospectus and Registration Exemptions (45-106).

³ The Derivatives Regulation (Québec) (the “QDR”) provides an exemption (the “standardized derivatives exemption”) from the derivatives registration requirement under the QDA for a person authorized to act as a dealer or an adviser or authorized to exercise similar functions under legislation applicable in a jurisdiction outside Quebec where its head office or principal place of business is located to the extent it carries on business solely for an “accredited counterparty” and its activity involves a standardized derivative that is offered primarily outside Quebec. The standardized derivatives exemption does not, however, provide an exemption from the derivatives qualification or authorization requirements.

⁴ Regulation 31-103 respecting Registration Requirements, Exemptions and Ongoing Registrant Obligations.

⁵ The term “material” would appear to qualify the terms “failure”, “malfunction” or “delay” in the governing French language version. We would hope that this technical translation error will be rectified in the final provision.

Draft cash collateral proposal for Ontario PPSA and background paper

Stikeman Elliott LLP — Wed, 04 Jan 2012 13:52:52 -0500

Margaret Grottenthaler -

The cash collateral working group drafting subcommittee of the Ontario Personal Property Security Law Sub-Committee of the Ontario Bar Association’s Business Law Section has prepared a draft proposal to amend Ontario personal property security law to deal more effectively with cash collateral. Over the past year the working group circulated a number of draft proposals and this final proposal reflects input from many committee members and others. The proposal is to be considered by the PPSL Committee later this month and if approved (which hopefully it will be) will serve as the basis for a formal submission of the Business Law Section of the OBA to the Ontario Ministry of Consumer Services (with a copy to the Ministry of Finance) early in this year. If the proposal is acceptable to the government, it is hoped that it could be put before the legislature shortly thereafter. Comments on the draft proposal are welcome. For more information, see the background paper on the proposals.

Quebec cash collateral update

Stikeman Elliott LLP — Fri, 09 Dec 2011 14:35:31 -0500

Sterling Dietze -

The Quebec National Assembly passed, on November 30, 2011, an Act to amend various legislative provisions mainly concerning the financial sector. As part of that Act, amendments were made to the Derivatives Act (Quebec) in respect of the use of set-off related to cash posted as credit support. We discussed the proposed amendments in a prior post. The provisions are now in force.

CSA release consultation paper on surveillance of OTC derivatives, market conduct rules and enforcement powers

Stikeman Elliott LLP — Mon, 28 Nov 2011 14:35:56 -0500

The Canadian Securities Administrators released a consultation paper last week addressing the regulation of OTC derivatives markets. Specifically, the paper makes various recommendations regarding surveillance and monitoring, market conduct and enforcement that are intended to strengthen financial markets and manage specific risks related to OTC derivatives. The paper is one of a series of eight papers building on the high-level proposals found in Consultation Paper 91-401 released in November 2010.

Surveillance and Monitoring

Citing the limited market information currently available to regulators relating to the trading of OTC derivatives, the paper recommends that further study and research be undertaken on the development of a comprehensive surveillance system for monitoring OTC derivatives markets to supplement current market surveillance. According to the report, a comprehensive approach to surveillance and monitoring would include enabling regulator access to trading data and monitoring participant positions.

Market Conduct Rules

To address the perceived lack of consistency in market conduct rules applicable to OTC derivatives across Canadian jurisdictions, the CSA recommend extending certain regulations pertaining to securities markets to OTC derivatives markets. Such regulations would include record keeping and audit trail requirements and prohibitions to prevent market manipulation and fraud, misrepresentations and insider trading.

Enforcement

According to the CSA, compliance, investigation and enforcement powers currently found in securities legislation should also be extended to cover trading in OTC derivatives.

Comments on the proposals are being accepted until January 25, 2012. For more information, see CSA Consultation Paper 91-403 Derivatives: Surveillance and Enforcement.

Regulatory overkill, Canadian style

Stikeman Elliott LLP — Fri, 25 Nov 2011 14:33:01 -0500

Michael Rumball -

Last week, I highlighted regulatory overkill in the U.S. where, together, Congress and the SEC have proposed scorched earth solutions to the issues raised by the financial crisis. Whereas the CSA commendably declined to imitate most of the more extreme U.S. initiatives, they seem to have gone off the rails somewhat in their approach to the exempt market. As was the case south of the border, the Canadian regulators have, in approaching a problem which could have been adequately addressed by a limited and targeted approach, instead mounted a multi-pronged attack. First, they proposed the removal of the existing prospectus exemptions for distributions of securitized products and the introduction of a new securitized product exemption which, although similar to the accredited investor exemption, is intended to exclude retail investors. Second, they would require that issuers deliver an information memorandum to investors which discloses “sufficient information about the securitized product and securitized product transaction to enable a prospectus purchaser to make an informed investment decision”. Finally, they proposed a certification requirement as to no misrepresentation for issuers and underwriters.

Certain commentators on these proposals strongly objected to the CSA’s “product-centered” approach, maintaining that traditional ABS products (as opposed to higher risk securitization products such as synthetic products and products created under an originate-to-distribute model) are not substantially different from, or have significantly different risk profiles than, other forms of complex debt financing and, accordingly, should not be treated any differently. It appears that the CSA may have taken cognizance of this complaint although their response may trend in the direction opposite from that which commentators may have hoped.

On November 10, 2011, the CSA issued Staff Consultation Note 45-401 in which they announced that they are undertaking a review of the minimum amount (MA) and accredited investor (AI) exemptions (together the “Private Placement Exemptions”). The reason for the review is perhaps revealing: “the global financial crisis and recent regulatory developments have raised questions about the use of [the Private Placement Exemptions].”

In the Consultation Note, the CSA maintains that the Private Placement Exemptions “have been premised on the investor having one or more of:

A certain level of sophistication,
The ability to withstand financial loss,
The financial resources to obtain expert advice, and
The incentive to carefully evaluate the investment given its size.”

I would enlarge on the foregoing by incorporating the view of the American Securitization Forum (ASF) in their comment letter on the securitized products proposal and apply it to complex exempt products in general: “Complex … products offered without all of the protections of the prospectus-delivery regime should be limited to investors who have the knowledge and experience to evaluate the securities they are considering for purchase and the ability to ascertain what disclosure, reports and other contractual features they require in connection with a prospective purchase”.

For convenience, the CSA premises and the ASF enlargement are together referred to below as investor sophistication. A completely reliable determination of investor sophistication is inherently a factual exercise which should be conducted on a case-by-case basis. In order for capital markets to function efficiently, however, tests of general application have been devised including the eligible securitized product investor test and the Private Placement Exemptions. As alluded to in the Consultation Note, the regulatory trick is to find a balance between a test which is so lax that it will allow unsophisticated, retail investors to participate in the exempt market and one that is so severe that it will close the market to investors who do not need the protections provided by a prospectus offering, thereby adversely affecting the raising of capital, especially by small and medium sized enterprises.

It is also undoubtedly true that investor sophistication is a somewhat relative concept which may vary in relation to the complexity of the investment. A given investor may be considered sophisticated when assessing of a vanilla corporate debt investment but a complex transaction of one sort of another may be beyond his level of sophistication. (Thus the ASF has proposed the concept of “qualified institutional buyer of structured finance products” to the SEC, which could be adapted to other complex products, and under which an investor would have to satisfy a quantitative test as to structured finance products under management as well as certain qualification standards relating to such investor’s knowledge and experience in the purchase and surveillance of structured finance products.) That the CSA recognize that this has implications beyond securitized products is implied in the Consultation Note where the CSA state that “the size of investment alone does not assure investor sophistication or access to information, particularly where the minimum amount is used to sell novel or complex products without any accompanying disclosure. At most, the size of the investment is an indicator only of the investor’s ability to withstand financial loss.”

The determination of the appropriate thresholds to be utilized in the various exemptions and which exemptions are appropriate in respect of which products will be the subject of much debate between the CSA and market participants and, while of crucial importance to the continued functioning of the exempt market, is not the subject-matter of this piece. My point here is a relatively simple, even fundamental, one; once an acceptable test for investor sophistication has been established, whatever the details may be, the one conclusion that necessarily follows is that there can be no public policy argument for requiring the delivery of disclosure to the investor; in other words, to find that the investor is sufficiently sophisticated is ipso facto to find that he is sufficiently knowledgeable and powerful enough to demand, obtain and understand all of the information necessary to allow him to exercise a prudent investment decision without the necessity of regulatory intervention or oversight. It is in superimposing a disclosure requirement (not to mention the certification requirement) on top of revising the exemption in order to better assure investor sophistication that the CSA are guilty of regulatory overkill in the case of the proposed securitized product rules. They are in essence saying that, although an investor may be sufficiently sophisticated to purchase without imposing disclosure, we are going to impose it anyway. But surely this is ultimately to entirely collapse the distinction between the private and the public markets and an attack on the basic right of contract which, in the absence of cogent public policy reasons to the contrary, should be unimpeded by regulatory intervention. It is of particular interest that the Consultation Note does not explicitly include any such requirements in the context of the Private Placement Exemptions (although there are various seemingly innocuous references to the relevance of disclosure which interested stakeholders should not let pass without comment).

It will be interesting to see how the CSA integrates their approach to exempt products in general with their approach to securitized products. That they will take cognizance of the latter is specifically acknowledged in the Consultation Note where they indicate that they will be considering the comments received in response to the securitized product proposals as part of their general review of the Private Placement Exemptions. “We believe it is important that our assessment of those exemptions be informed by the CSA’s proposals concerning securitized products and the comments of stakeholders with respect to those proposals”. It may be overly optimistic to hope that, in issuing Staff Consultation Note 45‑401, the CSA may in fact be signalling a shift in direction away from the previous product-centered approach towards an approach of more general application. If so, it will be difficult for the CSA to justify a differentiated application of the exemptions between securitized products and other complex products. Indeed, logically, it almost seems inevitable that the true differentiation should be between vanilla products on the one hand and complex products of any sort on the other and the real challenge may well be in devising a workable definition of ‘complex’.

Is cash collateral king again in Quebec?

Stikeman Elliott LLP — Fri, 18 Nov 2011 15:44:52 -0500

Sterling H. Dietze -

It is currently a challenge in Canada for Canadian entities in the derivatives, securities lending and repurchase space to offer a first priority security interest on cash to their counterparties. The Quebec government recently introduced an amendment to the Derivatives Act (Quebec) (the QDA) that, if passed as tabled, will restore confidence in the use of absolute transfer of cash and the related use of contractual set-off or compensation when dealing with cash as credit support for these types of transactions from Quebec counterparties. The amendments also specifically address cash collateral provided to a derivatives clearing agency by its members. We give some background to this issue and then outline the application of the proposed rule.

Background

Cash as credit support for obligations of counterparties to derivatives, securities lending and repurchase transactions has become more and more prevalent over the past numbers of years. ISDA has reported that 80% of collateral for derivatives contracts is in the form of cash. The use of cash collateral will increase in importance as more and more derivatives transactions are cleared by central counterparties.

In the US and many EU countries, a first priority security interest over cash in a deposit account may be obtained by control in a manner very similar to control under Canadian securities transfer legislation or by effective set-off arrangements. The same is not the case in Canada. If a secured party is granted a security interest in cash, the traditional view is that valid security under the laws of the jurisdiction of the grantor's location needs to be obtained, the security needs to be perfected by registration, a search of the relevant register needs to be undertaken and estoppels, subordinations or waivers from competing or prior ranking creditors need to be obtained. This may be a costly and time-consuming exercise and ultimately may not be successful.

As an alternative to such security, until recently, it was the practice to transfer cash absolutely (not by way of a security interest) and create a debtor creditor relationship and express right of set-off. This is indeed how many cash collateral arrangements are put in place generally, not only in the financial products market. If the cash provider defaulted, the creditor could set-off (or under Quebec law, compensate) its obligation to repay the cash against the debt (eg. the net termination amount). The effectiveness of this arrangement relied on the enforceability of contractual rights of set-off or compensation and not the creation of a first priority security interest in cash. Set-off or compensation were understood to operate outside of the general rules about the perfection and ranking or priority of security interests.The majority decision of the Supreme Court of Canada in Caisse Populaire Desjardins de l'Est de Drummond v. Canada, a federal income tax case out of Quebec, casts doubt on the effectiveness of this approach. The Supreme Court characterized the lender's contractual right to set-off or compensate a debtor's obligation to repay a loan against the lender's own liability under the term deposit that the debtor was required to maintain with the institution as the enforcement of a "security interest" in the term deposit for purposes of income tax legislation. The Court held that the Federal Government's claim in respect of employment insurance and Canada pension plan premiums ranked ahead of the lender under the Income Tax Act (Canada) provisions that confer priority on the government over other "security interests". One of the major challenges with the application of this case is that the definition of security interest in the Income Tax Act is not materially different from that under the provincial common law personal property security acts. The application under Quebec law is less clear given the very different regime applicable to security.

The challenges with cash collateral in Canada are now front and center given the G-20 undertaking to move to central clearing of standardized derivatives and the new Basel capital rules that will incent collateralization of uncleared swaps as well. The Federal Finance Minister has formally communicated with the provincial Ministers of Justice and Finance outlining the challenges in respect of cash collateral and encouraging provincial legislative modifications to address this issue. The letter addressed to the Quebec Minister of Justice was tabled with the Committee on Public Finance of the Quebec National Assembly by the Quebec Minister for Finance on November 10, 2011.

Quebec's Response

On November 10, 2011, the Quebec Minister for Finance introduced an amendment to a bill currently being studied by the Committee on Public Finance of the Quebec National Assembly. If enacted, an amendment would be made to the QDA in order to address cash credit support by way of contractual set-off or compensation associated with derivative contracts, foreign exchange contracts, securities lending and repurchase contracts (as well as master agreements related thereto) and contracts between a clearing agency and one of its members and the applicable rules of the clearing agency. We note that the QDA requires that "clearing houses" and other categories of "regulated entities" be recognized by the Autorité des marchés financiers (Quebec's financial services regulator) in order to carry on derivatives activities in Quebec.

What Will the New Provision Accomplish?

We believe that, once the provision is adopted and in full force, it will restore confidence in the use of an absolute transfer of cash, creation of a debtor-creditor relationship and the related use of contractual set-off or compensation when dealing with cash as credit support from Quebec counterparties with respect to derivatives, securities lending and repurchase transactions.

Some of our observations on the proposed amendment are as follows:

The person posting the cash may be the counterparty or any other credit support provider.
The type of transactions covered are derivative transactions (as defined under the QDA), foreign exchange contracts, securities lending contracts, securities repurchase contracts and all master agreements in respect of these. Contracts between a derivatives clearing agency and one of its members as well as the rules governing such relationship are also covered.
The rule covers an arrangement of contractual set-off or compensation in respect of cash. Certain standard forms of credit support documents will therefore need to be modified in order to take this into consideration in order to establish an enforceable and perfected credit support arrangement over cash.
The governing law in respect of the validity of such contractual set-off or compensation will be the law chosen by the parties or the law that may be inferred with certainty from the terms of the agreement.

The provision does not purport to characterize whether a particular contractual set-off or compensation arrangement constitutes a security interest but rather indicates that such an arrangement in respect of cash is enforceable against third parties without any further formality. This means that no registration is necessary in order to make such arrangement enforceable against third parties; eliminating any perceived need to register in order "to perfect" this arrangement.

One of the potential issues in fixing this issue for financial product obligations only is that it might lead to an inference that these types of transfer and set-off arrangements in the context of other types of transactions (such as loans) do require perfection by registration. Hopefully such an inference will not be drawn given that the purpose of the amendment is really to achieve clarity in the context of the types of transactions for which cash credit support is particularly important and provided in substantial volumes on a daily basis. In our view, the proposed amendment only reflects the appropriate interpretation of the law in this area regardless of the type of obligation secured.

The provision does not set out a rule in respect of priority. The general rules applicable to contractual set-off or compensation, as interpreted by the courts, will therefore apply. In Quebec, a contractual set-off or compensation arrangement over cash should therefore prevail over a movable hypothec without delivery (the mainstream consensual non-possessory security interest in Quebec) whether registered before or after the cash credit support arrangement, without any necessity for the cash credit support arrangement to be registered in Quebec.

Since the rule addresses the opposability or enforceability of contractual set-off or compensation arrangements as against third parties, we believe that most current continuing arrangements that fall within the scope of the rule will also benefit from the rule once it comes into force.

The amendment is not designed to cover all arrangements where cash may be used as credit support. As examples, it will not cover a cash collateral deposit with the letter of credit issuer as support in connection with a letter of credit facility nor will it provide an easy way of obtaining a first priority security interest on cash held in a deposit account at a third-party institution even if securing a financial product transaction. In these cases, the traditional route still remains applicable. We would hope that these situations would be addressed in the near future in a way compatible with both a contractual set-off or compensation arrangement, where applicable and the control construct applicable in the US and many EU countries.

Conclusions

The Quebec legislator has taken steps that will restore confidence to the use of contractual set-off or compensation as a means to offer cash as credit support in connection with derivatives, foreign exchange, securities lending and securities repurchase transactions. The initiative also supports derivative clearing agencies and their relations with their members.

If the amendment is passed as presented, cash should soon regain its preeminent position as collateral for transactions of this kind involving Quebec counterparties able or willing to provide cash credit support on an absolute transfer basis.

The amendment is available in French and English.

Regulatory overkill, American style

Stikeman Elliott LLP — Fri, 18 Nov 2011 14:12:40 -0500

Michael Rumball -

Emerging from the vast literature generated by the recent financial crisis are two competing narratives attempting to identify the root cause of the crisis. One, emanating from the more conservative side of the political spectrum, emphasizes the role played by governmental policies encouraging and subsidizing the expansion of home ownership among middle and low income households. The other side focuses on the extent to which a free market philosophy came to dominate governmental thinking and led to deregulation and hence catastrophe. Although it will be crucial, from a policy perspective, to eventually ascertain just exactly what were the main drivers of the crisis, due to entrenched partisan and dogmatic differences, it may not be possible to do so until we have achieved some historical perspective. However, what does appear to be common to both narratives is that governmental actions, or, perhaps more precisely, their unintended consequences, were in some way heavily implicated.

Apart from anything else, what the foregoing might suggest is that governments should be cautious about its interventions in the market place. Rather than grand, sweeping reforms, the long-term effects of which governments have notoriously unable to accurately anticipate, what may be called for are more surgical, incremental reforms, which, if necessary, can be revisited and adjusted from time to time as their effects become manifest.

Nevertheless, and at the risk of setting up a straw man, the position taken by U.S. regulators in respect of the ABS market appears to be that, while the last crisis may well have occurred as a result of problems specific to the real estate sector, as no one can predict the source of the next contagion, it is best to take vigorous prophylactic measures across the board now. Accordingly, they have been widely accused of, and abused for, taking a “one-size-fits all” approach pursuant to which they have crafted rules of universal application.

This approach has attracted vociferous criticism the main line of which generally goes as follows: The financial crisis occurred as a result of poor asset quality due to the application of the originate-to-distribute model characteristic of the RMBS/CMBS sector. The other, non-mortgage-backed sectors, do not use this model and investors in these sectors experienced no spike in losses during the crisis. To apply a solution crafted to address the unique problems of the RMBS/CMBS sectors to these other sectors is both unfair and unnecessary and will lead to the suffocation of those markets.

Despite sympathy for the foregoing, I am not quite sure that it entirely responds to the regulatory position, which is not to say that that position is justified. Perhaps the issue can be better approached from a slightly different angle, one that is based on the proposition that the crisis was symptomatic of a series of faulty credit decisions which made up a chain of events, each link of which was comprised of an aggregation of credit decisions each of which in turn was characterized by a fundamental lack of prudence.

The first link was comprised of decisions made by mortgage originators who advanced loans to borrowers based, in the most extreme cases, on little or no down payment, no documentation, no proof of income and, ultimately, fraud. Whatever the ultimate root-cause of these decisions, it is clear to most, including the regulators, that what stoked them was the enormous demand for product, any product, by investors. Hence, the motivation to originate for the sole purpose of distribution. By not retaining any of the risk, by not keeping any skin in the game, the originators were incentivized to worry less (or not at all) about product quality and more (or entirely) about product quantity, knowing they could pass any losses on.

The next link was characterized by the credit decisions made by purchasers of the mortgages and the issuers of securities backed by the mortgages. The fault with these decisions lay in the lack of proper due diligence on underwriting standards being applied by originators and thus the quality of the purchased mortgages as well as a failure to adequately disclose to purchasers of the securities the problematic underwriting standards and poor asset quality. Their level of imprudence may also in large part be attributable to a belief that they could also pass any problems on to investors. (It has always been a source of some wonder to me that some of the biggest players were nevertheless caught with an enormous amount of these assets/securities when the crisis arose . I am inclined to believe that this was a result of bad timing more than anything else.)

The last link in the credit chain was inhabited by investors in MBS who failed to ensure that they understood the product in which they were investing and their true exposure to faulty underwriting standards, relying too heavily on the credit analysis provided by rating agencies which have subsequently been accused of being hired enablers rather than reliable gate-keepers.

The regulators have consistently maintained that their goals in crafting the ABS proposals were two-fold: to protect investors while at the same time recognizing the importance of maintaining the securitization industry in order not to compromise the availability of credit to consumers. They have been accused, however, of paying little more than lip service to the latter and the solutions evidenced by their proposals would seem to support this accusation.

Accordingly, they have chosen to mandate prudence at each link in the chain. First, they impose prudence on originators by requiring them to have skin-in-the-game and by devising complex and expensive mechanisms to police the accuracy of representations and warranties. Second, they impose prudence on purchasers/issuers by requiring burdensome asset level disclosure and asset reviews. Third, they attempt to impose prudence on investors by attempting to dislodge their reliance on the credit analysis provided by the rating agencies and substituting therefore requirements of doubtful utility or value such as waterfall computer programs and cash-flow certification.

It should, however, have been apparent that the crisis would never have occurred unless each link in the chain of credit decisions leading to it had been faulty. In other words, without all three levels of imprudent credit decisions there would have been no crisis and the final two links are rooted in and totally derivative of (albeit compounding) the original set of credit decisions involving the failure to apply prudent underwriting standards. What necessarily follows from this is that regulators should have been able to achieve their goal of protecting investors by causing a break in the “chain of imprudence” at any single link rather than by taking a shotgun approach which will necessarily involve extensive collateral damage.

For instance, in those sectors, such as autos and credit cards, in which there is no historical evidence of the imprudent application of less than rigorous underwriting standards, and which have historically had both corporate and structural incentives to the exercise of appropriate levels of prudence in the origination of loans, there is no justification at all for imposing further costs and burdens by the application of rules which have been specifically crafted to address a model and to correct abuses not shared by these sectors. The evil at which the rules are aimed simply did not and does not exist in these sectors. The application of these rules will create no further benefits and will entail only further costs, which should perhaps be viewed as a bright line test for regulatory overkill. Only if and when these other sectors were to evolve in the direction of the RMBS/CMBS sector would the application of similar rules to them be justifiable.

Once the issue of imprudent underwriting standards is satisfied either, in the case of autos and credit cards, by finding no evidence of the application of such imprudent standards, or, in the case of RMBS/CBMS, by application of the new rules (assuming for present purposes that such rules are adequate and effective for such purposes) the chain of imprudence will have been effectively broken and there is no justification for the imposition of further burdens down the credit chain for the same reason: they will bring no extra benefit but will entail heavy costs. This is especially true for such artificial constructs as the proposed waterfall computer program and cash-flow certification. (While it may be argued that mandating adequate disclosure (the second link in the chain) should thus be sufficient in the case of RMBS/CMBS, there may be other reasons why it is preferable to instead regulate at the origination link given the levels of malfeasance in the form of predatory lending which seem to have been all too common during the heyday of the crisis.)

Perhaps a medical analogy is the most fitting conclusion: The regulators have it within their means to neutralize the cancer by the simple excision of an identifiable tumour; but instead they seem to be insistent upon extensive radioactive and chemical therapy which, while it will certainly eliminate the tumour, may well kill the patient.

American Senators introduce covered bond legislation

Stikeman Elliott LLP — Fri, 11 Nov 2011 15:44:52 -0500

P. Jason Kroft and Javier Gonzalez -

On November 9, 2011, a group of Democrat and Republican U.S. senators introduced legislation to create a regulatory framework for an American covered bond market. Specifically, the United States Covered Bond Act sets out the legal context for such a market and clarifies investors’ rights in the event of an issuer’s default.

By way of background, covered bonds are debt products issued by financial institutions and backed by a cover pool of assets, such as high-quality mortgages and public sector loans. Although they operate similarly to asset-backed securities, there is an important difference: if the issuer defaults the investor has preferential claim to the loans. Covered bonds are therefore seen as a safe source of funding for financial institutions.

European banks have issued covered bonds for hundreds of years, and the product has become increasingly popular in other jurisdictions in recent years. According to the bill’s sponsors, however, U.S. financial institutions have lagged behind due to the lack of a regulatory framework. Senator Hagan indicated that the proposed legislation “would level the playing field for U.S. financial institutions.”

American investors’ demand for this product is high, as such investors have funded over $37 billion of covered bonds issued by foreign financial institutions so far in 2011. Seeking to make the most of such high demand, senators in support of the bill wish to allow American institutions of all sizes to issue the debt instrument.

Not everyone is fully supportive, however. The Federal Deposit Insurance Corporation, a government entity that guarantees US bank deposits, has expressed concerns that the use of covered bonds may reduce the banks’ assets for their deposit funds.

A similar covered bond bill was passed in June by the House of Representatives Financial Services Committee, though it has not been voted on by the full House. Both bills seem to have bipartisan support, which bodes well for the timely implementation of covered bond legislation in the U.S.

In Canada, covered bonds have become a popular source of funding for domestic banks during recent years. Canada, however, also lacks a legislative framework for covered bonds. The Department of Finance issued a consultation paper on May 11, 2011, setting out the main elements of a proposed legal framework for covered bonds.

Quebec introduces amendments regarding cash collateral

Stikeman Elliott LLP — Fri, 11 Nov 2011 14:37:52 -0500

On November 10, 2011, the Quebec Minister for Finance introduced an amendment to Bill 7 presently before the Committee on Public Finance of the National Assembly which contemplates an amendment to the Derivatives Act (Quebec). The intent of the proposed rule is to give more clarity and certainty to the effectiveness of a contractual right of set-off in respect of cash given as credit support in connection with agreements including derivatives, securities lending and repurchase agreements (as well as under related master agreements) and dealings between a derivatives clear agency and its members. A more in-depth note will follow next week.

OSC finds Coventree ABCP disclosure deficient

Stikeman Elliott LLP — Fri, 11 Nov 2011 14:02:14 -0500

Sean Vanderpol and Alex Colangelo -

On September 28, the Ontario Securities Commission (OSC) released its decision in the case against Coventree Inc. Coventree, an investment bank specializing in structured finance, was the largest third-party sponsor of asset-backed commercial paper (ABCP) in Canada. OSC staff had alleged, among other things, that Coventree failed to disclose material facts in its prospectus of November 2006, and also failed to disclose material changes regarding subsequent developments in the subprime market.

Ultimately, the OSC found that while Coventree did not breach disclosure requirements with respect to its prospectus, the company did fail to disclose material changes to its business that occurred in early 2007 and during the August 2007 disruption in the ABCP market. Particular points of interest in the decision include the OSC’s discussion of materiality, the use of prospectus disclosure as a baseline for assessing the materiality of future events and the distinction made between a change in the price of a security and a change in the value of a security.

The following are some key highlights emerging from the decision, some of which are discussed in detail below:

while “material facts” are broader than “material changes” both are based on an objective assessment to be made in a contextual basis;
prior disclosure can establish a “baseline” from which future disclosure decisions may be assessed (in that the company cannot later rely on the lack of impact that an event or occurrence may have if its prior disclosure did not provide adequate information for investors to be able to judge the subsequent event);
disclosure of risks to which a company is subject is not sufficient to satisfy its material change disclosure obligation, if and when the risk actually transpires;
materiality is based on the effect of the information on either the market price or the value of the securities;
an issuer will not be liable for making premature disclosure where an event or occurrence has actually transpired, even though its impact or significance may be uncertain; and
external events or developments that have a direct effect on or consequences for an issuer’s business or operations may constitute a material change.

Preliminary Matters

As a preliminary matter, the OSC considered the difference between “material fact” and “material change”. While material facts are those facts that would reasonably be expected to have a significant effect on the market price or value of securities, a material change also requires a change in an issuer’s business, operations or capital. As such, the OSC confirmed that the definition of “material fact” is broader than that of “material change”, as the former will not necessarily arise from a change in an issuer’s business, operations or capital. The standard of materiality for both concepts, however, is the same and based on an objective standard. Importantly, the assessment of materiality also requires “a contextual determination that takes into account all of the relevant circumstances”. Assessments of materiality should not, however, be made with the benefit of hindsight. Thus, according to the OSC, Coventree’s disclosure decisions, which were made at the time events were unfolding, were not judged in light of the knowledge that a market disruption in the ABCP market actually occurred in August 2007. The OSC also confirmed that the business judgment rule does not apply to decisions regarding disclosure under the Securities Act. As such, Coventree’s disclosure decisions were not protected from scrutiny after the fact by an appeal to business judgment.

Prospectus Disclosure

OSC Staff alleged that Coventree's prospectus, filed with the Commission on November 16, 2006, failed to disclose the fact that Coventree had received a letter from the Dominion Bond Rating Service (DBRS) on November 10 stating that the rating organization would henceforth be taking a more restrictive approach to rating credit arbitrage transactions. This was considered to be particularly important in this context, as Coventree relied on the prospectus exemption for suitably rated short-term debt in order for its conduits to issue the ABCP, and DBRS was the only approved organization rating ABCP with "Canadian style liquidity". Ultimately, however, the OSC found that the DBRS letter did not constitute a material fact, as the letter was: (i) unclear as to the criteria that would be applied in reviews of structured finance asset transactions; (ii) appeared to be a continuation of DBRS's existing "measured approach" to approvals; and (iii) did not affect outstanding transactions.

Despite this conclusion, the OSC did make a number of observations regarding the prospectus that were ultimately relevant in the Commission’s consideration of subsequent disclosure decisions. Of particular interest was the OSC’s pronouncement that the disclosure respecting the proportion of Coventree’s revenues deriving from credit arbitrage transactions (about 80%) was less than full, true and plain. According to the OSC, “full” disclosure is provided when disclosure is made of facts sufficient to permit investors to make an informed investment decision; “true” disclosure occurs if the disclosure is accurate, not misleading and does not omit a fact that is material or necessary to understand the facts as disclosed; and “plain” is disclosure that is understandable to investors in a plain language. The OSC also found that the prospectus failed to communicate that Coventree considered the credit arbitrage business to be “dead or dying”. The OSC’s observations in this respect were relevant insofar as the Commission concluded that the disclosure deficiencies it identified made it much more difficult for public shareholders and potential investors to fully understand the significance of subsequent developments.

DBRS release regarding credit rating methodology

OSC Staff also alleged that Coventree failed to disclose DBRS’s decision in January 2007 to change its credit rating methodology. According to Staff, the DBRS release was a material change and ought to have been immediately disclosed by Coventree.

While Coventree argued that the DBRS release did not change its business or operations in any way, the OSC found that the release imposed a requirement for global style liquidity that had not previously been required. Ultimately, the DBRS release was found to be an escalation of DBRS’s previous concerns regarding the credit arbitrage market and, given Coventree’s reliance on “Canadian style liquidity”, the DBRS release did in fact result in a material change to Coventree’s business.

Of particular interest is the OSC’s response to Coventree’s argument that the DBRS release could not have constituted a material change since there was no change in the market price of Coventree’s shares after the information was ultimately disclosed in Coventree’s second quarter MD&A. The OSC rejected this argument, stating that the fact that Coventree’s share price was not affected by the eventual disclosure did not mean that no material change had occurred. Rather, the OSC framed the issue as whether particular information would reasonably be expected to have had a significant effect on the value of securities, despite the lack of effect on the market price of the securities. According to the OSC, “one cannot assume…that the lack of impact on market price means that the information disclosed was not material.” In the immediate case, therefore, the OSC found that the DBRS release would reasonably be expected to have had a significant effect on the value of Coventree’s shares. Also, as described earlier, Coventree’s prospectus disclosure ultimately acted as a form of baseline from which to draw inferences regarding investors’ knowledge. Specifically, the OSC stated that investors did not appreciate how important credit arbitrage and CDO related SFA transactions were to Coventree’s business. Hence, the lack of a change in the market price did not necessarily imply that there had been no material change.

Material change prior to August 13, 2007

OSC Staff also alleged that Coventree failed to disclose liquidity related events in the days leading up to the disruption in the ABCP market that occurred on August 13, 2007, and that these events constituted a material change. In response, it was argued, among other things, that the events in question were external and widely known, and that specific disclosure by Coventree would have been premature. These arguments were, however, rejected by the OSC.

According to the OSC, it would not have been premature to disclose actual events and developments and their consequences to Coventree’s business, even if there was uncertainty as to their causes, future effects, financial impact or duration. As the OSC stated, “[a]n issuer does not subject itself to any liability…for premature disclosure where the disclosure made relates to events and their consequences that have occurred and is accurate, balanced and appropriately qualified.” According to the OSC, the possibility that ABCP market issues could be resolved as part of a negotiated “soft landing”, as believed by Coventree, was contingent, uncertain and highly speculative and did not insulate Coventree from its disclosure obligations.

The OSC also rejected Coventree’s argument that the events in question were external and did not require disclosure as per section 4.4 of NP 51-201 Disclosure Standards. According to the OSC, that provision is premised “on the assumption that investors will be aware of external economic developments and their general effects on reporting issuers.” In this context, the OSC was of the view that public shareholders and potential investors had very limited knowledge of the ABCP market and of events and developments affecting that market (again, looking back in part to the baseline of the prospectus).

Even if the exemption did apply, the OSC stated that the developments affecting Coventree were uncharacteristic of the effect generally experienced by other issuers in the same industry, due to Coventree’s size and its conduits’ exposure to ABCP and, as such, Coventree would be unable to rely on the provision regardless. According to the OSC, Coventree made a “critical error to the extent that it assumed that these external events or developments could not and did not have direct effects on, and consequences for, its business and operations that constituted changes in that business for purposes of the definition of ‘material change’ in the Act.”

In light of the OSC’s findings, on November 8, the Commission ordered Coventree to pay an administrative penalty of $1 million and costs of $250,000.

Overview of comments on SEC's Re-proposal of shelf eligibility conditions

Stikeman Elliott LLP — Wed, 02 Nov 2011 11:26:01 -0500

Michael Rumball -

As reported earlier, on July 26, 2011 the SEC issued for comment a proposing release entitled “Re-Proposal of Shelf Eligibility for Asset-Backed Securities and Other Additional Requests” (the Re-Proposal). The Re-Proposal put forward modifications to the proposals originally issued in April 2010 relating to those Shelf Eligibility Conditions dealing with certification and asset repurchases. The comment period for these re-proposals expired on October 4.

As expected, the most contentious element of the Re-Proposal was that portion of the certification dealing with expected cash flow from the securitized assets. It may be recalled that the original proposal required the chief executive officer of the issuer to certify that “the securitized assets backing the issue have characteristics that provide a reasonable basis to believe that they will produce, taking into account internal credit enhancements, cash flows at times and in amounts necessary to service any payments of the securities as described in the prospectus”. While the Re-Proposal purports to address some of the criticisms levelled against the original proposal, it continues to address, in somewhat modified form, the ultimate performance of the offered securities. As argued earlier in this space, commentators continue to insist that “certification should only address the disclosure included in the prospectus, rather than a belief as to the future cash flows from the pool assets or the quality of the ABS”.

As pointed out by the American Securitization Forum (ASF),

“prospectuses for ABS offerings do include extensive disclosure concerning the risks and uncertainties that could adversely affect the timing and sufficiency of cash flow, and it is precisely those disclosed risks and uncertainties that prevent the certifying person from being able to know that the securitization will produce cash flows at times and in amounts sufficient to service payments on the ABS. Taken on the whole, the certification as revised and re-proposed remains an assessment by the certifying officer of the expected future performance of securitized assets and the ABS, but without any qualification by reference to the risks and uncertainties described in the prospectus that could affect that conclusion.”.

Others also observed that what is being proposed is fundamentally a forward-looking statement but without the requisite cautioning statements that otherwise accompany and provide a safe harbour for forward-looking statements.

Commentators generally indicated that such a requirement is beyond the ability of the certifying officer, fundamentally unfair and would have a chilling affect on the use of, if not a complete barrier to, shelf registration.

Even the investor members of ASF and the Securities Industry and Financial Markets Association (SIFMA) derived no comfort from such a certification as they recognized that it was of little value as a substitute for the credit analysis provided by rating agencies since the necessary analysis by the officer is likely to be beyond his expertise as well as being inherently conflicted. As indicated by the Asset Management Group of SIFMA,

“As investors, we would like nothing more than to have individual officers stand firmly behind the product of their employers. Yet we fear that such broad certification requirements will discourage able executives from taking executive positions for fear of being personally embroiled in private litigation and government enforcement actions if the securities fail to perform as expected. At this point in the recovery cycle, we think it is essential to facilitate new mortgage market securitizations and not impose unnecessary barriers to new issuances. If executive officers feel like they personally will be made the scapegoat for unmet performance, it is reasonably likely that they will not participate in the securitization process.”

The other shelf eligibility re-proposal, relating to the appointment of a credit risk manager, garnered a mixture of general support for the concept and criticism of certain of the constituent elements; specifically the two minimum conditions under which asset review would be required: first, if “the credit enhancement requirements, as specified in the underlying transaction agreements, are not met”, and second, “at the direction of investors pursuant to the processes provided in the transaction agreement and disclosed in the prospectus”.

The ASF argued that it was a mistake to attempt to mandate a one-size-fits-all minimum objective test which may, in fact, not even be applicable in respect of certain transactions. It proposed that this test be replaced by a requirement that the transaction documents provide for a review of the pool assets upon the occurrence of a trigger based on objective factors as specified in the transaction documents and disclosed in the prospectus.

“This will allow the market to develop the most appropriate objective triggers for particular types of ABS transactions, which should be designed to cause review at a time that pool asset performance indicates that the cost of review is warranted, while preserving the flexibility to adopt alternative triggers on a going forward basis as market participants evaluate the effect of this relatively new mechanism and the efficacy of different triggers in different types of transactions.”

The second trigger also attracted its fair share of criticism, most persuasively on the grounds that it would be subject to abuse, as it represents a riskless and cost-free option for investors and would create the potential for conflict among investors within the same ABS transactions. Accordingly, it was suggested that a minimum percentage of investors should be needed to invoke the trigger and frivolous claims should be discouraged by requiring unsuccessful claimants to pay the costs of review.

Although the Re-Proposal did not alter the original proposal relating to asset-level disclosure, but merely requested additional comments on certain specific features of that proposal, certain commentators (including, most vehemently, the Vehicle ABS sponsors) took the occasion to reiterate their strident opposition to requiring asset-level disclosure for all asset groups by pointing out that Congress had already addressed this point in the Senate Report on Dodd-Frank: “The Committee does not expect that disclosure of data about individual borrowers would be required in cases such as securitizations of credit cards or automobile loans or leases, where asset pools typically include many thousands of credit agreements, where individual loan data would not be useful to investors, and whose disclosure might raise privacy concerns.”

Finally, certain commentators took the opportunity to weigh in once again on the private placement proposals. According to SIFMA,

“We are acutely aware that during the financial crisis investors – as well as transaction sponsors – incurred large losses on certain structured securities that, as a result, may now be perceived as types of securities having a high level of risk. However, the proposed changes in regulations applicable to private offerings to institutional investors would, in almost all private offerings of ABS and other structured finance products as they are commonly conducted substantially eliminate the principal distinctions between registered public offerings and private offerings to sophisticated institutional investors, by requiring issuers to covenant to provide initial disclosure consistent with that in [a registered]… offering and ongoing reporting as if the issuer were required to report under… the Exchange Act. This broad regulation of exempt private transactions would represent a historic shift in Federal regulation of the securities markets, requiring that every issuer of structured finance products provide the full, broad range of disclosure required to be provided in public offerings for the protection of every investor, including individuals and small institutions, to even the largest, most sophisticated institutional investors in a private offering.

In our view, the scope of the proposal is unjustified, and the proposed changes could significantly impair the functioning of the private markets for structured finance products and reduce the availability of credit. We believe that there remains an important role for negotiated transactions in which securities are purchased by institutional investors that have the resources and experience to fend for themselves.”

The comments on the Re-Proposal illustrate the continuing lack of consensus among market participants and regulators over the proper scope of governmental regulation of the securitization industry. Although not in detail applicable to the current Canadian process, the general principles expressed above should also resonate north of the border.

Overview of comments on the CSA's exempt market proposals

Stikeman Elliott LLP — Mon, 24 Oct 2011 15:35:08 -0500

Michael Rumball -

Whereas the comments on the definition of securitized product and the prospectus disclosure proposals were quite limited and restrained, those on the proposed exempt market rules were both extensive and harshly critical. The general themes were common to most commentators. The proposed rules:

are an over‑reaction to the failure of the third‑party sponsored ABCP market in Canada;
focus unnecessarily on risks inherent in high‑risk structures such as those originated under the originate‑to‑distribute model or synthetic structures that either did not or no longer exist in Canada;
inappropriately apply a one‑size‑fits‑all approach to the traditional securitization market; and
unfairly differentiates between securitized products and other high risk securities.

Three elements of the proposed new rules attracted the most attention. First, the creation of the new definition of “eligible securitized product investor” and the elimination of the other exemptions were generally attacked as unfairly stigmatizing securitized products and, it was contended, could lead to a patch‑work of different exemption criteria for different products. Certain commentators suggested that sufficient protection would result if all exempt purchases were required to be completed through registrants with their know‑your‑client and know‑your‑product obligations. The implication in certain of the criticisms from dealers is that investors may come to view securitized products negatively due to the fact that they are to be treated differently under the proposal. It is not readily apparent, at least to me, how this would ever become an issue for investors other than, by definition, those who have been excluded under the new regime. The people most affected by the proposed change may, in fact, be those sitting at various trading desks who will have to be careful not to sell securitized products to non-eligible securitized product investors; but, having said that, I would have thought that their know-your-client and know-your-product obligations would have already necessitated the taking of such care.

The opposition to the proposal was not universal, however, at least in concept. Neither the author nor the American Securitization Forum (ASF) found the elimination of retail investors to be particularly troublesome. As stated by the ASF: “ASF supports the view that complex securitized products offered without all of the protections of the prospectus‑delivery regime should be limited to investors who have the knowledge and experience to evaluate the securities they are considering for purchase and the ability to ascertain what disclosures, reports and other contractual features they require in connection with a prospective purchase”.

Virtually all commentators were united in their criticism of the requirement to provide an information memorandum. This strength of this criticism is only reinforced if the proposed change to the universe of eligible investors is conceded. Having eliminated the retail investor, what remain are precisely the highly sophisticated investors who have the knowledge of what they need and the ability to obtain it through negotiation. The proposal represents an unwarranted infringement on the right to contract and should, at minimum, be capable of being waived. (Similarly, the proposal requiring continuous disclosure in respect of exempt distributions runs afoul of this principle and should also be left to be negotiated by the participants.)

The ASF recommended that the CSA follow the U.S. approach which only requires delivery of an information memorandum if specifically requested by an investor or prospective investor. However, I continue to believe that this is a distinction without a difference. This view has recently been corroborated by the Securities Industry and Financial Markets Association (SIFMA) in their comment letter on the SEC’s Re‑Proposal of ABS Shelf Eligibility Conditions: “As a practical matter, however, this would mean that every issuer of structured finance products would need to compile and be prepared to provide all of the disclosure that would have been required in a registered public offering, whether or not any investor ultimately requests the information … The proposed changes … substantially eliminate the principal distinctions between registered public offerings and private offerings … In our view, the scope of the proposal is unjustified and the proposed changes could significantly impair the functioning of the private markets for structured finance products and reduce the availability of credit.”

There did not seem to be as much resistance in principle to the proposal to require minimum disclosure for short-term securitized products although several bank commentators indicated that it should not go beyond what is already required by the Bank of Canada for bank-sponsored conduits’ ABCP to qualify as collateral under the Bank of Canada’s Standing Liquidity Facility. In any case, according to CIBC (and seconded here), it is critical that the prescribed form contain program level information only, and not transaction details: “The costs and challenges in meeting the delivery requirement for updated transaction information in an information memorandum for each sale of ABCP could likely result in the ABCP market being eliminated.”

Finally, and perhaps most importantly, is the proposal which would require issuers, sponsors and underwriters to certify that information memorandum contain no misrepresentation. As indicated by the ASF, the proposal “is without parallel in the U.S. securities laws”. No justification has been forthcoming (or, indeed, exists) for such an extension of liability in respect of these products as opposed to any other exempt investment, however risky. It is one thing to require enhanced disclosure; it is something entirely different and totally unconnected to impose enhanced liability. As indicated by CIBC such an extension “would likely result in the demise of the private placement market for securtized products because it would largely eliminate the distinction between public and private offerings”. In addition to increasing transaction costs (which would be passed on to investors), perhaps more importantly it would naturally “result in a redirection of issuance volumes towards exempt products with lower liability risks or costs associated with them”.

Overview of comments on CSA's prospectus disclosure proposals

Stikeman Elliott LLP — Tue, 18 Oct 2011 13:32:28 -0500

Michael Rumball -

For the most part the CSA’s proposed prospectus disclosure rules escaped substantive comment although we and a few others did provide some technical comments. This is not surprising in as much as they by and large are a copy of the existing rules under Reg AB Among the few items which did attract attention were those requiring the disclosure of financial information in respect of significant obligors, credit enhancers and counterparties and that requiring disclosure of any material conflict of interest between participants in a transaction and investors.

In respect of the first item, several commentators pointed out that, where the obligor or credit enhancer is a private company, imposing an obligation on an issuer to obtain the financial information and to disclose it would be unfair and may preclude a seller from accessing the market due to a refusal of the obligor, etc. to provide such information. Most of these commentators recommended that it should be sufficient to direct the reader to publicly available information, if any, and not require disclosure of private and/or confidential information.

The conflict of interest disclosure is a more benign version of the Dodd‑Frank prohibition on transactions where a material conflict of interest exists. Several commentators(including the author) pointed out that a broad interpretation of the proposed rule relating to conflicts of interest could also catch many activities essential to securitizations such as hedging, servicing and market-making and recommended that the proposal be tailored to specifically target the types of transactions in connection with which the abuse arose. These of course are the well‑publicized occasions where financial firms that had designed certain highly complex synthetic CDOs and sold them to their customers then entered into transactions whereby they would profit from the failure of the original transaction.

Later developments on this front are illustrative of the danger in following along in the slip‑stream of the U.S. proposals, at least until the final rules are published. On September 19, 2011, the SEC released for comment a proposed rule under the Dodd‑Frank prohibition against conflicts of interest wherein they essentially adopted precisely the approach described above.

In so doing the SEC indicated that they were “not aware of any basis in the legislative history … to conclude that [the Dodd‑Frank provision]was expected to alter or curtail the legitimate functioning of securitization markets, as opposed to targeting and eliminating specific types of improper conflict. Moreover, as a preliminary matter, we believe that certain conflicts of interest are inherent in the securitization process and accordingly [the Dodd‑Frank Act]and our proposed rule should be construed in a manner that does not unnecessarily prohibit or restrict the structuring and offering of an ABS.”

Therefore, the SEC has proposed for comment a rule that specifically targets “short transactions” or transactions in which the securitization participant (or third party enabled by it) would benefit directly or indirectly from the actual, anticipated or potential adverse performance of the asset pool or the loss, default, early amortization or decline in market value of the ABS. In order to ensure that even this rule not limit certain bona fide activities, the SEC also provided specific exemptions relating to risk-mitigating hedging activities, liquidity commitment’s and bona fide market making.

Overview of comments of CSA securitization proposals

Stikeman Elliott LLP — Fri, 14 Oct 2011 08:00:29 -0500

Michael Rumball -
On August 31 the comment period in respect of the Canadian Securities Administrators’ Proposed Securitized Product Rules ended. About 30 comment letters were submitted. Over the next couple of weeks I will briefly canvass the comments received on the prospectus disclosure rules and the exempt market rules. Following is a brief discussion of the more general comments.

While almost all commentators concurred with the general principles enunciated by the CSA, a few concluded from the distinct nature of the traditional Canadian securitization market (no originate-to-distribute model; good asset performance) and the nature of the financial crisis that it experienced (liquidity only), that any new rules should leave traditional ABS alone and concentrate solely on those transactions which in fact at the root of the financial turmoil of the past few years. These were identified as those transations utilizing originate‑to‑distribute model and those involving synthetic securities. Although this view has much to recommend it, it does not seem likely that the CSA will abandon the omnibus approach which they have taken. They will probably feel that they have already provided sufficient recognition of the distinct nature of the Canadian market by refraining from applying the more intrusive Dodd‑Frank and Reg AB II proposals, an approach otherwise all but uniformly praised by commentators.

The entry point for the application of the Proposals is the definition of securitized product. Given the importance of this definition it is perhaps surprising that comparatively little attention was paid to it by most commentators. Those who did comment on it did little but indicate that they believed the definition to be too broad and cite a few examples of instruments that should not be caught. These included NHA MBS, Canada Mortgage Bonds, over‑the‑counter derivatives, corporate loans secured by pools of assets, innovative Tier 1 capital structures and structured notes. Apart from our own submission, very little analysis was provided to the CSA to allow it to structure a principle‑based definition. And we do not believe that the solution lies in merely listing the above as exceptions as, unless the definition itself is refined significantly, there will be too many classes of securities on the margins or in the “grey” zone. As illustrated in our submission, there are a number of other types of securities that could unexpectedly be caught by the definition and specifically listing included or excluded securities may not be an effective solution as such lists may result in further interpretive difficulties.

The extreme breadth of the definition will create a trap for the unwary issuer which may only become apparent upon receipt of a comment letter or, more problematically, a claim from an investor in a private transaction who later, being discontented with the outcome of his investment, is casting about for grounds for reimbursement. Indeed any proposed issuance of securities in the “grey” zone will need to be approached cautiously under the proposed definition. If the issuance is to be by way of prospectus, the new rules are tailored almost entirely to fit traditional ABS and a “grey” zone issuer would be hard‑pressed to understand what specific disclosure is required in respect of its issuance. It would be much worse, however, if the issuance is to be conducted in the exempt market since the issuer would be caught between the rock of not complying, and thereby potentially opening itself up to liability for non‑compliance, and the hard place of complying, and thereby voluntarily taking on unwarranted liability by operation of the new disclosure and certification requirements. The uncertainty surrounding the applicability of the definition of securitized product could virtually eliminate all issuances of these “grey” zone securities as it would be difficult to obtain a legal opinion which would give sufficient comfort on the applicability of and compliance with securities laws. It is therefore incumbent upon the CSA to strive for much greater clarity in this area and we believe that they should submit a new proposal on this point for comment.

In re Lehman Brothers Inc. [Again] - Affiliate Set-off

Stikeman Elliott LLP — Tue, 11 Oct 2011 12:48:12 -0500

Margaret Grottenthaler

UBS terminated its ISDA Master and FX transactions with Lehman Brothers Inc., was obligated to return about $23 million in collateral, wanted to set-off against that $23 million amounts owing by LBI to UBS affiliates as contemplated by the cross-affiliates set-off provision. Judge Peck said no. These types of clauses are enforceable pre-bankruptcy, but not once a proceeding is commenced. Mutuality is a requirement for post-petition set-off. He said, “Contractual provisions that purport to create synthetic mutuality are not a substitute for the real thing.”

Section 553(a) of the U.S. Bankruptcy Code requires mutuality as a condition of preserving a right of set-off. UBS argued that contractual set-off was an exception to the mutuality requirement. Judge Peck disagreed simply on the basis that the statute did not provide for that exception.

UBS’s argument that the swap agreement safe-harbour could be relied on to permit the set-off also failed for the reasons he gave in the Swedbank case.

As I pointed out in my brief on the Swedbank case, the result could be the same in Canada. The protection for the “law of set-off” that applies under the Bankruptcy and Insolvency Act and other insolvency statutes, while it contemplates contractual set-off, does not necessarily go so far as to include non-mutual set-off (unless it fits the bill for an equitable set-off). Also, the eligible financial contract safe-harbours by their terms require the set-off to be mutual.

However, perhaps it’s not correct to analyze the issue as one of set-off. Under Canadian bankruptcy law, a trustee in bankruptcy has no higher right under a contract than had the bankrupt (subject to exceptions such as being able to challenge preferential transfers). If the right to the payment of a sum of money under a contract is subject to a right to deduct amounts owing to affiliates, then why is that not enforceable? There may be stay risk that delays exercise of the right, but on what basis is it not binding on the insolvency representative simply as a matter of contract law? That is an interesting question that the court did not consider in the judgment and which has not received much judicial treatment in Canada either.

Okay, Okay, Here's My Book Reviews

Stikeman Elliott LLP — Mon, 03 Oct 2011 14:50:45 -0500

Margaret Grottenthaler

Since September more than a few readers of this blog asked why I had not posted a piece on my best summer reads. Since that was by far my most popular post of 2010 (yes it did get more hits than my post on the Indalex case), I guess I know where your priorities lie. I must meet the demands of my audience. I have to admit I stuck to fairly light fare for most of the summer, but I did read a few things in the crime/detective/thriller genre that you may like.

Red on Red by Edward Conlon – This first novel of Conlon’s, a working NYC detective (albeit a Harvard educated one), is narrated by a somewhat morose and conflicted NYC detective, dealing with a couple of related murders and complicated relationships with his partner (on whom he’s been asked to spy by internal affairs) and his spouse, his father – well just about everyone really. It’s more about the relationships than solving the crimes. Red on red refers to criminal on criminal crimes, but allegorically in the novel refers to the narrator’s betrayal (at least initially) of his partner (and his spouse, his father - well just about everyone really). The characters were well drawn and the writing more literate than the typical detective fare.

Started Early, Took My Dog by Kate Atkinson – This is a novel that begins with the ultimate impulse purchase. A retired female police office buys a 6 year old girl from her drug addict, prostitute mother after seeing mom treat the girl’s mother roughly at the mall at which she now works as a security guard. The subsequent murder of the girl’s mother complicates things needless to say. (Someone else takes the dog.) Kate Atkinson has been one of my favourite writers since I read Case Histories many years ago. She’s funny, moving, creative and never boring.

The Black Madonna by Peter Millar – My husband Doug brought this book up to the cottage for me on a Friday night and by the time he said “I bought you a book” on Saturday afternoon, I had already read it. Yes, it’s a fast read, but a good one. It’s a bit like The Da Vince Code but written by someone with an actual vocabulary and literary skill. You get a tour of Europe and a history lesson along with the fun.

I also finally got around to reading The Big Short by Michael Lewis, which I thought was a great read as well. Are derivatives lawyers allowed to like that book?

Feel free to post a comment with your own reading recommendations.

CSA Consultation Paper 91-402 - Derivatives: Trade Repositories

Stikeman Elliott LLP — Fri, 30 Sep 2011 14:16:44 -0500


Philip J. Henderson	Terence W. Doherty

The Canadian Securities Administrators (CSA) have published the first of eight consultation papers on OTC derivatives reform and, if the industry comment letters on this first paper are anything to judge by, there is a lot of work left to be done by Canadian regulatory authorities to implement Canada’s G-20 commitments on Over-the-Counter Derivatives Regulation. Consultation Paper 91-402 considers the subject of reporting of OTC derivatives trades to trade repositories.

At the G-20 meeting in Pittsburgh in September 2009, Canada committed to require that all OTC derivatives contracts be reported to trade repositories. On June 23, 2011, the CSA Derivatives Committee published Consultation Paper 91-402 – Derivatives: Trade Repositories. It set out a framework for proposed rules for the reporting of OTC derivatives transactions to, and the operation of, trade repositories and sought public comment on a number of issues relating to OTC derivatives transaction reporting and the regulation of trade repositories, including whether a “made-in-Canada” solution is necessary or appropriate. The public comment period closed on September 12, 2011. The CSA received twenty one comment letters from interested parties, many of which were quite lengthy and detailed and raised many questions and considerations for the regulators. The CSA will have much to think about in taking this proposal to the next stage.

The CSA Derivatives Committee identified trade repositories, which are centralized facilities for the collection of OTC derivatives data, and the related availability and transparency of transaction and aggregate market data for market and prudential regulators, central banks and the public as one of the most important components of OTC derivatives regulatory reform.

There are currently no requirements for Canadian market participants to report their OTC derivative transactions and positions. Therefore, Canadian regulators and the Bank of Canada do not have formal access to data regarding the size and composition of the Canadian OTC derivatives market, the activities of Canadian market participants and “Canadian referenced derivatives” entered into by foreign participants.

Trade Repository Requirements

The CSA Derivatives Committee recommends that trade repositories operating in Canada should:

be required to meet internationally accepted governance and operational standards recommended by the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) including standards relating to legal framework, governance, market transparency and data availability, operational reliability, access and participation, safeguarding of data, timely recordkeeping and communication procedures and standards,
have boards of directors with appropriate independent representation,
have a chief compliance officer and robust operational risk management capabilities,
provide fair and open access to market participants,
be required to accept all trades for each asset class for which they accept trade data,
safeguard confidential data, and
prevent any data use that could represent a conflict of interest.

The CSA Derivatives Committee also recommends that Canadian provincial securities and derivatives laws should be amended to include approved trade repositories in the definition of market participant.

What is not clear from the recommendations is whether a trade repository, whether domestic or foreign, would have to become registered or recognized in each province in which it accepts trade data from market participants. Hopefully, registration or recognition in (and regulation by) thirteen different provincial and territorial securities regulators can be avoided, especially for non-Canadian trade repositories.

The comment letter from the Canadian Market Infrastructure Committee (CMIC) submitted that the federal authority over systemic risk and banking means that the Bank of Canada should be at the centre of trade repository regulation (i.e., not the provincial securities regulators) within harmonized federal and provincial approval processes. The framework should be designed to provide federal authorities with the appropriate data for their systemic risk purposes and provincial securities regulators with the appropriate data for their market conduct purposes. The legislative approach that should be followed is the developent by federal authorities of federal legislation that would focus on the Bank of Canada’s trade repository requirements for systemic risk monitoring purposes, albeit in consultation with both provincial securities regulators and industry participants to ensure that the scheme of the federal legislation is consistent with the market conduct responsibilities of provincial securities regulators.

A Made-in-Canada Solution?

The CSA Derivatives Committee recommends studying whether a “made-in-Canada” solution is necessary and the requirements for foreign-based trade repositories. While there are efficiency arguments for a single global trade repository, at least for each asset class, there are of course reasons why Canadian regulators (federal and provincial) may prefer a local trade repository, including the possibility that foreign trade repositories may not develop systems that accept trade data from Canadian market participants for all types of OTC derivatives entered into domestically by Canadian counterparties or that Canadian regulators may not have sufficient access to foreign trade repositories holding trade data in respect of trades by Canadian counterparties or Canadian referenced derivatives or that such access might be interrupted in the future.

What is clear from the comment letters is that if Canada does pursue a domestic trade repository, the format and parameters of the data that are required must be the same as used by other trade repositories globally so that trade data feeds between market participants and trade repositories work efficiently.

OTC Derivatives Transactions Reporting Requirements

The consultation paper recommends that provincial market regulators mandate the reporting of all OTC derivatives transactions, both cleared and non-cleared, to an approved trade repository. This mandatory reporting includes the reporting of pre-existing OTC derivatives which should be reported within 180 days from the effective date of the new rules except for existing transactions which terminate or expire within one year of the effective date of the new rules. The CSA heard from industry in the comment letters that 180 days from the effective date of the new rules for the reporting of pre-existing OTC derivatives may be too short a period. Not only may it not be practical from an operational perspective for many market participants to meet that timeline, but data does not necessarily exist within organizations in the format that it would be required to be reported.

Who Must Report OTC Derivatives Transactions

The consultation paper proposes that one counterparty to each OTC derivative transaction should be required to report the transaction and any related post execution events to an approved trade repository. However, counterparties should be able to delegate reporting to a third-party service provider including a central counterparty clearing house. Financial intermediaries should bear the reporting onus in transactions with end users. Transaction counterparties should be permitted to elect the reporting party for transactions between two financial intermediaries or two end users. A foreign counterparty may assume reporting obligations provided that the transaction is reported to a trade repository approved in Canada.

OTC Derivatives Transaction Information Required to be Reported

The consultation paper recommends that the reported data include not only the principal economic terms, but also the full executed legal agreements entered into between the counterparties and should be reported in accordance with international standards for data reporting which would include unique identifiers for legal entities, transactions and product types. In addition, “continuation data” should be reported throughout the life of an OTC derivative transaction. Many comment letters state that the requirement to submit all legal documentation to a trade repository is too onerous for the institutions and in any event would not provide regulators with any additional useful information beyond the principal economic terms of the transaction. Also, the full legal documentation for some trades is often not executed until long after the trade date and, in the case of many bespoke trades, the full legal documentation can be voluminous. Also, not all parties use FpML confirmations so reporting the transaction documentation electronically is not always feasible.

Timing of Reporting

The CSA Derivatives Committee proposes that transaction reporting to trade repositories should be completed in real time once feasible for Canadian market participants and within one business day until real time reporting is implemented. Once real time reporting is implemented, large trades meeting a to-be-determined block trade threshold should be subject to a delayed reporting requirement in order to preserve the anonymity of market participants and ensure that there is no detrimental impact on market liquidity or function.

This real time reporting requirement engendered many comments, as it has in other jurisdictions. The need for real time reporting into a database that is not itself a market is questioned. While timely information is necessary, reporting time frames should depend on the level of data required to be reported, the complexity of the transaction and the availability of the required technology systems on a global basis.

The question of a block trade threshold is also addressed in many of the comment letters. For example, the International Swaps and Derivatives Association (ISDA) recommends that the analysis to determine appropriate minimum block trade threshold levels should be undertaken separately for the Canadian OTC derivatives market, different asset classes within the market and different products within each asset class as the appropriate threshold levels for different asset classes and products within assets classes in the Canadian market will be different. A uniform block trade threshold is too simplistic and would be damaging to liquidity. Also, all block trade thresholds should be reviewed periodically in light of current market conditions and there should be a mechanism for the immediate reassessment of thresholds during periods of market stress.

An appropriate publication delay for block trades should reflect the time it takes to hedge the exposure without unduly impacting the market and in light of liquidity in the particular market. Liquidity in many Canadian markets may be quite different from liquidity in some foreign markets. Many large Canadian market participants comment that the publication of block trade data should be delayed for at least a quarter as the public reporting of block trade data runs the risk of inadvertent disclosure of confidential information, potentially enables reverse-engineering strategies and runs the risk that the small number of relatively large participants in the Canadian markets would have the ability to figure out the individual positions of one another.

Access to Confidential Trade Repository Information

The consultation paper also raises a number of concerns relating to access to confidential information, including whether it is necessary for provincial regulators to enact legislation that expressly permits the disclosure of confidential information to and by trade repositories, that amendments to legislation should be enacted to ensure that confidential trade repository data is not made publicly available pursuant to public disclosure laws and that Canadian regulators and the central bank should establish cooperation agreements with foreign jurisdictions that have equivalent legal and supervisory frameworks to facilitate cross border access to trade repository data.

Availability of Information to Public

Another controversial proposal is that trade repositories should make available to the public aggregate data, including information on positions, transaction volumes and average prices. Anonymous post-trade transaction level data should also be made public provided that it would not be detrimental to market liquidity or function. The comment letters urge that the release of data to the public be studied thoroughly, because the publication of such data may compromise the positions of counterparties depending upon the size of the market and the level of aggregation of the data.

Inter-Affiliate Transactions and End User Exemptions

The consultation paper does not deal with the question of inter-affiliate trades. Should inter-affiliate trades be excluded from the reporting requirement (and possibly other aspects of OTC derivatives regulatory reform)? It has been argued that transactions between affiliates merely represent transfers of risk within a corporate group and should not be subject to the same reporting requirements as inter-affiliate transaction data will not provide any valuable information to regulators from either a systemic risk or market conduct perspective. Reporting of inter-affiliate trades will also increase the costs and burden for corporate groups that choose to consolidate their hedging activities in a single entity.

Nor does the consultation paper contemplate exemptions from the reporting requirements for hedging end users. The CSA will have to consider whether such exemptions should be made available for end users that are hedging risks (particularly in the commodities and energy markets) where they do not pose any systemic risk. Perhaps exemptions of this nature will be discussed by the CSA Derivatives Committee more broadly in its anticipated Consultation Paper 91-405 - Exemptions (Derivatives).

ISDA publishes response letter to OTC derivatives consultation

Stikeman Elliott LLP — Wed, 14 Sep 2011 13:14:48 -0500

As we discussed in a blog post earlier this summer, the Canadian Securities Administrators released a consultation paper in June that proposed a framework of rules for the reporting of OTC derivatives transactions and the operation of trade repositories.

Earlier this week, the International Swaps and Derivatives Association published a comment letter in response to the CSA's paper. Of particular interest, ISDA comments on some of the challenges in implementing a regime for mandatory reporting to trade repositories. It highlights some of the changes that have been made under the proposed U.S. regulations to facilitate foreign regulator access to U.S. based repositories which make the establishment of a single global trade repository for each asset class of derivatives a more palatable option for regulators. The comment letter also addresses block trade exception rules and the issue of real-time reporting of trade information.