Canadian Structured Finance Law

ISDA supports OBA proposal on cash collateral priority

Stikeman Elliott LLP — Mon, 14 May 2012 09:44:01 -0500

Margaret Grottenthaler -

Last week, the International Swaps and Derivatives Association released a letter it submitted to the Ontario government in support of the Ontario Bar Association's proposal to provide an automatic first priority ranking to financial institutions that have a security interest in cash in financial accounts perfected by control. As I noted in my post of February 14, the OBA proposal would give secured parties holding cash collateral the same degree of legal certainty as to their priority against other creditors that the Securities Transfer Act, 2006 provides to holders of securities as collateral.

In its letter, the ISDA stated that there is no legal assurance of priority in a registration regime. According to the ISDA, however, the certainty and predictability resulting from the proposed changes would "significantly contribute to financial stability in the derivatives markets" in which market participants take part and "enhance their ability to compete in these markets on a more cost-efficient basis." Ontario's Ministry of Consumer Services is accepting input on the issue until May 17.

More on the CSA's proposed end-user exemption

Stikeman Elliott LLP — Thu, 10 May 2012 14:40:00 -0500

Margaret Grottenthaler -

As we discussed last month, the Canadian Securities Administrators Derivatives Committee recently released the latest in a series of eight papers intended to build on the high-level proposals found in Consultation Paper 91-401 regarding the regulation of OTC derivatives. Specifically, Consultation Paper 91-405 considers the scope and characteristics of a proposed end-user exemption to address market participants that generally only trade to hedge commercial risks. According to the paper, this limited segment of end-users, not systemically important to the market, should be exempted from most of the proposed regulations concerning OTC derivatives. The CSA are accepting comments on the consultation paper until June 15, 2012.

Meeting Requirements

The Consultation Paper considers various criteria for determining who should qualify for the end user exemption. According to the CSA's proposal, an end user would include participants that: (i) trade for their own account; (ii) are not financial institutions; and (iii) hedge to mitigate commercial risks related to the operation of their business or a related affiliated entity or series of legal entities within that affiliated group. End users that otherwise meet the criteria for the exemption may still be found ineligible for the exemption, however, if they are deemed to be "Large Derivatives Participants" considered key participants in the market or whose default would represent a systemic risk to the market. An upcoming consultation paper on registration is expected to consider the thresholds for Large Derivatives Participants. The Committee also specifically rejected including certain criteria in determining whether a participant qualifies as an end-user, including those based on: (i) trade volume or notional dollar values of trades; (ii) sector specific exceptions; and (iii) standardized contracts and clearing.

In considering the definition of "hedging" for the purposes of mitigating commercial risks, the CSA make a number of observations. Specifically, the consultation paper states that the relevant derivatives transactions would have to specifically relate to the risk being hedged and should "reasonably be considered to be a suitable instrument for managing the risk." According to the CSA, the definition of hedging should also include positions that are treated as a hedge for accounting purposes as well as other positions that can be demonstrated to reduce the risk of loss arising from the end-user's business activity.

Ultimately, the CSA cite with approval the definition of hedging accepted by the Committee on Payment and Settlement Systems (CPSS). Generally, the CPSS characterizes hedging as being intended to offset or reduce the risk related to fluctuations in the value of an underlying interest or a position, or to substitute a risk to one currency for a risk to another currency. Under the CPSS definition, the transaction or series of transactions also has to result in a high degree of negative correlation between changes in the value of the underlying interest or position being hedged and changes in the value of the derivatives with which the value of the underlying interests or positions is hedged. According to the CPSS, there must also be reasonable grounds to believe that the transaction no more than offsets the effect of price changes in the underlying interest or position being hedged.

This characterization of hedging, however, assumes that the risk to be hedged will always relate directly to an underlying position or interest. In doing so, the consultation paper ignores activities such as the purchasing of weather derivatives intended to mitigate against the risk of an inclement winter, but that would not directly correlate to an underlying value in frost or snow.

Notification to Regulators

While participants seeking to rely on the end-user exemption would not require formal approval by regulators, they would have to provide notice of an intention to rely on the exemption. This one-time notice would include basic information about the market participant and would only have to be updated if there was a material change in the information.

According to the CSA, the process to be followed by eligible end-users would include attaining approval by the end-user's board of directors of the business plan or strategy authorizing management to use OTC derivatives contracts as a risk management tool. The CSA are silent, however, on how this requirement would apply to non-corporations. The consultation paper also suggests that the business plan would have to be disclosed in order to allow regulators to determine whether there had been compliance with the exemption. According to the consultation paper, these requirements are intended to ensure that the implications of trading OTC derivatives and the implementation of a hedging strategy will be considered by the board and management.

Reporting and Recordkeeping

While end-users would not have to report individual trades to a regulator, the trades would still have to be reported to a trade repository. According to CSA Consultation Paper 91-402, for derivative transactions between non-financial intermediaries, the parties would have to select one of the counterparties to the transaction to be the reporting party.

Considering the breadth of OTC derivatives activity captured, the reporting obligation may prove problematic. For example, is it expected that the obligation to report would capture individuals entering into contracts to hedge against increasing electricity prices, or farmers hedging to protect again inclement weather?

Users of the exemption would also have to maintain records of all trading activity, a record of the board's approval of the use of OTC derivatives and records demonstrating the analysis completed to demonstrate satisfaction of all necessary requirements. The consultation paper, however, does not provide information regarding whether the regulator may inspect the records, or the length of time that such records would have to be maintained.

As stated above, the consultation paper, which includes specific questions for the consideration of commentators, is open for public comment until June 15.

FSB WG Reports on role of sec lending and repo in shadow banking markets

Stikeman Elliott LLP — Wed, 09 May 2012 08:09:50 -0500

Margaret Grottenthaler -

On April 27, the Financial Stability Board Workstream on Securities Lending and Repos (WS5) under the FSB Shadow Banking Task Force published an Interim Report documenting WS5’s progress to date. As someone trying to keep track of regulatory developments in these areas, I found this report to provide a very useful overview of the markets, their relationship with each other and the market issues that these activities raise and which may come in for further regulation in future. If you are new to this area, I would also recommend it as way to quickly bring yourself up to speed.

The market overview in Part 1 is a very high level description of the functions and participants in four segments of the market, namely securities lending, leveraged investment fund financing and securities borrowing, interdealer repo and repo financing. Some helpful charts describe the interrelationship between these segments of the market, and further detail on each of these segments can be found in Annex 1 of the Report.

Part 2 describes five key drivers in the markets, namely the (i) demand for repo by certain risk averse institutions (such as money market funds, entities reinvesting cash collateral from sec lending activities, banks, pension funds, insurers, securitization vehicles) as a near-substitute for money market instruments; (ii) securities-based financing needs of leveraged intermediaries; (iii) facilitation of hedge fund and other investment strategies involving leverage and short selling; (iv) increasing need for banks and broker-dealers to gain access to securities for the purpose of optimizing the collateralization of repos, securities loans and derivatives; and (v) seeking of additional returns by institutional investors through the fees earned on lending securities or in re-investing the cash collateral received or posting it as collateral in other activities, such as OTC derivatives.

Part 3 described the place of these markets in the shadow banking system and notes the FSB’s main focus will be on (i) borrowing through repo financing markets; (ii) maturity transformation and leverage; (iii) the chain of transactions through which cash proceeds from short sales are transferred; and (iv) collateral swaps.

Part 4 provides an overview of regulation in various jurisdictions. Areas of regulation include:

capital rules;
limits on rehypothecation that apply to dealers;
securities and pension regulatory requirements applicable to fund investments;
concentration limits;
restrictions on eligible counterparties for certain participants;
restrictions on the term or maturity of securities loans and repos (in Canada for example, for money market funds);
collateral guidelines (such as minimum collateral value, criteria for acceptable collateral based on such things as credit rating, currency, restrictions on rehypothecation by investment funds and insurance companies, restrictions on cash collateral reinvestment (eg in Canada for 81-102 funds)); and
disclosure requirements.

WS5 has identified in Part 5 of the report seven preliminary issues that could be considered to have financial stability implications that apply to some or all of the market segments.

Lack of transparency – can it be improved? One point made here is that there may be insufficient disclosure of the rehypothecation activities by prime brokers to hedge fund clients.
Potential for heightened procyclicality resulting from:

    a.Changing value of collateral securities.
    b.Haircuts.
    c.Collateral re-use and velocity (the length of the collateral re-use chain).
Other risks resulting from re-use of collateral, including increased interconnectedness between firms.
Market turmoil caused by collateral fire sales on default during times of market stress.
Potential risks arising from agent lender practices, particularly with respect to indemnities.
Performance of bank-like activities by reinvestors of cash collateral, exposing portfolios to credit and liquidity risk.
Insufficient rigour in collateral valuation and management.

OSC hosts meeting of international regulators regarding OTC derivatives

Stikeman Elliott LLP — Tue, 08 May 2012 10:30:35 -0500

On May 4, the Ontario Securities Commission released a statement regarding a meeting held in Toronto earlier this month and attended by various international regulatory agencies regarding the regulation of OTC derivatives. Various issues surrounding implementation were discussed, including transparency, margin for uncleared derivatives, coordination of clearing mandates, access to data in trade repositories, and cross border clearing house crisis management. Ultimately, the meeting's purpose was to provide a forum for discussion among the regulators as they work toward international harmonization of the regulatory requirements.

In addition to the OSC and Quebec's Autorité des marchés financiers, the meeting included representatives from the Australian Securities and Investments Commission, Brazil's Comissão de Valores Mobiliários, the European Commission and European Securities and Markets Authority, Hong Kong's Securities and Futures Commission, Japan's Financial Services Agency, the Monetary Authority of Singapore, the Swiss Financial Market Supervisory Authority, and the U.S. Commodity Futures Trading Commission and Securities and Exchange Commission.

Risk retention redux: the international context

Stikeman Elliott LLP — Mon, 07 May 2012 10:35:14 -0500

Michael Rumball -

In comparison to the ongoing regulatory onslaught in Europe and the United States, we in Canada appear to have gotten off pretty lightly and may even have felt that this was completely justifiable given our country’s performance and the high performance standards maintained by Canadian assets throughout the financial crisis. Although there is little we enjoy more than a good dose of smugness, if we review the regulatory surge in its international context, we may have second thoughts about what may await us.

In their July 2011 report entitled “Report On Asset Securitization Incentives”, the Joint Forum, consisting of the Basel Committee on Banking Supervision, the International Organization of Securities Commissions and the International Association of Insurance Supervisors, while recognizing the potential benefits of securitization, acknowledged that “reforms are necessary to address the incentive conflicts and misalignments highlighted during the crisis, which distorted risk transfer, increased structural complexity and opacity, and led to extreme leverage in the financial system. If such negative aspects of securitization are limited through rules and supervisory frameworks that better align incentives and promote appropriate disclosures, the foundation should be in place for a sustainable and responsible securitization market”.

The Report goes on to say, however, that, due to a number of factors, a meaningful recovery in the securitization market is not imminent. Apart from negative perceptions of securitization as an investment class and other macro-economic factors, one of the main factors hampering the recovery is identified as concerns about the timing and content of regulations across sectors. In designing and implementing these regulations, “authorities should strive for consistency across global markets and sectors, taking into consideration local market circumstances, underlying business models, and each jurisdiction’s legal system. Such consistency should help limit opportunities for cross-border and cross-sector regulatory arbitrage for products having the same economic profile, and should create a level-playing field for issuers as well as investors.”

Some of the Joint Forum’s main recommendations include increased transparency through disclosure, raising origination and underwriting practices and standards for assets that are securitized and developing measures requiring originators and securitizers to retain an appropriate level of risk in the securitization transaction.

These remarks echoed those of IOSCO’s Task Force on Unregulated Financial Markets and Products contained in their Implementation Report of March 2011. They cite an earlier report which made recommendations about regulatory approaches to be considered by financial markets regulators. The key recommendations concerning securitizations dealt with:

Disclosure,
Retention of economic interest,
Investor suitability, and
International coordination and regulatory cooperation.

A survey had been circulated to members to determine the level of implementation of the recommendations. It was found that most jurisdictions, including Canada, were either enhancing or considering enhancement of their disclosure requirements. Most had also endorsed the skin-in-the-game concept and “are expected to implement the requirement for original sponsors to retain long term economic exposure to securitization.” Apparently Canada, Hong Kong and Japan were the outliners and they were said to be “still considering the appropriateness of implementing this concept.”

Based on the survey responses, the task force made two further recommendations. First, it recommended that regulators encourage improvements in disclosure standards for private or wholesale offerings of securitized products. Second it recommended that regulators engage in international co-operation toward convergence of national regulations where desirable.

As may be recalled, last year’s CSA proposals did not include anything relating to risk retention, but merely asked whether such rules were necessary or appropriate. In recent discussions with OSC personnel engaged in the regulatory review, it was confirmed that they in fact are still considering these matters and are presently engaged in a review of whether or not risk retention rules should be mandated in the Canadian market. Most of all, they appear to be sensitive to the risk of regulatory arbitrage, the main remedy for which, if you will recall from the Joint Forum Report, is thought to be consistency of regulations across markets. Another consideration which may eventually have some bearing on this point involves the Dodd-Frank Act itself. There have been recent applications to the SEC by the Europeans and Australians to carve out from the application of the Dodd-Frank risk retention rules a broader exemption than the currently-proposed 10% safe harbour, in essence a blanket safe harbour for investments from jurisdictions which have functionally equivalent risk retention rules. If this proposal is accepted and if Canada does not implement such rules, Canadians would be comparatively disadvantaged in respect of financings to U.S. investors. Consequently, once the Dodd-Frank risk retention rules have been settled, I do not think we should be at all surprised if the CSA were to propose similar rules for the Canadian securitization market.

In any such deliberations, the CSA must take into account the differences between the Canadian and American markets. In their submission to the SEC, the Australian Securitization Forum set out characteristics of the Australian housing loan market that sets it apart from the U.S. market, characteristics which largely apply to the Canadian counterpart:

“First, all Australian housing loans are full recourse loans. Indeed, unlike the majority of housing loans in the US, if a borrower defaults on their home loan (or any other form of consumer financing), the borrower remains liable for the full amount of that loan, even if there are insufficient proceeds obtained from the enforcement and sale of a borrower’s home to repay the outstanding balance of the loan. The lender has the ability to bankrupt the borrower in order to recoup this residual amount which significantly reduces borrower speculation and strategic defaults. Second, Australian housing loans are not tax deductible, which encourages the borrower’s rapid repayment of such housing loan resulting in home equity creation. Third, the Australian housing loan market did not experience the “originate-to-distribute” phenomenon that encouraged imprudent mortgage originations in the US housing loan market, the consequence of which led to many of the defaults in US RMBS securitizations. The sponsors of securitisations of Australian housing loans are affiliated with the entities that originate the loans. Finally note the Australian residential mortgage loan-to-value ratios at origination have traditionally been relatively low. These factors have contributed to relatively low default rates in Australia and a tendency by Australian borrowers to make every effort to repay their housing loans. This objective, already accomplished in the Australian RMBS market, is the driving forces behind the QRM and other “qualified asset” exemptions from the risk retention requirements under the Proposed Rule.

Further, the U.S. housing bubble arose in circumstances which were to a significant degree created by the unique policies of U.S. governments. In Free Fall: How Government Policies Brought Down the Housing Market (Wallison and Pinto, April 2012), the authors describe how the government-imposed affordable housing goals of the GSEs (Fannie Mae and Freddie Mae), the Community Reinvestment Act, mortgage interest tax deductibility and other policies created artificial demand which also distorted the private mortgage market and fueled the mortgage asset bubble:

“If the government had not created a ten-year bubble by making massive investments in subprime and other low-quality mortgages, the private sector would never have been drawn into the subprime market in such a significant way. The weakening of financial institutions in the mortgage meltdown-and the resulting financial crisis-would never have occurred.”

In an earlier paper, Dodd-Frank and Housing Finance Reform: A Cure That’s Worse Than The Disease (April/May 2011), Wallison contended that the key flaw in the Dodd-Frank Act is its effort to control the quality of mortgages by imposing regulation and regulatory costs on lenders and securitizers. Wallison argued that it was demand for product, rather than supply, which was responsible for the quality of the mortgages that originators and securitizers produced. “But the notion that securitizers were responsible for the low quality of the mortgages they distributed led the framers of the Dodd-Frank Act to focus their regulations on securitizers, rather than on the quality of the mortgages themselves. The animating idea was that if securitizers were required to take risks through the risk-retention device, they would seek out and securitize higher-quality mortgages.” This focus will, he argued, have significant adverse effects on the market. The five percent risk retention amount, which cannot be hedged or sold, can only be carried by a securitizer that has a substantial balance sheet thus providing the largest banks with a significant advantage. In addition, various provisions of the Dodd-Frank are so complex that “there is virtually no way small originators can be expected to comply. They will be driven out of the origination business as effectively as small securitizers will be driven out of the securitizion business.”

Wallison suggested that mortgage lending and particularly securitization are by their natures susceptible to a gradual weakening of underwriting standards. “This is because housing prices frequently become a source of speculative investment, causing booms or busts. As housing prices rise in bubbles or booms, they tend to obscure delinquencies and defaults, and both lenders and investors come to believe that ‘this time is different’ or that continued rising prices will compensate for weak underwriting standards.” He concluded as follows:

“The housing finance plan outlined in the [Dodd-Frank Act] is largely unworkable. If it goes into effect, the risks it imposes on regulators will substantially raise mortgage costs, and the risk-retention and [Qualified Residential Mortgage] provisions will not have the intended effect of reducing the origination of subprime or other weak and risky mortgages. Moreover, the act will impede the development of a robust private securitization market and, to the extent that a private market develops, ensure that the largest banks continue to dominate it.”

In contrast to the flawed approach of the Dodd-Frank Act, Wallison instead proposed that the focus should be on the product entering the securitization chain: only prime mortgages (to be defined by statute) would be eligible for securitization, a simple measure which would prevent the deterioration of mortgage underwriting standards in the future. The elements of prime mortgages which he described are broadly similar to the eligibility criteria commonly applied in Canadian RMBS transactions. As an additional proxy for risk retention, consideration could also be given to allowing only seasoned mortgages to be securitized.

It should be apparent, however, that the implementation of any such proposal would have significant policy implications. While it may have a salutary stabilizing effect on the market for prime mortgages, it would almost certainly also result in a more restricted market for non-prime mortgages, at least in comparison to that which existed prior to the crisis, due to the consequential adverse effect on pricing and liquidity. As reported in this space on April 27, the introduction of the federal Jobs, Growth and Long-Term Prosperity Act, by restricting eligible covered bond collateral to loans having an LTV ratio of less than 80%, will result in driving potential funders to non-prime borrowers into the private RMBS securitization market. Implementation of the proposal described above would frustrate any such movement thereby having a significant and, perhaps, permanent adverse effect upon the ability of non-prime borrowers to obtain mortgage financing at all. Whether or not to significantly dampen, if not eliminate, the non-prime mortgage loan market is obviously a significant policy choice which must be carefully considered by all of the relevant regulatory and governmental participants and not simply the CSA.

Bank of Canada designates CDCS under Payment Clearing and Settlement Act

Stikeman Elliott LLP — Thu, 03 May 2012 13:54:33 -0500

Last week, Bank of Canada Governor Mark Carney designated the Canadian Derivatives Clearing Service (CDCS), operated by the Canadian Derivatives Clearing Corporation (CDCC), as subject to oversight under Part I of the Payment Clearing and Settlement Act. The designation is effective April 30, 2012. According to the TMX Group, of which the CDCC is part, the designation "reflects the importance of CDCC's fixed income central counterparty facility to the efficient, secure and reliable operation of a Canadian dollar core funding market."

CMHC and covered bonds: be careful what you wish for

Stikeman Elliott LLP — Fri, 27 Apr 2012 14:53:51 -0500

Doug Klaassen and Mark McElheran -

On April 26, 2012, the federal government introduced the Jobs, Growth and Long-Term Prosperity Act, the legislation to implement the March 29, 2012 federal budget. Buried in this legislation (over 420 pages!) are significant changes to both the Canada Mortgage and Housing Corporation (CMHC) and the law in respect of Canadian covered bonds that will have direct and material effects on our mortgage and securitization markets. Industry participants who initially asked for covered bond legislation must surely be regretting it.

CMHC is now (finally) under adult supervision. As a federal Crown corporation with over $540 billion of outstanding guarantees on Canadian housing (an amount equal to the entire Canadian federal debt), CMHC will now report to the Office of the Superintendent of Financial Institutions, instead of the Minister responsible for Human Resources and Skills Development Canada (believe it or not!). With CMHC approaching its current statutory guarantee cap of $600 billion (which has been raised 4 times in 8 years), something had to give.

However, the legislation does much more. It amends the National Housing Act to provide for a legislative covered bond framework, and prohibits federally regulated institutions (banks, trust companies and insurers) from issuing covered bonds outside this framework. In particular, these amendments generally provide for:

a covered bond registry to be established and maintained by CMHC that will identify registered issuers and registered programs
eligible covered bond collateral is restricted to uninsured loans made on the security of residential property located in Canada (but not more than four residential units)
insured mortgage loans (by any of CMHC, Canada Guaranty, Genworth or PMI) are not eligible covered bond collateral
loans having an LTV ratio in excess of 80% are not eligible covered bond collateral
statutory protection for the enforcement of covered bond contracts and covered bond collateral in the event of a registered issuer’s bankruptcy or insolvency

What does it all mean? The single most important feature of this legislation, by a country mile, is the exclusion of CMHC insured mortgages from future Canadian covered bond pools. Most Canadian banks use CMHC insured mortgages exclusively in their cover pools to effectively provide a sovereign guarantee on their bonds, thus reducing their cost of funds. This easy route to a relatively cheap funding source is now gone. If Canadian banks continue to issue covered bonds under the new framework, spreads will inevitably widen. Bondholders under new covered bond issuances will now be taking increased credit risk. Apart from pricing changes, issuing banks can also expect their credit and underwriting policies and procedures to come under somewhat closer scrutiny by bond purchasers.

For issuing banks, it is “back to the covered bond drawing board”. Money is fungible and the comparative cost of issuing covered bonds as a funding source will be reviewed, given the likelihood of wider spreads. Programs will have to be re-established (probably from scratch) to accommodate the new framework (resulting in “Canadian covered bonds 2.0”). The investor base may also change. Without the implicit sovereign guarantee, investments in new Canadian covered bonds will be based on much different considerations than in the past. Covered bonds will still provide attractive credit enhancement and should remain a cheaper source of funds than bank deposit notes, but will clearly cost more than before. For those banks that decide to revamp their programs, the rewards will likely be longer term. Building an international brand in the covered bond market based on the uninsured (but much deeper) Canadian mortgage market will take time and cost more in the short term, but should pay off in the end as it preserves an important alternative source of capital.

For the Canadian housing market and mortgage borrowers, the legislation is definitely bad news. Borrowing costs will rise as bank lenders will pay more for the funds used to provide these mortgages. As banks (and their bondholders) assume more of the credit risk (and losses) in these programs (and with CMHC approaching its own statutory guarantee limit), mortgage underwriting by the banks should become stricter and more selective (whether they acknowledge it or not). If so, fewer borrowers will qualify for the best priced loans and more borrowers on the fringes will be pushed out of the banks’ market.

The winners? Clearly not the banks. Arguably Canadian taxpayers, who are ultimately on the hook of CMHC’s mortgage guarantee program (and 90% of the private insurers’ guarantee obligations as well). But close runner-ups may be the Canadian private mortgage lenders (who are not federally regulated) and the Canadian securitization market. The funding advantage of Canadian banks in the mortgage market has eroded somewhat with these changes. It’s still not an even playing field but it is closer now than it was. With a larger potential market and higher spreads, these private lenders will need to raise capital somewhere and the (now dormant) private rmbs securitization market is a logical consideration. While it is still very early, this legislation should create more opportunities for growth and profit in these areas than we’ve seen in some time.

As a post-script, while the new covered bond legislative framework itself might be considered a theoretical positive, from an issuer perspective any substantive benefits are highly debatable. The existing Canadian covered bond structures work well, and there is no evidence that this new framework will actually perform “as advertised” and increase the size of the existing investor base and, as a result, bring in spreads. Who are these potential investors who have been waiting patiently on the sidelines for these legislative changes in order to invest in Canadian covered bonds? Our guess is that they don’t actually exist. From our perspective, this new legislative framework appears to provide a lot more regulation for no real benefit. From an issuer’s and investor’s perspective today, the entire exercise looks like a real step backward.

High regulatory tide

Stikeman Elliott LLP — Tue, 17 Apr 2012 13:47:30 -0500

Michael Rumball -

Over the past few months, while waiting for further regulatory developments in the securitization space, I have engaged in a self-taught course in finance and economics. Along with the plethora of tell-all’s detailing the main players in and the course of the late great financial crisis, or the “Great Recession” as it seems to be called in some sectors, among the titles perused were The Origin of Financial Crises (Cooper), Zombie Banks (Onarin), How Markets Fail(Cassidy), Extreme Money (Das), The Black Swan (Taleb), The Myth of the Rational Market (Fox), Fault Lines (Rajan), This Time Is Different (Reinhart & Rogoff), Endgame (Mauldin and Tepper) and Freefall (Stiglitz). While this has (predictably) failed to result in the development of any sort of expertise on my part, the main conclusion that I managed to draw from this reading is that there was no single cause of the financial crisis; rather it resulted from the interaction of a multitude of interconnected factors the significance of which is yet to be fully understood. Nevertheless, I will venture a few observations:

Financial crises and asset bubbles, far from being once-in-a-century, unpredictable catastrophes, in fact occur fairly frequently. Financial models based on market efficiency which exclude or minimize the likelihood of such events, and policies derived from such models, are of more than doubtful utility in any but the most benign environment. What this implies is not only that the crisis should have been expected and regulators should have been watching for signs of its approach and been ready with measures to address it, but more importantly, we should expect one again and there can be no excuse next time for any similar failure. (Regulators’ notes to selves: next time, let them fail!)
The 21^st century real estate bubble was particularly pernicious due, I believe, to the identity of the parties who had an interest in pumping it up and riding it. Certainly, these included the usual suspects: originators, brokers and dealers who, perhaps under the influence of rather perverse incentives, concentrated on the quantity, without due regard to the quality, of assets. (It has become clear that incentives do matter and crucially so. Reputation, trust and even the financial health of one’s customers, firm and country ultimately suffered as motivating factors in comparison to the lure of great personal wealth to be achieved at little or no personal risk.) But what made this bubble so huge was the co-opting of millions of mortgagors who had a direct and tangible interest in accelerating the housing market. Once the general public had bought in it would have taken a rare regulator or government to risk being identified as the one who “took away the punch bowl”.
The incentives which fueled the behavior which pumped the bubble were fostered in a relaxed regulatory and monetary environment highlighted by, among other things, (i) maintenance of artificially low interest rates, (ii) repeal of the Glass-Steagall Act which separated investment and commercial banks, (iii) relaxation of banks’ leverage requirements and (iv) decisions not to regulate derivatives or predatory lending practices. The concurrent introduction and extensive utilization of extremely complex instruments to effect MBS transactions had the effect of both camouflaging and multiplying the risks inherent therein. The value of ‘financial innovation’ has been greatly exaggerated and oversold. According to Reinhart and Rogoff, financial innovation is a variant of the regulatory liberalization process which in turn often precedes banking crises by simultaneously facilitating banks’ access to external credit and more risky lending practices at home: “indeed, it helped predict them”.
The most significant and damaging legacy of the crisis may be the resulting increased level of sovereign debt including but not limited to the cost of bailouts. Again, Reinhart and Rogoff: “Highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked”. Whether or not Keynesian stimulus spending to get out of a recession is the correct approach, the benefit of further stimulus spending when the economy is already over-leveraged surely merits further and perhaps different considerations.

The following is a quote from an article appearing in the January 19, 2007 edition of the London Times by Gerard Baker entitled “Welcome to the Great Moderation: Historians will marvel at the stability of our era”:

“Economists are debating the causes of the Great Moderation enthusiastically and, unusually, they are in broad agreement. Good policy has played a part: central banks have got much better at timing interest rate moves to smooth out the curves of economic progress. But the really important reason tells us much more about the best way to manage economies.

It is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle … The economies that took the most aggressive measures to free their markets reaped the biggest rewards.”

Well, we all know now how that turned out and in the aftermath of the crisis it was no surprise that the global regulatory forces, until then in full retreat, would once again be feeling their oats. Although they have certainly taken their time getting there, the regulatory landscape will soon (a relative term) be significantly altered. In addition to the Dodd-Frank proposals and its equivalents in most jurisdictions in the G20, revised Basel III measures will affect the incentives for banks to hold securitizations including new capital, liquidity and leverage requirements. Just in the last month there have also been announcements from OSFI, CMHC, Mark Carney, the new chairman of the Financial Stability Board, the governor of the Federal Reserve System and the German Bundesbank which could be construed as being in support of the broad proposition that regulators need to forge a set of macro-prudential tools which will allow them to “take away the punchbowl” from overheated credit markets. As far as I can determine, there is little reason to believe that ongoing resistance from the financial community is going to have any more effect upon the rising tide of regulatory change than did Canute’s command to the ocean.

One of the objections commonly raised by commentators on the proposed ABS rules, including myself, is that, by employing a one-size-fits all solution to problems that were associated with only certain sectors of the market, other sectors, specifically traditional ABS, have been unfairly caught in the net. In addition, the stigma which is still attached to the securitization industry generally is an ongoing impediment to the resuscitation of the market. Perhaps in recognition of the futility of attempting to stem the rising regulatory tide, certain industry participants appear to be trying a new tactic. A recent report on Reuters describes work by financial lobby groups on a new ‘quality label’ for certain high-quality ABS to be known as “Prime Collateralized Securities” or PCS. Apparently the idea is to “bring added quality, transparency and standardization to the market, with a goal of improving overall quality”. Banks are also hoping to persuade European regulators to include PCS among the assets they can use in their liquidity buffers. Under the currently proposed rules, securitization bonds, even those with the highest qualifications or with sovereign guarantee, are considered a completely illiquid asset for the calculation of the liquidity coverage ratio. The report says that “the project inspires both enthusiasm and nervousness among observers. One banker, speaking anonymously, expressed concern that it could be abused by banks to disguise toxic assets.” In order to address this concern, it is proposed that the PCS label would be granted by an “independent entity”. (If this all sounds vaguely familiar, just substitute ‘AAA’ for ‘PCS’ and ‘rating agencies’ for ‘independent entity’ and it should start to clear up.) Whether or not traditional ABS can be rescued from the fate which seems to await MBS and synthetic products is still in doubt. Simply rebranding them as PCS will not avoid the substantive issue of how the integrity of the brand, and thus investors, are to be protected.

CSA release consultation paper on derivatives end-user exemption

Stikeman Elliott LLP — Tue, 17 Apr 2012 10:25:40 -0500

The Canadian Securities Administrators (CSA) last week released Consultation Paper 91-405 Derivatives: End-User Exemption, the latest in a series of eight papers intended to build on the high-level proposals found in Consultation Paper 91-401 released in November 2010.

As is suggested by its title, the paper considers an end-user exemption to OTC derivatives regulation. Ultimately, an end-user exemption is intended to avoid discouraging the use of OTC derivatives by market participants that are not in the business of derivatives trading but that trade in OTC derivatives to mitigate commercial risks related to their business. As such, according to the CSA, an end-user exemption must address this specific segment of the market without undermining the broad objective of increased regulation of OTC derivatives contracts.

Thus the paper, among other things, sets out the CSA Derivatives Committee's position on the application of an end-user exemption, the criteria for determining eligibility, and what an eligible end-user would need to do in order to rely on the exemption.

The consultation paper, which includes specific questions for the consideration of commentators, is open for public comment until June 15.

Ontario Government Announces Intention to Amend Cash Collateral Law

Stikeman Elliott LLP — Tue, 27 Mar 2012 17:00:38 -0500

Margaret Grottenthaler -

The Ontario Government released its 2012 budget this afternoon and, in doing so, stated its intention to amend the cash collateral provisions of the Personal Property Securities Act to facilitate the granting of first priority security interests in cash. These changes will not be in this budget bill, but hopefully will be introduced as a bill in the fall.

Specifically, the Government, according to its budget summary, intends to:

propose legislative changes...to Ontario’s personal property security legislation, to make it easier for businesses and financial institutions to provide or obtain a first-priority security interest in cash collateral. If enacted, these changes would support a competitive Ontario business climate, help meet Canada’s international financial reform commitments and mitigate financial system risk related to over-the-counter derivatives.

Presumably this budget statement is intended to clearly convey to the market the government’s commitment to making these important changes. As I discussed in a post last month, the Ontario Personal Property Security Law Sub-Committee of the Ontario Bar Association’s Business Law Section released a proposal earlier this year to amend the PPSA to deal more effectively with cash collateral. While the exact nature of the Government's amendments remain to be seen, the OBA subcommittee's recommended changes will be influential in developing the particular solution to give secured parties holding cash collateral the same degree of legal certainty as to their priority against other creditors that the Securities Transfer Act, 2006 provides to holders of securities as collateral.

IIROC republishes proposals to permit partial swap offset strategies

Stikeman Elliott LLP — Wed, 22 Feb 2012 16:49:46 -0500

On February 17, the Investment Industry Regulatory Organization of Canada (IIROC) republished proposed amendments to its Dealer Member Rules that would extend the current margin treatment on swap offsets to partial swap offsets. The proposals are intended to ensure that the capital requirements reflect the reduced position risk of partial swap offsets on interest rate and total performance swaps. The proposals, initially published in February 2009, now include housekeeping amendments to clarify the minimum margin requirements for unhedged interest rate and total performance swap positions.

Comments are being accepted on the proposed amendments until March 19, 2012. For more information, see IIROC Notice 12-0057.

OBA submission on cash collateral finalized

Stikeman Elliott LLP — Tue, 14 Feb 2012 14:22:31 -0500

Margaret Grottenthaler -

As I discussed in my post of January 4, the Ontario Personal Property Security Law Sub-Committee of the Ontario Bar Association’s Business Law Section has been working on a draft proposal over the last year to amend Ontario's personal property security legislation to deal more effectively with cash collateral. The OBA subcommittee's submission has now been finalized. The OBA highlights that the recommended changes will give secured parties holding cash collateral the same degree of legal certainty as to their priority against other creditors that the Securities Transfer Act, 2006 provides to holders of securities as collateral.

Hopefully the government will accept the recommendations and put these changes on the spring legislative agenda.

CSA release consultation paper on segregation and portability in OTC derivatives clearing

Stikeman Elliott LLP — Fri, 10 Feb 2012 15:39:11 -0500

The Canadian Securities Administrators released a consultation paper today intended to build on earlier proposals to construct a framework for the treatment of market participant collateral in centrally cleared OTC derivatives transactions. Specifically, the paper addresses the segregation of assets put forward as collateral for OTC derivatives transactions cleared through a central counterparty by customers that access the CCP indirectly through clearing members. The paper also addresses the transfer of customer collateral and customer positions upon the default or insolvency of the clearing member of a CCP.

According to the CSA, the paper's recommendations are intended to ensure that "CCPs clearing OTC derivatives possess adequate rules and infrastructure to facilitate the segregation and portability of collateral in a manner that provides market participants with appropriate protections". To that end, the paper recommends, among other things: (i) that clearing members be required to segregate customer collateral from their own proprietary assets and that the Complete Legal Segregation Model (whereby all customers' collateral is permitted to be held on an omnibus basis, but is recorded and attributed by both the CCP and clearing member to each customer based on their collateral advanced) be employed; (ii) that if CCPs or clearing members are permitted to reinvest posted customer collateral, investments should be restricted to instruments with minimal credit, market and liquidity risk; (iii) that CCPs should hold customer collateral at one or more supervised and regulated entities that have robust accounting practices, safekeeping procedures and internal controls; (iv) requiring CCPs to make the segregation and portability arrangements contained in their rules and policies available to the public in a clear and accessible manner; (v) that provincial market regulators enact rules requiring that every OTC derivatives CCP be structured to facilitate the portability of customer positions and collateral; and (vi) that parties to an uncleared OTC derivatives transaction be free to negotiate the level of segregation required for collateral.

The CSA is accepting public comment on the consultation paper, including with respect to the specific questions posed regarding its recommendations, until April 10, 2012.

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. For more information, see CSA Consultation Paper 91-404 Derivatives: Segregation and Portability in OTC Derivatives Clearing.

SE at ASF 2012

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

Mark McElheran -

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’.