Canadian Structured Finance Law

CASLA panel considers proposed developments in securities lending

Stikeman Elliott LLP — Thu, 09 May 2013 09:50:24 -0500

I spoke at the CASLA conference yesterday about the pending regulatory developments in Canada with respect to the early warning regime and changes to National Instrument 81-102 and prepared a short article on these changes. Previous items in this blog have covered these developments generally, but the paper focuses on the securities lending aspects of the proposed developments. Other materials from the conference will soon be posted on the CASLA website. This third annual conference organized by the Canadian Securities Lending Association was very well attended and extremely informative

Categories of registration and business triggers under CSA's proposed derivatives registration regime

Stikeman Elliott LLP — Fri, 03 May 2013 10:16:35 -0500

Margaret Grottenthaler and Sumeet Thind -

As we discussed last month, the Canadian Securities Administrators Derivatives Committee recently published Consultation Paper 91-407 Derivatives: Registration, which contains regulatory proposals specific to the implementation of a registration regime for derivatives market participants in Canada. Under the Paper’s proposals, the imposition of “derivative-appropriate” registration requirements would be based on the type of activity conducted by derivative market participants regardless of the nature of the underlying asset.

The Committee developed the proposals in light of Canada’s G20 commitments to improve the regulation and oversight of OTC derivatives markets and with consideration of derivatives registration regimes in the U.S. and Europe. While the Committee also considered the existing securities regulatory framework, the proposed business triggers for derivatives registration and the requirements applicable to registrants would be substantially different than those applicable in the securities context, given the differences in the purpose of trading, the existence of risk-amplifying leverage in most categories of derivatives and the complexity of derivatives contracts.

Ultimately, the Paper discusses minimum requirements for each category of registration, namely those of (i) derivatives dealers; (ii) derivatives advisers; and (iii) large derivative participants.

Categories of registration

Derivatives Dealer

Persons carrying on the business of trading in derivatives or holding themselves out to be carrying on that business would be required to register as a derivatives dealer in each province and territory in which they conducted such business.

While the Ontario Securities Act contains a list of activities that are considered a “trade”, the Paper clarifies that certain activities such as the termination, material amendment, assignment, novation or disposition of a derivatives contract will also be considered a derivatives trade. Therefore, after inception, a derivatives trade will be considered to occur whenever there is a material change to the terms of the derivatives contract.

Further, a number of factors, largely derived from securities case law and regulatory decisions, would be considered when determining if a person is in the business of trading derivatives. The non-exhaustive list of factors that may suggest a business purpose or activity would include (i) the provision of services relating to the intermediation of trades between counterparties to derivative contracts; (ii) acting as a market maker by taking both a long and a short position in a derivative or category of derivatives; (iii) trading with the intention of being remunerated or compensated; (iv) contacting anyone to solicit derivatives trades; (v) providing clearing services to third parties; and (vi) engaging in activities similar to a derivatives dealer.

Under the factors provided, as with the analogous securities dealing registration requirements, dealing in derivatives does not have to be an entity’s primary business to be captured by the triggers proposed by the Committee.

Derivatives Adviser

Persons that carry on the business of advising others in relation to derivatives, or who hold themselves out to be in that business in any Canadian jurisdiction, would be required to register as a derivatives adviser. A person would be considered to be "advising" in relation to derivatives whenever they provide another person with any advice or direction relating to trading derivatives, including providing advice in relation to (i) the management of a portfolio of derivatives; (ii) the use of derivatives as an investment strategy or part of an investment strategy; and (iii) hedging strategies.

In determining whether a person was “in the business” of providing derivatives advice, a number of factors would be relevant, including whether the person was (i) directly or indirectly providing advice about derivatives trading activity with repetition, regularity or continuity; (ii) being, or expecting to be, remunerated or compensated; (iii) contacting anyone to solicit business relating to advising in derivatives trades; and (iv) engaging in activities similar to a derivatives adviser, including promoting a trading strategy or offering software that provided a client with guidance relating to the purchase of derivatives.

Large Derivatives Participant (LDPs)

According to the Paper, entities holding a “substantial position” in a derivative or category of derivatives, and whose exposure to derivatives markets results in counterparty exposure that could pose a serious risk to financial markets, should also be subject to registration. Registration under the LDP category would not be based on a business trigger. While the Paper does not provide one, the Committee recommended that consultation proceed to establish a threshold for this category of registrant.

Individual Representatives

The Committee also recommended that the new regime include the registration of individuals (i) where they are the ultimate designated person (such as the president or CEO), chief compliance officer or chief risk officer of a registrant; (ii) as a representative of a derivatives adviser where they provide clients with advice relating to derivatives, whether or not the client is a qualified party; and (iii) as a representative of a derivatives dealer where they provide services relating to trading to clients, whether or not the client is a qualified party.

Exemptions from requirement to register

The Paper proposes a number of exemptions from the registration requirement.

Dealers Providing Advice

A person registered as a derivatives dealer would be exempt from the obligation to register as a derivatives adviser where (i) the obligation to register as a derivatives adviser resulted solely from the provision of advice in relation to a derivatives trade; (ii) the advice was not in relation to an account over which that the derivatives dealer has discretionary trading authority; (iii) the derivatives dealer did not charge a fee for the provision of the advice; and (iv) the derivatives dealer had complied with all of the registration requirements applicable to a derivatives adviser.

Governments

The Paper proposes that government entities not be subject to an obligation to register. Further, crown corporations whose obligations were fully guaranteed by the applicable government would be exempted from registration as an LDP or as a derivatives dealer where their trading activity was restricted to trading as a counterparty with qualified persons. However, a crown corporation would not be exempt from a requirement to register where it (i) triggered registration as a derivatives adviser by advising entities that were not governments or crown corporations; (ii) triggered registration as a derivatives dealer and intermediated trades on behalf of clients that were not governments or crown corporations; or (iii) triggered registration as a derivatives dealer and trades with counterparties that were non-qualified parties.

Clearing Agencies

The Paper recommends that recognized clearing agencies (or those exempt from recognition) not be subject to a requirement to register as a derivatives dealer, derivatives adviser or a LDP where the obligation to register resulted solely from carrying on the ordinary business of a clearing agency. (There is already or will be a separate registration regime for clearers.)

Transactions with Affiliated Entities

The Committee recommends that the registration requirements not apply to persons based on dealing or advising activities solely with affiliates.

Uniform definition of derivative across CSA jurisdictions is needed

The Paper does not define what would constitute a “derivative” for the purposes of registration and, at present, no single, harmonized definition of derivatives products exists across CSA members. Legislation in many Canadian jurisdictions contemplates that an instrument meeting the general definition of derivative may be treated as a derivative, a security, or excluded in whole or in part from regulation. Moreover, some jurisdictions include derivatives in the definition of security, while other jurisdictions maintain a separate definition altogether.

In CSA Consultation Paper 91-301 relating to reporting to trade repositories, the Committee introduced the “Scope Rule” to resolve conflicts that arise when a contract or instrument meets both the definition of "derivative" and "security" under applicable provincial legislation. The Scope Rule purports to classify which contracts or instruments are to be regulated as derivatives, securities or outside the scope of both derivatives and securities legislation altogether. In this respect, Consultation Paper 91-301 can provide some insight as to which types of instruments the Committee may recommend to be considered derivatives for the purposes of triggering registration as a derivatives dealer or adviser. In any event, the Committee will need to induce a high degree of regulatory coordination, both within Canada and between Canadian and global authorities, to ensure that a uniform and consistent definition is applied under the new registration regime. The CSA received a number of comments on certain issues with that definition in the context of the proposed trade reporting rule.

Absence of de minimus exemption

Unlike under Dodd-Frank, there is no proposed exemption for a person that engages in a de minimus level of swap transactions. The amount of business an entity engages in will be factored into the determination of whether the entity is carrying on business as a dealer.

Potential for compliance with two registration regimes

Persons dealing in or advising on derivatives that have securities as their underlying asset will be subject to registration under both the proposed derivatives regime and the existing securities regime. The Committee states that all types of derivatives should be subject to a consistent regime regardless of whether or not such derivatives have securities as their underlying asset. The Paper thus recommends that steps be taken in order to streamline the registration process to ensure that such persons can be registered and regulated in an efficient manner.

Investment funds to be regulated by the securities registration regime

According to the Committee, investment fund managers should continue to be registered under the securities registration regime regardless of the nature of the investment fund or the assets held by the fund. However, an advisor to a fund who triggers the obligations outlined above would be subject to the derivatives advisor registration requirements, in addition to the securities registration regime, if such an adviser provided advice in relation to both derivatives and securities.

Third party regulators to carry out regulatory functions

The Paper proposes that the CSA rely on third-party regulators to carry out some or all of the regulatory functions of the new registration regime. The Committee has stated that these regulators could include foreign regulators and regulators responsible for regulating financial institutions (i.e. OFSI) and self-regulatory organizations (i.e. IIROC).

Specifically, under the Consultation Paper, foreign derivatives dealers and advisers subject to an equivalent registration regime in their home jurisdiction could be exempted from certain registration requirements, such as with respect to financial and solvency obligations, compliance and risk management systems and entity-level record keeping. In such cases, however, registration in the applicable Canadian jurisdictions would still be required.

Although substituted compliance or equivalence may resolve conflicts and duplication, it may not be the most appropriate solution in every case. As the OTC Derivatives Regulator Group recently noted, close consultation by the CSA with the relevant authorities in other jurisdictions will be necessary to ensure the efficacy of substituted compliance. The details regarding how substituted compliance will work in practice is expected to be discussed in future meetings of international regulators.

Ontario reaffirms plan to amend PPSA re cash collateral

Stikeman Elliott LLP — Thu, 02 May 2013 17:00:34 -0500

Margaret Grottenthaler -

According to the Ontario budget released today, personal property security legislation will be amended to make it easier for businesses and financial institutions to provide or obtain first‐priority security interests in cash collateral. Sound familiar? That’s what the last budget said. But the budget does recognize that significant progress has been made on the government's proposals, and key aspects will be finalized pursuant to further consultations.

I think we can read into that that the government generally accepts the approach of the OBA’s Personal Property Security Law sub-committee proposing a perfection by control regime for cash, but that there are some details to work out. We all know the devil is in the details though!

SEC releases proposals on cross-border swaps

Stikeman Elliott LLP — Thu, 02 May 2013 12:53:00 -0500

Margaret Grottenthaler -

On May 1, the U.S. Securities and Exchange Commission proposed new rules and interpretive guidance setting out how the comprehensive regime for regulating swaps introduced by Dodd-Frank would apply to cross-border activities involving securities based swaps regulated by the SEC.

Of interest to Canadian market participants is that the SEC's proposals adopt a substituted compliance approach and provide some detail around how that will work in cross-border transactions. It proposes a regime whereby there may be substituted compliance accepted for some purposes (e.g. registration) but not others (e.g. trade reporting) depending on the SEC’s position with respect to regulation of that area in the substituted jurisdiction.

The SEC is accepting public comments on the proposed rules, including potential alternatives, for 90 days after publication in the Federal Register. For more information, see SEC Release No. 34-69490.

EC releases report on G-20 progress on OTC derivatives regulation extra-territoriality issues

Stikeman Elliott LLP — Wed, 01 May 2013 13:47:06 -0500

The European Commission recently prepared a brief report of the OTC Derivatives Regulators Group that sets out the progress to date made among international regulators with regards to dealing with the extra-territorial aspects OTC derivatives regulation.

Specifically, the report considers such issues as (i) the scope of regulation and recognition, equivalence or substituted compliance for cross-border compliance; (ii) the bases for determinations of comparability of the applicable regime in a jurisdiction; (iii) the treatment of regulatory gaps; (iv) the understanding among regulators on the timing of new regulatory requirements; (v) the understanding on sharing of information and supervisory and enforcement cooperation; and (vi) data access.

The report also sets out the expected issues to be considered in the upcoming months, including with respect to identifying issues regarding the provision of information to trade repositories, as well as regulators' access to such trade repositories.

CSA release recommendations regarding derivatives registration regime

Stikeman Elliott LLP — Thu, 18 Apr 2013 16:05:05 -0500

The Canadian Securities Administrators today released the latest in a series of consultation papers considering the regulation of derivatives in Canada. Specifically, CSA Consultation Paper 91-407 considers the regulation of derivatives market participants through the implementation of a registration regime.

Under the recommended regime articulated by the paper, three categories of registration would be created, namely those of (i) derivatives dealers, being persons carrying on the business of trading in derivatives or holding themselves out to be carrying on that business; (ii) derivatives advisers, being those carrying on the business of advising others in respect of derivatives, or who hold themselves out to be in that business; and (iii) large derivative participants, being entities, other than derivatives dealers, that have a substantial aggregate derivatives exposure.

Those required to be registered under the proposed regime would then be subject to various requirements respecting such things as proficiency, solvency, honest dealing obligations, and gatekeeper and business conduct requirements in the case of derivatives dealers and advisers. Exemptions from registration requirements would also be available in certain circumstances. For example, clearing agencies would generally not have to register, and foreign derivatives advisers and dealers would be exempted from specific regulatory requirements where they are subject to equivalent requirements in their home jurisdictions.

The paper also recommends that registered entities that have clients or counterparties that rely on their advice be subject to additional registration requirements. Alternative proposals are considered where dealers are trading with non-qualified parties: one that would preclude dealers from entering into trades with counterparties that are non-qualified parties unless the counterparties receive advice from a registered derivatives adviser, and the second that would require that the dealer inform counterparties that are non-qualified that there is a conflict of interest.

According to the paper, if the first alternative is implemented, “representatives dealing with counterparties will not be required to be registered as all counterparties will either be qualified parties or will be represented by independent derivatives advisers.” In the case of the second alternative “a party entering into transactions with counterparties that are non-qualified parties will typically be considered to be in the business of trading derivatives unless that non-qualified party is represented by a derivatives dealer or adviser”. The CSA are seeking input on the appropriate definition of "qualified party". There is also a recommended exemption for crown corporations when dealing with qualified parties and not intermediating any trades.

Under the recommended proposals, an individual would have to register where the person is (i) the ultimate designated person, chief compliance officer or chief risk officer of the registrant; (ii) involved in providing clients with advice relating to derivatives; (iii) involved in providing trading services to clients as an intermediary to a trade; or (iv) involved in a trade with a counterparty that is a non-qualified party that is not represented by an independent derivatives adviser. The individual registration requirements would apply to frontline staff that deal with clients and those that manage or supervise such staff. Where individuals provide clients with advice, they would have to register whether or not the client was a qualified party.

The CSA are accepting comments on the consultation paper, including with respect to a number of specific questions regarding the paper's numerous recommendations, until June 17, 2013.

Reminder: May 1st deadline for compliance with business conduct rules under Dodd-Frank Act

Stikeman Elliott LLP — Thu, 18 Apr 2013 13:59:35 -0500

P. Jason Kroft, Jeff Hershenfield and Sumeet Thind -

Almost two years after the passage of the Dodd-Frank Act, the overhaul of the US derivatives market is rapidly shifting into the implementation phase. While most provisions of the Dodd-Frank Act are directed at US Swap Dealers (SDs) and Major Swap Participants (MSPs), some of the Dodd-Frank rules also affect Canadian counterparties that don't deal in or speculate with swaps but use swaps merely to hedge exposures in their business or investments (End-Users). By May 1, 2013, all End-Users must have provided their SDs with certain information and representations in order to enable SDs to comply with the Commodity Futures Trading Commission’s external business conduct rules (the Business Conduct Rules).

It is important to note that SDs will only continue offering and executing swaps with End-Users who have provided such information. As such, End-Users who have not already been contacted by their SD counterparties regarding this deadline may want to consider approaching the relevant SDs to discuss this matter, as these rules may have application for Canadian End-Users that engage in derivatives transactions with US Swap Dealers.

The Business Conduct Rules

The Business Conduct Rules generally attempt to enhance protections for swap counterparties of SDs and MSPs though due diligence, disclosure, fair dealing and anti-fraud requirements. In short, the Business Conduct Rules act like a customer protection regime for counterparties of SDs and MSPs. The rules require SDs and MSPs to apply a new “know-your-counterparty” process and collect certain information about their counterparties.

Under the Business Conduct Rules, SDs and MSPs will be subject to strict and detailed business conduct standards obligating them to undertake the following actions, among other things:

conduct due diligence on their counterparties to verify eligibility to trade (including eligible contract participant status);
refrain from engaging in abusive market practices;
provide disclosure of material information about the swap to their counterparties;
provide a daily mid-market mark for uncleared swaps;
inform their counterparties of their right to:
- clear a swap that is not required to be cleared;
- select the derivatives clearing organization through which a cleared swap is cleared; and
- request a scenario analysis and a daily mid-market mark for cleared swaps;
provide material information sufficient to allow the counterparty to assess the swap’s material risks, characteristics, incentives and conflicts of interests; and
when recommending a swap to a counterparty, make a determination as to the suitability of the swap for the counterparty based on reasonable diligence concerning the counterparty.

As a result, End-Users must complete the necessary amendments to their swap documentation and will be asked to provide certain information and additional representations before May 1, 2013 in order to enable SDs to comply with the new rules.

ISDA August 2012 DF Protocol Agreement

A current ISDA protocol provides a standardized process for SDs to collect know-your –counterparty information and confirm that clients are allowed to execute trades.

ISDA has launched the ISDA August 2012 DF Protocol (the Protocol), which provides for certain standardized amendments to existing ISDA documentation. The Protocol is designed to facilitate compliance with the CFTC's rules by supplementing existing master agreements or other written agreements relating to swaps. The Protocol consists of the following six main components:

The Protocol: The main structural document;
Adherence Letter: Evidences a party’s agreement to be bound by the Protocol;
Questionnaire: Allows a party to provide information about itself, make certain safe-harbour elections, and identify the counterparties with whom it is willing to apply DF Supplement provisions;
Addendum 1: Contains additional optional reps relevant to counterparties not completed when the Protocol was first launched;
DF Supplement: Contains representations, covenants, disclosures, acknowledgements and notifications related to the Covered Rules that counterparties may apply to their swap trading relationship; and
DF Terms Agreement: Allows parties to apply selected provisions of DF Supplement to their trading relationship in respect of swaps, whether or not they have an existing master swap agreement.

In order to accept the terms of the Protocol, a party must: (1) sign and deliver the Adherence Letter, (2) pay an adherence fee of $500 and (3) complete the Questionnaire. Once these steps have been completed, the existing master agreements between the parties would deemed to be amended based upon the election made in the Questionnaires. Practically speaking, it will take some time to adhere and complete the Questionnaire, so End-Users should being the process as soon as possible if they have not already done so.

The Protocol procedure is not required by the CFTC's rules; rather, the Protocol is a mechanism put in place by ISDA to assist swap dealers and major swap participants in complying with their responsibilities under the CFTC's Dodd-Frank regulations. It is possible for a SD or MSP, on the one hand, and an End-User counterparty, on the other, to execute a bilateral amendment agreement that addresses the Dodd-Frank requirements instead of adopting the Protocol, and some SDs and MSPs have circulated such agreements to certain of their clients.

The deadline for compliance with the Business Conduct Rules is May 1, 2013. By this date, End-users will need to have either adhered to the Protocol or entered into a bilateral agreement by that date. The Protocol is unlike previous protocol processes that ISDA has employed and End-Users will want to carefully review the documentation associated with the protocol to understand its implications.

OSC releases draft statement of priorities for 2013-2014

Stikeman Elliott LLP — Thu, 04 Apr 2013 14:50:14 -0500

The Ontario Securities Commission today released its draft statement of priorities for the upcoming year, which sets out the actions the OSC intends to take during fiscal 2013-2014.

Key OSC priorities include: (i) expanding outreach to the investor community; (ii) publishing an initial assessment of the application of the best interest standard for advisers and dealers; (iii) providing investors with more effective and meaningful disclosure through publication of a rule requiring advisers and dealers to provide cost disclosure and performance reporting in client statements, as well as publication of final proposals for delivery of Fund Facts; (iv) advancing the discussion on mutual fund fees and fees for other investment products; (v) considering the regulatory issues posed by new capital-raising strategies such as crowdfunding; (vi) examining issues associated with the evolution of markets, including electronic trading and the impact of the order protection rule; (vii) intensifying the enforcement program and targeting the most serious harm; and (viii) developing rules for an OTC derivatives regulatory framework, including for clearing and trade reporting.

The OSC is accepting comments on its draft statement until June 3, 2013. For more information, see OSC Notice 11-768.

OSC asks investment fund managers to consider budget changes to forward agreements

Stikeman Elliott LLP — Thu, 04 Apr 2013 09:09:09 -0500

The Ontario Securities Commission yesterday released a staff notice setting out the issues that investment fund managers should consider in light of the recent federal budget. Specifically, under proposed amendments to the Income Tax Act, distributions to unitholders of a mutual fund resulting from partial or full settlements of a forward agreement will now be treated as income distributions.

According to OSC Staff, investment fund managers should consider the effects of these changes on their funds, specifically with respect to disclosure obligations, especially if the income conversion feature is an "essential" aspect of the fund. The notice also suggests that managers consider whether to cap affected funds to new and additional investments, whether changes to funds' investment objectives and strategies will be needed, and whether funds need to be restructured, reorganized or terminated.

For more information, see OSC Staff Notice 81-719.

CSA propose amendments to early warning reporting regime to enhance disclosure

Stikeman Elliott LLP — Tue, 02 Apr 2013 08:33:04 -0500

Amanda Linett and Ruth Elnekave -

The Canadian Securities Administrators (CSA) have published for comment proposed amendments to the reporting threshold, triggers and related disclosure requirements under Canada’s early warning reporting (EWR) regime intended to “provide greater transparency about significant holdings of issuers’ securities”. These amendments could affect the conduct of certain equity derivative transactions and related hedging activities.

Currently, under the EWR regime, prescribed disclosure is required by any investor that acquires beneficial ownership of or the power to exercise control or direction over 10% or more of any class of a public company’s voting or equity securities. Additional reporting is required on each incremental acquisition of 2% as well as a change in a material fact contained in an earlier report. Certain eligible institutional investors (EIIs) can take advantage of relaxed timing requirements for early warning reporting under the alternative monthly reporting (AMR) regime.

As discussed in an earlier post on our securities blog, the key changes under the proposals include:

decreasing the reporting threshold from 10% to 5%;
clarifying that the reporting trigger applies to a 2% decrease in ownership and a decrease below the new 5% threshold;
expanding the reporting trigger to capture certain types of derivatives that affect an investor’s total economic return in an issuer;
expanding the scope of required disclosure to include a broader range of interests and require more specific disclosure; and
making the AMR regime unavailable to investors who actively engage with shareholders on certain corporate matters.

Reporting Threshold and Timing

The proposals provide for a decrease in the EWR threshold from the current 10% to 5% under both the EWR and AMR regimes. Under the “moratorium” provisions of the EWR regime, which prohibit further purchases until one full business day after a report is filed, the cooling-off period would apply at the new 5% threshold.

Under the amendments, the required news release (which is currently required to be filed “promptly”) would have to be filed promptly but no later than the opening of trading one business day following a reportable transaction, and the timing for filing the report would not change. Timing for reporting under the AMR regime would also not change.

The CSA’s stated objectives for lowering the EWR threshold to 5% include addressing the increased prevalence of shareholder activism and the ability of 5% shareholders to influence control of an issuer, requisition a shareholders’ meeting or affect the outcome of significant transactions or the constitution of the issuer’s board of directors, as well as harmonizing Canada’s standard with that of several major foreign jurisdictions. In this regard, a 5% threshold would be consistent with jurisdictions including the United States, the United Kingdom and Australia.

Hidden Ownership and Empty Voting

The CSA are concerned that the current EWR requirements may not capture investors using “hidden ownership” strategies whereby derivatives are used to accumulate substantial economic positions in public companies on an undisclosed basis, and this interest is then potentially converted into voting securities in time to exercise a vote. They have similar concerns with “empty voting” strategies whereby investors may utilize derivatives or securities lending arrangements to hold voting rights in respect of an issuer and possibly influence the outcome of a shareholder vote without having an equivalent economic stake in the issuer.

To broaden the scope of the EWR and AMR regimes to include such interests, the proposals would provide that for purposes of the reporting trigger, a person would be deemed to have acquired beneficial ownership or the power to exercise control or direction where they acquire beneficial ownership, control or direction over an “equity equivalent derivative.” This term is proposed to be defined as a derivative which is referenced to or derived from a voting or equity security of an issuer and which provides the holder, directly or indirectly, with an economic interest that is substantially equivalent to the economic interest associated with beneficial ownership of the security. The CSA note that an equity equivalent derivative would generally include only cash-settled equity total return swaps, contracts for difference or substantially similar derivatives, but not partial-exposure derivatives such as options and collars that provide the investor with only limited exposure to the reference securities.

Securities Lending Arrangements

Under securities lending arrangements, the lender disposes of its securities and the borrower acquires the securities, generally along with the right to vote the securities for the duration of the loan. The CSA state that the current regime requires the lender and borrower to consider the securities disposed of and acquired, respectively, in determining whether the reporting requirement has been triggered, notwithstanding the duration of the loan.

In light of the proposed requirement to report 2% decreases in ownership, the reporting requirement would specifically apply to lenders under securities lending arrangements, absent available exemptions. However, the proposals would exempt the lender (but not the borrower) from reporting securities lent out as a disposition under a “specified securities lending arrangement” that provides an unrestricted ability for the lender to recall the securities (or identical securities) before a meeting of securityholders and/or requires the borrower to vote the securities in accordance with the lender’s instructions. Further, in order to provide the market increased transparency about the use of these arrangements, it is also proposed that securities lending arrangements in effect at the time of a reportable transaction be disclosed, even if such transaction did not involve the securities lending arrangement.

Changes to Scope of Alternative Monthly Reporting

Under the current regime, an investor that qualifies as an EII is entitled to utilize the AMR regime, which only requires them to report an increase in ownership of 2.5% or more within 10 days of the end of the month in which the threshold is crossed and does not require a press release or a trading moratorium. The EII can generally remain in the regime unless and until it makes or proposes or intends to make or propose a transaction in which the EII would obtain a controlling interest in the reporting issuer. Upon this happening, they are required to issue a press release and immediately begin reporting in the EWR regime. However, unlike in some other jurisdictions, a decision to become “active” does not give rise to the same result. In other words, an investor is currently able to accumulate a substantial interest in an issuer’s shares even after deciding to become “active” and is only required to disclose the share purchases 10 days after the end of the month in which they occur. The CSA are concerned that this is inconsistent with the policy rationale underlying the relaxed timing requirements of the AMR regime, being the availability of the regime only to an EII with a passive intent.

Under the proposals, the AMR regime would not be available for an EII that solicits, or intends to solicit, proxies from securityholders of a reporting issuer on matters relating to the election of directors of the reporting issuer or a reorganization, amalgamation, merger, arrangement or similar corporate action involving the securities of the reporting issuer. In practice, the proposals would mean that upon initiating or intending to initiate such activist activity and thus becoming disqualified from accessing the AMR regime, activist investors would be required to immediately file a news release and within two business days file an early warning report containing the proposed enhanced level of disclosure, thereby making their intentions known to the market significantly earlier than under the AMR regime.

Enhanced Early Warning Report Disclosure

To address the CSA’s concerns with respect to the use of boilerplate language and inadequate disclosure regarding the purpose of reportable transactions, the proposals include new EWR forms under both the EWR and AMR regimes with more detailed disclosure requirements as well as instructions on the type of disclosure expected by the CSA. Key additions include disclosure of:

“deemed” control (triggered by the ownership of, or control or direction over, an equity equivalent derivative) of the relevant securities by the reporting investor, either alone or together with a joint actor;
the material terms of any existing “related financial instrument”¹ (including an equity equivalent derivative) involving the class of security subject to the early warning report, as well as the number of underlying securities if the reportable transaction involved an equity equivalent derivative;
the material terms of any existing securities lending arrangement (including duration and recall provisions), as well as whether the reportable transaction involved such arrangement. In the case of a reporting investor that is a lender under any existing specified securities lending arrangement, the material terms thereof;
whether the consideration paid or received represents a premium to the market price, and a description of method of acquisition or disposition if other than by purchase or sale;
any plans of the reporting investor or a joint actor which relate to a list of specified actions, including an extraordinary corporate transaction involving the issuer, changes in the issuer’s board or management, material changes in the issuer’s business or corporate structure and any intention to solicit proxies from the issuer’s securityholders; and
specified information in respect of any agreements or understandings between the reporting investor and a joint actor and any other person with respect to any securities of the issuer, whether or not such agreement relates to the reportable transaction.

Implications of the Proposed Changes

Reducing the reporting threshold from 10% to 5% could benefit potential offerors by identifying more broadly (and earlier in the process) securityholders that hold 5% of the target securities (including for purposes of securing lock-up agreements), and allow issuers more time to defend against a potential offeror or activist shareholder. On the other hand, pre-bid accumulation transactions may be hindered, and potential acquirors would need to consider, in some cases, the earlier disclosure to the market of their intentions.
Narrowing the scope of the AMR regime would, in certain cases, eliminate the cover offered to activist EIIs under the AMR regime and make their intentions known to issuers they are targeting substantially earlier.
The proposed changes may result in increased compliance costs, largely to investment managers, mutual funds and other institutional investors, and we would expect the volume of reporting under the EWR regime to increase significantly, particularly among public mutual funds which are subject to a higher portfolio concentration limit of 10% and are not eligible to report under the AMR regime.
Investors who use derivatives and securities lending as a risk management tool in connection with short and/or long positions in an issuer’s stock and who may not have previously been caught may have to publicly disclose holdings, and at the lower 5% threshold.
Investors would need to plan early in connection with stock accumulations, consider carefully whether a particular proposed transaction is caught by the EWR regime, and generally assess possible implications in connection with reportable transactions such as the potential dissemination of investment strategies.

The CSA’s proposals would amend the early warning reporting requirements currently found in Multilateral Instrument 62-104 Take-Over Bids and Issuer Bids, National Policy 62-203 Take-Over Bids and Issuer Bids and National Instrument 62-103 The Early Warning System and Related Take-Over Bid and Insider Reporting Issues. As MI 62-104 applies in all provinces and territories except Ontario, the CSA also expect that amendments to the Securities Act (Ontario) and Ontario Securities Commission Rule 62-504 Take-Over Bids and Issuer Bids will be proposed to give effect to the CSA’s proposals in Ontario.

The CSA’s request for comments, which specifically poses a number of questions regarding the thresholds and proposals, is open until June 12, 2013.

We remind readers that June 12, 2013 is also the deadline for submission of comments to the CSA in connection with their proposed new rule to regulate poison pills and to the Autorité des marchés financiers in Québec in connection with its consultation paper advocating a broader overhaul of the take-over bid regime, as discussed in our earlier post.

^1"related financial instrument” has the meaning given to that term in National Instrument 55-104 Insider Reporting Requirements and Exemptions and generally refers to an agreement or understanding that affects, directly or indirectly, the relevant person or company’s economic interest in a security of the reporting issuer or economic exposure to the reporting issuer.

CSA propose operational requirements for closed-end funds

Stikeman Elliott LLP — Thu, 28 Mar 2013 13:48:48 -0500

Joel Binder -

The Canadian Securities Administrators yesterday proposed changes to National Instrument 81-102 Mutual Funds (NI 81-102) that would introduce core operational requirements for publicly offered non-redeemable investment funds generally analogous to the requirements applicable to mutual funds.

This "Phase 2" of the CSA's Modernization of Investment Fund Product Regulation Project involves significant changes to the regulation of non-redeemable investment funds. Key elements of the proposals include (i) extending the application of investment restrictions under NI 81-102 to non-redeemable investment funds; (ii) imposing a 10% concentration restriction (with fixed portfolio ETFs permitted to exceed this limit); (iii) limiting investments in physical commodities and specified derivatives with underlying interests in physical commodities; (iv) imposing a cash borrowing limit of up to 30% of NAV (and permitting borrowing only from "Canadian financial institutions" and limiting borrowing activities to cash borrowing only); and (v)limiting investments in mortgages to guaranteed mortgages only. In addition, dilutive securities issuances would be prohibited with specific prohibitions on the ability to issue warrants or similar securities.

Non-redeemable investment funds would also be prohibited from investing in other non-redeemable investment funds (fund-of-funds) while a larger portion of fund assets would be permitted to be invested in illiquid assets. The proposals would also impose a framework for securities lending, repurchases and reverse repurchases similar to that applicable to mutual funds and introduce new requirements for the manager to bear the organizational costs of launching a new fund, as well as prescribe requirements governing conflicts of interest and circumstances where regulatory and/or securityholder approval will be required for certain fund or management changes. Changes are also proposed to requirements for custodianship of assets, redemptions and prescribed prospectus disclosure.

While the proposals relate principally to non-redeemable investment funds, some of the proposed amendments would also impact mutual funds.

The proposals form part of Phase 2 of the CSA's investment fund modernization project. Phase 1 of the project, which codified exemptive relief frequently granted in recognition of market and product developments, came into force in 2012. The purpose of Phase 2 is to "identify and address any market efficiency, investor protection or fairness issues" arising as a result of the different regulatory regimes that apply to different types of funds.

Included in Phase 2 is the creation of a more comprehensive alternative fund framework through amendments to National Instrument 81-104 Commodity Pools, which would apply to mutual funds and non-redeemable investment funds that use alternative investment strategies not be permitted under NI 81-102. While specific amendments to NI 81-104 are not proposed at this time, the CSA have raised a number of questions on which feedback is requested.

The CSA is accepting comments on their proposals until June 25, 2013.

The Fairness Budget: Was it fair to all?

Stikeman Elliott LLP — Wed, 27 Mar 2013 09:40:09 -0500

Doug Klaassen, Jason Kroft and Mark McElheran -

The Canadian federal budget delivered on March 21, 2013 had a couple of very significant highlights (or perhaps more appropriately characterized as lowlights) for the Canadian structured finance industry.

Restrictions on Use of Government-Backed Mortgage Insurance

Buried on page 141 of the Conservative budget (did they honestly think no one would notice?), under the heading “Reinforcing the Housing Financing Framework”, is a very short one-page summary of new measures intended to “increase market discipline in residential mortgage lending and reduce taxpayer exposure to the housing sector”.

While the heading promises all good things, “market discipline” is a two-edged sword, particularly in the Canadian housing market where homeowners, home builders, banks and other financial institutions have long become accustomed to living off of CMHC’s generous mortgage insurance program. What the Conservative budget proposes is nothing short of the most dramatic overhaul of the Canadian housing and residential mortgage markets that we have seen or are likely to see in our lifetimes. It makes everything that the Conservative government has done to CMHC and covered bonds over the past 18 months, at the direction of Mr Flaherty, look like mere tinkering in comparison. That is, if they actually do it….

So what’s changing? The principles are there, but the details are not. These principles boil down to the following. First, CMHC will “gradually” limit portfolio insurance of low ratio mortgages to those mortgages that will be held in securitization programs sponsored by CMHC. While the announcement is ambiguous, this appears to cover portfolio insurance issued by CMHC and other private mortgage insurers backed by the federal government, such as Genworth MI Canada. Second, the Conservative Government proposes to limit any “taxpayer-backed insured mortgage”, whether high ratio or low ratio, from being used as collateral in any securitization, other than a CMHC sponsored securitization.

What does it mean? The devil is always in the details, but instead of “reinforcing” the Canadian housing markets, these proposals actually propose the opposite - a substantial withdrawal of CMHC and other “taypayer-backed mortgage insurers” from the Canadian mortgage market. Low ratio mortgages are a substantial part of this market and the “gradual” withdrawal of portfolio insurance (whether provided by CMHC or others) will, just as gradually but directly, increase the costs of borrowing, as the lenders take on more default risk and seek “market” compensation for it. Perhaps Mr. Flaherty didn’t think that Canadian financial institutions really understood the message he has been trying to send about low interest rates, but there is no mistaking it this time.

Unfortunately, Canadian homeowners will bear the full cost of these changes. There should be no doubt that, regardless of the political spin, that Mr. Flaherty wants this result. Whatever a mortgage lender’s cost of its capital actually is, you can be sure that it will be passed on directly to mortgage borrowers. And there is no question that these changes will result in an increased cost of capital for Canadian mortgage lenders. CMHC has mortgage insurance exposure of roughly $550 billion. CMHC’s Canada Housing Trust securitization program (CHT) accounts for no more than $215 billion of this exposure. The remainder of CMHC’s insured loans are held by Canadian financial institutions or in their historical covered bond programs. Financial institutions rely heavily on CMHC insured mortgages because it reduces their cost of capital and makes their assets more liquid. Even at current leverage levels for our financial institutions, insured mortgage lending has always been a very easy, risk free way for Canadian financial institutions to make a profit. Once low ratio mortgage insurance is limited to a level where it becomes a real market constraint (that is, assuming that “gradual” implementation of these changes does not mean “not in my lifetime”), more selective mortgage lending and higher interest rates in the Canadian residential market is inevitable. So, Canadian homeowners should start saving because they will be paying more.

The same thing will happen on high ratio mortgage loans. As CMHC’s mandate is cut back and its concentration of high ratio loans grows, its overall insurance portfolio will look smaller but a lot riskier than it is today. Inevitably, it will raise insurance premiums to cover this increase risk. Again, Canadian homeowners will pay.

Where are the market reinforcements? The Conservative budget proposes to “reinforce” the Canadian housing framework. What will fill the gaps left behind as CMHC retreats from this market? Over what period of time will these proposals be implemented? Other private mortgage insurers are currently in the market, but most of the larger players are still “taxpayer-backed” to the tune of 90%. Will they even be allowed to fill in the gaps or will they be similarly constrained by the proposals? We simply don’t know, as the budget is painfully thin on details. Will private (non-CMHC) securitization conduits be able to fill the gaps? Contrary to the budget commentary, this private conduit market (unlike the Banks) is a shadow of what it was pre-recession. If they are able to step into the gap, the capital will be provided on market terms that are higher than those in the current insured conduit programs.

As a final note, sceptics will find it hard to take these proposals too seriously, given the widespread potential political impact of these changes and the wiggle room that the budget commentary provides. The reality is that, whether you rent or own a house in Canada, these proposals matter to a very broad swath of the Canadian electorate, and when it comes right down to it, no one is going to want to pay the piper if real pain is involved.

Forward Agreement Transactions

The recent budget may significantly reduce one financial product transaction type that had become prominent in the Canadian capital markets, described as character conversion transactions in Budget 2013.

Many closed end funds and other structured products in the market have utilized derivative contracts in order to convert what would otherwise be an ordinary income inclusion into a capital gain. This was essentially achieved by entering into an agreement (typically a forward agreement) to buy or sell capital property at a specified future date. The purchase or sale price of the capital property under the forward agreement would not be based on the performance of the capital property (such as a basket of listed common shares) over the time period of the forward agreement but by reference to the performance of a reference portfolio of investments. This portfolio would typically contain investments that if held directly would produce ordinary income.

To ensure the appropriate tax treatment of the derivative-based return on a forward agreement, Budget 2013 proposes to treat this return as being distinct from the disposition of a capital property that is purchased or sold under the forward agreement that has a duration of more than 180 days. Generally, if a forward agreement is used and the value of the capital property to be delivered is based entirely on the performance of a reference portfolio, the taxpayer would have an income inclusion equal to the amount by which the fair market value of the property delivered when the forward agreement is settled exceeds the amount paid for the capital property. In addition, Budget 2013 proposes that the income described above be added to the adjusted cost base of the capital property to prevent double tax on the sale by the taxpayer of such capital property.

Practically speaking, a mutual fund that has entered into a forward agreement with a counterparty and receives capital property on the settlement of the forward agreement will have an income inclusion equal to the difference between the fair market value of such property and the amount paid for the property under the forward agreement. The mutual fund will then distribute that income, along with any returns of capital, to its unitholders. As a result of the proposals in Budget 2013, distributions to unitholders resulting from partial or full settlements of a forward agreement by a mutual fund that previously would have been capital gains distributions will now be income distributions. Return of capital distributions are not affected.

These measures will apply to forward agreements entered into on or after budget day. They will also apply to a forward agreement entered into before budget day if the term of the agreement is extended on or after budget day. If the offering of new units of an existing mutual fund with a forward agreement results in the extension of the forward agreement, such forward agreement will be subject to the Budget 2013 proposals.

IIROC proposes expanded oversight of debt securities trading

Stikeman Elliott LLP — Fri, 22 Feb 2013 14:21:16 -0500

On February 20, IIROC released for comment a proposed new rule that would require reporting of debt transactions.

Specifically, under the proposal, each IIROC dealer member would have to report on a post-trade basis all debt market transactions executed by the dealer member, including those executed on an Alternative Trading System (ATS) or through an Inter-Dealer Bond Broker (IDBB).

For these purposes, “debt securities” would mean any securities that provide the holder with a legal right, in specified circumstances, to demand payment of the amount owing, including in respect of a debtor-creditor relationship. The fact that a security was issued in another country or denominated in a foreign currency would not disqualify it from being a debt security and the term would include securities with short-term maturities or mandatory tender periods such as commercial paper and floating rate notes as well as traditional notes and bonds. Debt securities, however, would not include derivative products that are not securities (e.g., futures contracts, interest-rate swaps).

The stated purpose of the proposed rule is to facilitate the creation of a database of transaction information that would enable IIROC to carry out its responsibilities with respect to surveillance and oversight of over-the-counter (OTC) debt market trading. IIROC acknowledges in its notice that historically, the standards for regulatory reporting for debt instruments have been quite different from those for equities, whereas equities traded on exchanges and ATSs with a high degree of transparency, including real-time order-and trade data as well as complete post-trade (historical) information. IIROC notes, however, that as market structure has continued to evolve, significant changes have increased the amount of information available in real time or post-trade for such securities and many regulators have also begun to implement more stringent requirements for trade reporting.

IIROC expects to publish the final version of the rule in Q4 of this year. The new requirements would then be phased in over time, with implementation beginning between six and 12 months after publication of the final rule.

IIROC is accepting comments on the proposals until May 22, 2013. For more information, see IIROC Notice 13-0058.

SCC Decision in Re Indalex not good news for cash collateral arrangements

Stikeman Elliott LLP — Fri, 08 Feb 2013 14:40:55 -0500

Margaret Grottenthaler -

Swaps market participants accepting cash collateral from an entity subject to Ontario provincial pension benefits legislation will want to consider the implications of this decision on their priority. Unfortunately and somewhat surprisingly, the Supreme Court of Canada did not overturn a key part of the Ontario Court of Appeal’s decision. Four of seven judges agreed that the deemed trust under the Pension Benefits Act (Ontario) (PBA) and, consequently, the statutory priority conferred on that trust under the Personal Property Security Act (PPSA) applied to the statutory liabilities of an employer to fund certain deficiency payments that arise during the wind-up of a pension plan. The secured creditor with an assignment of the DIP financing ultimately prevailed in its appeal on the basis of other arguments and was found to take priority over the deemed trust, but it did not prevail on this fundamental issue regarding the liabilities covered by the deemed trust.

In our blog post on the Court of Appeal decision we addressed whether the decision had a negative effect on credit support provided for derivatives transactions and other securities financing transactions, such as securities loans, repo and margin loans. As stated in that post, there is potential for the deemed trust to take priority over cash collateral accounts where Ontario law alone governs priority, because the PPSA gives the deemed trust priority with respect to “accounts”, and cash collateral arrangements are characterized as “accounts”. The priority and deemed trust applies not only to wind-up deficiencies, but also other amounts the employer owes to the pension fund (e.g. delinquent current service costs and remittances on behalf of employees). As a practical matter, the other liabilities subject to the deemed trust tend to be in a less significant amount and, consequently, they get paid from the assets readily available to the insolvency representative if they are in arrears. The wind-up deficiency amount, however, can be extremely large with respect to defined benefit plans, and essentially unascertainable until wind-up occurs. This is what makes the decision particularly concerning. There is no legal requirement to share the pain of the deemed trust among secured creditors, so the most readily accessible assets tend to fund the liability. The deemed trust beneficiaries may be looking further afield, however, when it comes to the deficiency liability and a nice healthy pool of cash collateral may look very attractive. Swap providers may not have the same influence in insolvency proceedings as the employer’s lending syndicate to force the employer into bankruptcy (where the deemed trust is clearly subordinated to secured creditors). I’ll first briefly review the parts of the decision that are relevant to the cash collateral issue. I will then tell you why I think it might affect priority for cash collateral (but not securities collateral) and offer some recommendations for dealing with this issue.

The Decision

Insolvent Indalex Canada commenced a proceeding under the Companies’ Creditors Arrangement Act (CCAA). Essentially it was a sale of the business as a going concern (what’s called a liquidating CCAA) and the dispute was over part of the sale proceeds. A debtor-in-possession financing was put in place, which was guaranteed by a related US company. The sale proceeds were not sufficient to repay the DIP lenders so the guarantor paid out on the guarantee and became subrogated to the rights of the DIP Lenders. By the terms of the court order the DIP loan had priority over “all other security interests, trusts, liens, charges and encumbrances, statutory or otherwise”.

There were two pension plans involved, one for the company executives and one for the salaried employees. The case revolved around whether a portion of the sale proceeds equal to the unfunded pension liability belonged to the pension funds, based on a statutory deemed trust under the PBA or an equitable constructive trust, or to the holder of the DIP loan, based on the priority conferred on the DIP loan by the court order.

Employers have a statutory obligation to make certain payments into a pension plan. There are three deemed trust provisions in the Ontario pension legislation; one for amounts collected from employees that were to be contributed but weren’t, one for unpaid current service costs and one for amounts accrued to the date of the wind up but not yet due under the plan or regulations. The latter deemed trust only arises on a wind-up of the plan. The case related to this third type of deemed trust. An employer must pay (over a five year period) amounts in addition to the current service costs if there are insufficient assets to cover the value of the pension benefits (deficiency liability). The amount can depend on certain elections made after wind-up by the employees and can change over time based on changes in underlying actuarial and other assumptions. The question was whether the amounts that became payable by the employer over the period extending beyond the wind-up date for this deficiency liability were “accrued” obligations at the date of wind-up or not. The executive plan was not in the process of being wound-up so no deemed trust under the PBA arose or it.

Helpfully the SCC confirmed that the deemed trust only arose where a wind-up order was made in relation to the plan and the majority found that a constructive trust over the employer’s assets was not an appropriate remedy for any breach of fiduciary duty on the part of the employer. The salaried plan was in the process of being wound up before commencement of the proceeding so the court did consider the deemed trust issue with respect to that plan.

The deemed trust provision is in section 57(4) of the PBA. Where a pension plan is wound up, it deems the employer to hold in trust an amount “of money” equal to “employer contributions accrued to the date of the wind-up but not yet due under the plan or regulations”. The PPSA provides that the PBA deemed trusts have priority over a security interest in “accounts” and “inventory”. Because of the reference to “accrued” liabilities, the majority of the SCC judges (4 of 7) agreed with the Court of Appeal that it included all the liabilities, including the unfunded deficiency liability that would otherwise be paid over the period following the wind-up. One can easily criticize the majority’s interpretation of the PBA, but what would be the point! What is positive news, however, is that unlike the rather incoherent approach in the Court of Appeal reasoning, the majority made it clear they were relying on the priority granted by the PPSA and not simply on the creation of the deemed trust.

Justice Deschamp (with whom Moldaver J. agreed), before dealing with the issue of priority of the DIP charge, addressed the issue of whether the PPSA priority for the deemed trust would apply in a CCAA proceeding. She first considered the argument that the PBA deemed trust did not apply in a CCAA proceeding because the priorities must be determined under the federal insolvency scheme, which does not include provincial deemed trusts. There is a disappointing lack of analysis on this point by the court. Deschamp J. noted that in order to avoid a “race to liquidation under the BIA. Courts will favour an interpretation of the CCAA that affords creditors analogous entitlements.” She then stated, apparently to contrary effect, that this does not mean that courts may read bankruptcy priorities into the CCAA at will.

Provincial legislation defines the priorities to which creditors are entitled until that legislation is ousted by Parliament. Parliament did not expressly apply all bankruptcy priorities either to CCAA proceedings or to proposals under the BIA. Although creditors of a corporation that is attempting to reorganize may bargain in the shadow of their bankruptcy entitlements, those entitlements remain only shadows until bankruptcy occurs.

Deschamps J. concluded that the PBA and PPSA priorities continue to apply in CCAA proceedings, subject to the doctrine of federal paramountcy.

The case then focused on whether the DIP financing charge primed the deemed trust on the basis of the federal paramountcy doctrine. The court was unanimous in its decision that the DIP charge did prevail. It is not entirely clear how much of Deschamps J.’s analysis with respect to the survival of PBA and PPSA priorities in a CCAA proceeding was adopted by the other justices. While Cromwell J. (giving the judgment for two others) seems to adopt these paragraphs of Deschamps J.’s analysis, he does so in a very cryptic fashion.

What this reasoning suggests is that the deemed trust on the basis of the super-priority conferred by the PPSA would prevail over all other secured creditors with an interest in accounts or inventory outside of a CCAA or BIA proceeding and in a CCAA proceeding as well, unless the federal paramountcy doctrine could be invoked. This, however, was an issue that was not before the court and which none of the judges were expressly considering. They were focused on the priority of the DIP charge.

Collateral for Derivatives

In a typical credit support arrangement for derivatives, the collateral is securities or cash. Securities are delivered through the book entry system to the secured party (or transferee in the case of a title transfer arrangement) and in Securities Transfer Act terms, the secured party becomes the entitlement holder. Cash is also typically transferred directly to the account of the secured party. Cash collateral is an “account” in PPSA terms so the question is whether the deemed trust’s priority over accounts could apply to that cash collateral account. Based on that other questionable SCC decision in Caisse Drummond even absolute transfer and set-off arrangements with respect to cash may be characterized as security interests subject to statutory priorities.

Doesn’t apply to securities or securities accounts. An important point to note is that priority for this deemed trust (or others) would not extend to securities, securities entitlements or securities accounts or other forms of collateral such as precious metals, and futures contracts. The statutory priority for the deemed trust conferred by the PPSA applies only over “accounts” and “inventory” and their proceeds, and investment property is specifically excluded from the definition of “account”. The Securities Transfer Act also protects a purchaser for value (which would include a secured party under a Credit Support Annex) from adverse claims of which it has no notice and as an entitlement holder, secured parties should not be subject to these provincial law claims that arise after the transfers.

(There is also a statutory lien under the PBA (not discussed in the case) for the same amounts, but the same STA protection against adverse claims would apply in favour of a secured creditor with control.)

Deemed trust may not apply to cash collateral accounts. The PBA deemed trust requires the employer to hold “money” in trust for the beneficiaries. The PPSA priority only applies if the deemed trust itself attaches to the assets in the first place. This suggests that the contemplated assets are ones that the employer has a property interest in. If the account is itself a cash collateral account and the account debtor is the secured party, then any money the employer will realize from that account is only the net amount after payment of the secured obligation. In other words, a flawed asset analysis and right of set off may prevail in this circumstance. If funds are wired to a secured creditor for its own account (even if intended as a collateral arrangement), then the funds are no longer property that the employer can hold for itself or anyone else. The property which the employer has is the rights against the secured party with respect to the cash collateral account and those rights are limited by the credit support agreement. While this argument may be attractive, there is no assurance it would prevail.

In CCAA proceedings protections for cash collateral for eligible financial contracts may prevail. The CCAA provides that no order made in the proceeding can have the effect of subordinating financial collateral for an eligible financial contract. If a DIP charge can defeat a deemed trust but a DIP charge cannot defeat financial collateral for an eligible financial contract, it logically should follow that it would be inconsistent with the CCAA for the deemed trust to prevail over the cash collateral arrangement if it was securing derivatives exposures or securities financing arrangements. Of course, this does not help with priorities outside of insolvency.

Payment Clearing and Settlement Act may help. Where the PCSA applies, it also provides for enforceability of credit support arrangements involving cash collateral securing eligible financial contracts, which may also create a conflict between federal law and the PPSA super-priority. The PCSA says that a party to an eligible financial contract may deal with its financial collateral. This is a reflection of the policy (based on concerns about systemic risk in the financial system) that laws, including insolvency laws, should not interfere with these rights. While it overrides insolvency laws, it is not restricted in its application to insolvency laws. It could be considered as a paramount federal law. It only applies, however, where the agreement is between two financial institutions (as defined) or between a participant in a clearing house and its customer with respect to the cleared transactions.

Windup only. The deemed trust only arises on wind-up of the plan. Wind-up very often occurs after an insolvency proceeding has already commenced. By that time, a derivatives counterparty, not being subject to the normal insolvency stays, will have realized on its cash (or securities collateral) and, therefore, the deemed trust cannot attach to that property for that reason alone. In other words, collateral holders should not sit on their rights.

To be clear, the Indalex reasoning would not apply to federally regulated pension plans such as those provided by banks for their employees or under provincial legislation. While the federal and other provincial legislation provide for deemed trusts, the priority of those trusts is not clearly given priority by a provision similar to s.30(7) of the PPSA.

Some Recommendations

I continue to believe that parties should use the ISDA English law Transfer Annex CSA or amend the NY Form of CSA to provide for title transfer of cash where that is possible. While there is no assurance it will defeat the problematic Caisse Drummond analysis, there is certainly a good basis for that position. If the set-off is effective, the only property the deemed trust could attach to is the excess collateral value.

If you are taking cash collateral, it would be prudent to determine whether a counterparty has a defined benefit pension plan, to monitor its funding status and to include a termination event triggered by any step taken by the employer or regulator to wind-up the plan.

Where possible, hold cash collateral outside of Ontario in a jurisdiction that would not apply Ontario law to priority issues. If the collateral is held outside of Canada by a non-Canadian entity (which is often the case), the deemed trust claimants would have to assert the claim in a foreign jurisdiction. That may be a tough case to make in a foreign court, especially in jurisdictions like the U.S., which apply the law of the depositary intermediary to priority issues.

At the end of the day, there is a risk that this statutory deemed trust could take priority over cash collateral accounts. Hopefully the Ontario legislature will accept the strong recommendation of the OBA PPSL Committee as part of its cash collateral proposal to clarify that section 30(7) does not apply to cash collateral accounts over which a secured party has control. Industry participants may want to take this opportunity to communicate to the government the importance of this point and generally of moving forward quickly with its promise to make the cash collateral amendments as soon as we have a working Legislature again in Ontario. If the law is not clarified secured creditors may not have confidence that they prime this deemed trust when dealing with entities subject to the PBA with defined benefit plans. There is no point in implementing reform designed to reduce systemic risk (requiring collateral for uncleared swaps for example) if it ends up creating more of it or limits the access of Ontario entities to important swaps markets.

Proposals for the regulation of shadow banking

Stikeman Elliott LLP — Mon, 04 Feb 2013 12:42:20 -0500

Michael Rumball -

Much of the blame for the recent financial crisis has been attributed to the shadow banking system. This paper explores the development of that system, its role in the financial crisis and the subsequent proposals for its regulation. Click here for the full text of the article.

OSFI provides update on OTC derivatives markets reform

Stikeman Elliott LLP — Fri, 25 Jan 2013 11:33:33 -0500

The Office of the Superintendent of Financial Institutions Canada (OSFI) yesterday released a progress update with respect to the implementation of G-20 reforms for OTC derivatives markets.

According to OSFI, federally-regulated deposit-taking institutions can expect updates to various guidelines, including the Derivatives Best Practices Guideline (B-7), during 2013 in response to international regulatory convergence. OSFI also notes that central clearing principles and other changes to bilateral counterparty risk management will be reflected in Guideline B-7. Meanwhile, while capital requirements for large bank-to-bank and bank-to-shadow bank exposures in OTC derivatives markets have been increased with the recent updates to OSFI's Capital Adequacy Requirements guideline, additional capital requirements for the risk of credit valuation adjustments to derivatives are being delayed until January 2014.

OSFI's initiatives in this area complements the work currently being undertaken by the Canadian Securities Administrators towards fulfilling its G-20 commitments to regulate OTC derivatives markets.

ASC issues new OTC derivatives order

Stikeman Elliott LLP — Wed, 23 Jan 2013 15:00:33 -0500

Keith Chatwin -

On December 31, 2012, the Alberta Securities Commission replaced Blanket Order 91-503 with Blanket Order 91-505 Over-the-Counter Derivatives.

As we discussed in an earlier post, an initial version of Rule 91-505 was published in February 2011, with a revised rule proposed in October 2012. As discussed at the time, the revised proposal reintroduced the concept of “qualified parties” and created an exemption from the prospectus and registration requirements for all over-the-counter OTC derivatives (included in the definition of “futures” in the Alberta Securities Act) contracts where each party is a qualified party, subject to the potential for incremental future requirements as may be imposed as a result of the CSA’s ongoing initiatives relating to trade reporting, clearing and other associated matters in relation to derivatives.

The final Blanket Order is consistent with the form of the October proposal.

CSA publishes model rules on trade repositories, derivatives data reporting and the determination of derivatives

Stikeman Elliott LLP — Fri, 21 Dec 2012 14:13:29 -0500

William A. Scott -

On December 6, 2012 the OTC Derivatives Committee of the Canadian Securities Administrators (the Committee) published for interim guidance and comment CSA Staff Consultation Paper 91-301. This is a noteworthy step in the efforts by provincial securities regulators to fulfill Canada’s G-20 commitments to regulate OTC derivatives.

The paper sets out two model provincial rules and accompanying model explanatory guidance pertaining to, firstly, trade repositories and derivatives data reporting (the TR Rule) and, secondly, the determination of products which will be treated as derivatives for purposes of the TR Rule (the Scope Rule). The Committee sets out the implementation process, stating that once comments on the model rules have been considered, they may be modified and then each Canadian jurisdiction will need to publish for comment its own rules, explanatory guidance and appendices with appropriate local modifications. The Committee recognizes that this may result in some differences in the final rules from jurisdiction to jurisdiction, but their stated intention is that the substance of the rules be the same across all jurisdictions and that market participants in derivatives products receive the same treatment throughout Canada.

The TR Rule and Scope Rule are drafted on the basis of the Ontario Securities Act which contains framework provisions for the regulation of the derivatives market, including the activities of trade repositories. The implementation process is complicated by the fact that not all existing securities legislation currently provides an appropriate framework to implement such rules. In the case of Alberta and British Columbia, New Brunswick, Nova Scotia and Saskatchewan, existing securities legislation will need to be amended. In Manitoba and Ontario, only OTC derivatives will be subject to those province’s rules, since exchange-traded contracts are currently subject to their respective Commodity Futures Acts. In Quebec, certain provisions of the Scope Rule would not be applicable as they are already covered by the Quebec Derivatives Act. In addition, since the rules will be implemented on a jurisdiction-by-jurisdiction basis, the timing of their coming into force in various jurisdictions may vary.

The TR Rule reflects proposals contained in CSA’s Consultation Paper 91-402 –Derivatives: Trade Repositories which was released on June 23, 2011. The TR Rule covers two areas: (1) the requirements trade repositories must meet to be designated or recognized by provincial regulators as acceptable entities to which market participants may report their trades, and (2) the reporting obligations of derivatives market participants themselves. The Committee envisages that exemptions from certain requirements may be available for foreign trade repositories that are subject to comparable regulatory regimes in other jurisdictions. In keeping with the objective of harmonizing such legislation with regimes elsewhere, the TR Rule broadly follows the approach taken by the CFTC in Part 49 of its regulations relating to swap data repositories and the international standards set out in Principles for financial market infrastructures published by CPSS and IOSCO.

The TR Rule sets out detailed requirements for an entity to qualify as a designated or recognized trade repository. These focus on, among other things, governance, risk management procedures and record-keeping. In the case of foreign trade repositories, the requirements include providing access to their books and records to Canadian regulators and submitting to the jurisdiction of the Canadian courts. The TR Rule stipulates who is required to report and sets out in its appendix detailed requirements regarding what information is to be reported.

The Scope Rule provides a gloss on the broad definition of “derivative” in the Ontario Securities Act and aims to narrow the range of products that are to be treated as derivatives subject to derivatives data reporting obligations under the TR Rule. The Scope Rule will initially apply for purposes of the TR Rule but, in order to provide flexibility, it may be amended as necessary to apply to other model rules as they are promulgated. The Committee notes that the interpretative guidance provided in the Scope Rule is not intended to alter the guidance provided in existing instruments, for example OSC Staff Notice 91-702 relating to contracts for differences offered in the retail markets.

The Scope Rule sets out several sub-rules to determine whether a product is a “derivative” for purposes of the TR Rule. The first sub-rule lists a variety of derivatives (excluded derivatives) which are to be excluded from the definition of “derivative” appearing in applicable legislation, including transactions which are:

regulated by gaming control legislation;
insurance or annuity contract issued by licensed insurers in Canada;
spot market contracts or instruments for the purchase and sale of currencies or physical commodities which, subject to limited exceptions, involve physical settlement only; and
evidences of deposit issued by banks, cooperatives, credit unions, caisse populaires or loan and trust corporations.

The explanatory guidance also states that the Committee consider that there are other instruments, such as contracts or instruments which, while not expressly excluded, should not be considered “derivatives” if they are entered into for consumer, business or non-profit purposes that do not include investment, speculation or hedging.

The second sub-rule provides that all investment contracts and over-the-counter options (to the extent that they are not excluded derivatives referred to above) that are derivatives and that are otherwise securities solely by reason of falling under the relevant securities act definitions of “investment contract” or “option”, are prescribed not to be securities. The explanatory guidance indicates that OTC foreign exchange contracts and contracts for differences would fall into this category. Physically-settled OTC options over securities would also be covered provided they are not compensation or financing options referred to below:

The third sub-rule provides that all contracts or instruments (other than any contract or instrument to which the first and second sub-rules above apply) that are securities and are otherwise derivatives are prescribed not to be derivatives for purposes of the TR Rule. This is intended to cover structured notes, ABS, exchange-traded notes and warrants which are to be treated as securities, even if they contain an embedded derivative.

Finally, all contracts or instruments that would otherwise be derivatives (other than any contract or instrument to which any of the above sub-rules apply) are prescribed not to be a derivative if such contract or instrument is used by an issuer or an affiliate of an issuer solely to compensate an employee or service provider or as a financing instrument, and its underlying interest is a share or stock of that issuer or its affiliate.

While those familiar with the nuances of the distribution of legislative powers in Canada will understand why this multi-step approach to implementing a pan-Canadian regulatory regime is being taken, it will no doubt strike observers from the derivatives world outside of Canada as surprisingly complicated and cumbersome. Moreover, the potential for variances between the applicable rules in jurisdictions within Canada, although a boon to lawyers practicing in this area, will likely result in some continued inefficiency in the market (although perhaps less than that caused by the existing patchwork regulatory regime).

The introduction to CP 91-301 indicates that the model rules approach will address existing regulation in other areas (such as the regulation of financial institutions). It remains to be seen how these provincial rules will be integrated into the existing federal regime governing the derivatives activities of Canadian banks, which represent the vast majority of the market.

CP 91-301 will be open for comment until February 4, 2013. The Committee notes that it is looking for specific feedback on section 40(2) of the TR Rule which exempts from reporting requirement transactions in relation to physical commodities if the local counterparty is not a dealer or adviser and has less than $500,000 aggregate notional value, without netting, of outstanding transactions at the time of the transaction, including the additional notional value related to the transaction in question.

IIROC describes expectations regarding sale of PPNs

Stikeman Elliott LLP — Wed, 19 Dec 2012 16:25:53 -0500

The Investment Industry Regulatory Organization of Canada yesterday released a guidance note setting out its expectations regarding application of know your client and suitability obligations to dealings in principal protected notes (PPNs) by IIROC dealer members. The guidance follows publication of a CSA staff notice (excluding Quebec) this past August that described the CSA's expectations that deposit-taking institutions will use registered dealers and individuals to distribute all PPNs that are not “Specified PPNs,” being those with a term of five years or less.

IIROC Dealer Member Rule 18.14 allows registered representatives and investment representatives to engage in another gainful occupation provided certain conditions are met, effectively permitting dual employment with the investment dealer and an affiliated financial institution. According to IIROC, the sale of PPNs by such a dually employed individual could create client confusion as to which entity the client is dealing with (the financial institution or the IIROC dealer) and would result in the application of know your client and suitability protections dependent on the distribution channel.

Consequently, IIROC states that all sales of PPNs by an IIROC registered individual must be transacted solely in their capacity as an employee or agent of the dealer member. IIROC also expects that all dealers will have policies and procedures to give this expectation effect and to ensure adequate supervision and compliance oversight. For more information, see IIROC Notice 12-0384.

Bill C-45 amending PCSA and CDIC now in force

Stikeman Elliott LLP — Mon, 17 Dec 2012 14:55:22 -0500

On December 14, Bill C-45, designed to implement certain measures of Budget 2012, cleared the Senate and was given Royal Assent.

As we've discussed in previous blog posts, the Bill amends the Payment Clearing and Settlement Act and Canada Deposit Insurance Corporation Act to support central clearing of OTC derivatives, enhance federal powers to deal with insolvent deposit taking institutions and introduce a new temporary stay on eligible financial contracts when an order incorporating a bridge institution is made.

The relevant provisions came into force on the date of Royal Assent.