In January 2015, the Staff of the Canadian Securities Administrators (the “CSAs”)8 issued notice 44-305, “Structured Notes Distributed Under the Shelf Prospectus System.” The notice sets forth the CSA’s views relating to a number of key issues arising in connection with structured notes under the Canadian shelf prospectus system.9
In general, the notice provides guidance for public offerings into Canada as to:
- disclosure issues in offering documents;
- post-issuance disclosure considerations to investors; and
- the CSA’s filing process to “pre-clear” the offering documents for new structures.
In this article, we address a number of ways in which the CSA guidance compares to recent guidance from U.S. regulators.10
Fees, Pricing and Estimated Value
Disclosures. Taking a page from recent U.S. regulatory developments, the notice states that structured note issuers should “ensure that their disclosure provides sufficient transparency regarding fees including any financial benefits the issuer may embed into the structuring and pricing of the notes. The disclosure should enable an investor to readily assess the costs of investing in the note and the potential financial benefit the issuer and dealer will receive from the sale of the note. The disclosure required will vary depending upon the fee structure and whether the issuer has embedded a profit component into the offering price of the note.”
Accordingly, in addition to disclosing all of the relevant fees received by structured note issuers and underwriters, the CSA will request issuers to add the following disclosures:
- cover page disclosure of the issuer’s estimate of the note’s fair value based on its valuation of the economic components that could be combined to provide the same exposure as the structured note;11
- a brief explanation that the fair value of the note is based on the issuer’s estimate of the value of the note’s economic components and a brief description of what those components are;
- an explanation regarding why the issuer’s estimate of the note’s fair value may be different from the offering price, including whether the offering price includes an estimated profit for the issuer, and what fees, costs or other amounts that the issuer adds to its estimate of the note’s fair value; and
- an explanation that the issuer’s estimate of the note’s fair value may differ from the price at which an investor can sell the note in the secondary market, and why.
In addition to the cover page disclosure, the CSA recommends that the disclosures of these matters be addressed in a separately captioned section of the offering document, and in the “risk factors” section.
The CSA staff noted that it may request issuers to provide, confidentially, a description of the valuation models and assumptions used to estimate the fair value of a particular note.
Policies and Procedures. In addition to the above disclosure documents, the CSA will generally ask issuers to include a statement in their disclosure documents to the effect that they have adopted written policies and procedures for determining the fair value of the note, which include:
- the methodologies used for valuing each type of component embedded in the note;
- the methods by which the issuer will review and test valuations to assess the quality of the prices obtained, as well as the general functioning of the valuation process; and
- conflicts of interest.
Pre-Inception Performance Data (“Backtesting”)
The notice indicates that it has reviewed disclosure documents, for quantitative models in particular, that sought to include hypothetical or back-tested performance data regarding how the model or strategy would have performed had it been in existence prior to the date of actual inception. The CSAs are concerned that the disclosure of this type of information in the prospectus supplement has the potential to be “overly promotional and misleading.” As a result, the CSAs have requested its removal from offering documents.
This approach reflects FINRA’s guidance as to advertising materials provided to retail investors, but is more restrictive than the SEC’s disclosure regime for prospectuses. We discuss these differences in our article in our December 1, 2014 issue of this publication, which may be found at the following link: http://www.mofo.com/~/media/Files/Newsletter/2014/12/141201StructuredThoughts.pdf (page 2).
Similar to the SEC’s 2012 “Sweep Letter” (comment 11),12 the CSA indicated that issuers should not include disclaimers for liability as to third party information, such as index descriptions. The CSAs believe that such disclaimers and cautionary language do not reflect the Canadian securities law liability scheme. However, as in the U.S., the CSA permits issuers to identify information as third party information, and to state that the issuer has not verified the accuracy or completeness of such information.
The notice indicates that the CSA staff will continue to review structured notes filed for pre-clearance and to monitor the development of the market. The CSA will consider what gaps may exist under its regulatory approach, and whether additional regulatory requirements may become necessary.