Unlike most other major Canadian jurisdictions, Ontario does not yet have a specific regime governing trading in over-the-counter ("OTC") derivatives. As a result, Ontario market participants need to determine whether or not the instruments they trade fall within the definition of a "security" in the Securities Act (Ontario) (the "Act") and are, therefore, subject to prospectus and dealer registration requirements. As the exact parameters of the definition of "security" under the Act are constantly evolving, it is very difficult for market participants to precisely identify which OTC derivatives activities are subject to regulation under the Act.
While recent amendments to the Act (not yet in force) and the OTC derivatives regulatory reform efforts of the Canadian Securities Administrators ("CSA") Derivatives Committee suggest that any regulatory uncertainty in this area is only temporary, waiting is not an option for market participants, who need to comply with the law as it currently exists.
A recent exemption order granted by the Ontario Securities Commission (the "OSC") provides Ontario market participants with a path to achieving clarity regarding dealer registration and prospectus requirements for their OTC derivatives trading activities before regulatory reforms are enacted.
In Re Deutsche Bank AG and DB Commodities Canada Ltd.,1 the OSC granted Deutsche Bank AG, Canada Branch ("Deutsche Bank") and its wholly-owned subsidiary, DB Commodities Canada Ltd. ("DBCC"), an exemption from the prospectus and dealer registration requirements of the Act for trades in OTC derivatives (the "OTC Exemption").
The OTC Exemption is similar to the exemptions already available to sophisticated parties in British Columbia, Alberta, Saskatchewan and New Brunswick.2 The OTC Exemption is also similar to the dealer registration exemptions for sophisticated parties contained in the Quebec Derivatives Act (the "Quebec Act").3
Deutsche Bank and DBCC intend to rely upon Multilateral Instrument 11-102, Passport System, to use the OTC Exemption in Manitoba, New Brunswick,4 Nova Scotia, Prince Edward Island, Newfoundland and Labrador, the Northwest Territories, Yukon and Nunavut.5 As a result, Deutsche Bank and DBCC will be subject to a mostly uniform regime across Canada with respect to disclosure and registration requirements for OTC derivatives transactions with sophisticated parties.
The OTC Exemption applies to transactions between Deutsche Bank or DBCC, as the case may be, and a "Permitted Counterparty".
"Permitted Counterparty" is defined as any party that would qualify as a "Permitted Client" for the purposes of National Instrument 31-103, Registration Requirements, Exemptions and Ongoing Registrant Obligations other than an individual.
"Permitted Counterparty" includes:
- Canadian and foreign banks, trust and loan companies, insurance companies and credit unions;
- Canadian and foreign registered securities dealers and advisers;
- Canadian and foreign federal, provincial and municipal governments;
- Regulated pension funds;
- People or companies acting on behalf of managed accounts;
- Investment funds managed or advised by a registrant; and
- People or companies (other than individuals or investment funds) that have net assets of at least $25 million as shown on their most recently prepared financial statements.
"Permitted Counterparties" are largely the same parties as those included in the definition of "Qualified Party" in the British Columbia Security Commission and Alberta Security Commission's blanket orders, and in the definition of "Accredited Counterparty" in the Quebec Act with some notable exceptions.
The following parties are not Permitted Counterparties:
- Individuals (no matter how sophisticated or wealthy they may be);
- Hedgers (parties who enter into OTC derivatives to offset risks that they incur in the course of their business activities); and
- High volume OTC derivatives traders (also not included in the definition of Accredited Counterparty).
In addition, the minimum asset test for persons other than individuals under the Quebec Act is $10 million in cash, securities or deposits, rather than the $25 million in net assets minimum included in the definition of Permitted Counterparty.
The OTC Exemption is available solely in respect of "OTC Derivative" transactions.
"OTC Derivative" means one or more of, or any combination of, an option, a forward contract, a contract for differences, or any instrument of a type commonly considered to be a derivative, in which (1) the agreement relating to, and the material economic terms of, the option, forward contract, contract for differences, or other instrument have been customized to the purposes of the parties to the agreement and the agreement is not part of a fungible class of agreements that are standardized as to their economic terms, (2) the creditworthiness of a party having an obligation under the agreement would be a material consideration in entering into or determining the terms of the agreement, and (3) the agreement is not entered into or traded on or through an organized market, stock exchange or futures exchange.
There are almost no limitations on what may be the underlying interest of the OTC derivative. These definitions mirror those of a 2004 OSC order Re British Columbia Investment Management Corporation.6
no credit or margin
In order for an OTC derivatives transaction to qualify for the exemption, Deutsche Bank and DBCC may not offer or provide any credit or margin to the Permitted Counterparties with whom they transact.
books and records
The OTC Exemption reaffirms that Deutsche Bank and DBCC are "market participants" for the purposes of the Act and as such they are subject to requirements under the Act to keep various books and records related to their OTC derivatives trading activities.
four year limit
The duration of the OTC Exemption is limited to four years, unless a new rule or legislation that specifically governs OTC derivatives comes into force before the four-year period has expired. The new legislation contemplated in the OTC Exemption includes the derivatives framework in Ontario established in 2010 by amendments to the Act which have not yet been proclaimed into force.7
some questions remain
The OTC Exemption does not clarify whether Deutsche Bank and DBCC are able to simply rely upon the representation of a counterparty as to its status as a "Permitted Counterparty" or if independent verification is required.
Furthermore, it is not clear whether the absence of margin or credit will be a requirement for granting similar orders to others in the future. There is no elaboration on whether or not inherent leverage constitutes "margin or credit".
Finally, there is no guidance in the OTC Exemption as to the type of parties who can apply for similar exemptions. Deutsche Bank is a Schedule III bank and can already rely on section 35.1 of the Act for an exemption from the dealer registration requirements and DBCC is a subsidiary of such an entity. It remains to be seen if parties who are not federally regulated financial institutions or subsidiaries of such entities will be able to obtain similar relief.
Despite these open questions, the OTC Exemption offers sophisticated parties trading in OTC derivatives a method for removing the regulatory risk involved in OTC derivatives trading. It provides an alternative to the "Accredited Investor" ("AI") prospectus requirement exemption, which has traditionally had its own regulatory uncertainty relating to the requirement to file a report of exempt distribution with the securities regulators.8
The OTC Exemption was granted by the OSC more than a year after Deutsche Bank and DBCC submitted their joint application. The application made expansive arguments and grounded the order sought in larger goals of providing regulatory certainty and harmonization across jurisdictions for OTC derivatives trading in Canada. As such, the decision of the OSC to grant the order may reflect a change in its stance toward OTC derivatives trading between sophisticated parties.
Other parties applying for a similar exemption may reasonably expect that the OSC has been persuaded that OTC derivatives trading between sophisticated parties should be exempted from dealer registration and prospectus requirements, provided the traders qualify as Permitted Counterparties. In our view, sophisticated parties trading in OTC derivatives in Canada should consider applying for an exemption order that reflects the OTC Exemption.
The possibility of the OTC Exemption being available to other parties trading in OTC derivatives moves Canada toward greater certainty and uniformity in derivatives regulation. However this uniformity may be short lived, as Alberta appears to be headed in the opposite direction. Alberta Securities Commission Staff Notice 91-703 Over-the-counter Derivatives published for comment by the Alberta Securities Commission on February 28, 2011, proposes replacing the existing blanket order with a new rule that has a much more limited registration exemption for trades in OTC derivatives.
It is expected that the CSA Derivatives Committee's soon to be released consultation paper concerning dealer registration requirements for OTC derivatives trading will provide greater insight into the views of Canadian regulators and point the way to a truly uniform pan-Canadian regime. Upcoming Derivatives Law Bulletins will cover these and other developments in detail.