Important developments for Canadian and cross-border derivatives activities in the Québec market
Québec's new Derivatives Act (the Act) received royal assent on June 20, 2008 and will come into force on dates to be set by the Government. The Act will regulate both over-the-counter (OTC) and exchange-traded derivatives in standalone legislation, subject to certain carve outs for OTC derivatives activities involving "accredited counterparties" and in other cases to be specified by regulation.
Some of the highlights of the new legislation are noted below. Since the key provisions of the Act cross-reference regulations that have yet to be published, it is still too early to determine the exact scope and application of the Act and its potential impact on the various segments of the Canadian and cross-border derivatives market. It is expected that the Act and companion regulations (once published) will enter into force at the same time over the course of the next few months.
Bill 77, the legislative proposal to establish a new Derivatives Act, was tabled by the Québec Minister of Finance on April 9, 2008. Bill 77 followed the publication in August 2007 by the Autorité des marchés financiers (AMF), Québec's financial markets regulator, of a proposed framework for the regulation of the derivatives markets in Québec, which included drafts of the legislation, regulations and policy statements, as well as an earlier concept paper published in May 2006. The proposed framework and concept paper both attracted detailed comments by Canadian and foreign stakeholders in the industry.
As noted in our April 2008 Structured Finance Update, Québec Legislates in the Canadian Derivatives Market and Releases a New Derivatives Act, the driving factor underlying the fast-track adoption of this legislation is the Québec government's determination to stake Québec's position as the lead jurisdiction in the derivatives space in Canada. Québec's position is centered on the trading activities of the Montréal Exchange (MX) (the Canadian financial derivatives exchange) and the new Montréal Climate Exchange (MCeX)1.
Over the two-day period leading up to the adoption of the final legislation, the Québec government's Public Finance Commission (the Commission) held hearings with leading Québec stakeholders, which had been invited to provide oral comments on key aspects of the draft legislation. Given this timeframe, the Act does not differ materially from the draft of Bill 77, although certain technical amendments were adopted as part of the final legislation and the companion regulations may address various issues brought to the attention of the Commission.
Key Features of the Proposed Derivatives Act
Regulation of both OTC and exchange-traded derivatives
The Act will regulate trading and advisory activities with respect to all forms of "derivatives", which is broadly defined, including both "standardized derivatives" and OTC derivatives. The proposed Act would define an "over-the-counter derivative" as "any derivative other than a standardized derivative" and a "standardized derivative" as "a derivative that is traded on a published market, whose intrinsic characteristics are determined by that market and whose trade is cleared and settled by a clearing house". This definition would include U.S. and other foreign listed futures and options.
Derivatives dealer and adviser registration requirements
The Act imposes a dealer registration requirement on any person who engages or purports to engage in (1) derivatives trading on the person's own behalf or on behalf of others; or (2) any act, advertisement, solicitation or conduct directly or indirectly in furtherance of an activity described in (1). Significantly, proprietary trading activities are subject to registration. The Act also imposes an adviser registration requirement on any person who engages or purports to engage in the business of advising others as to derivatives or the buying or selling of derivatives, or who is in the business of managing derivatives portfolios. A dealer or adviser registered under the Québec Securities Act that meets the conditions under the Act for registration to carry on business in derivatives and pays the prescribed fees would be deemed to be registered under the new Act. Existing Québec registrants could also transition their registration under the Act.
No exemption for exchange-traded derivatives activities involving accredited counterparties.
As discussed below, the Act provides for certain important exemptions for OTC derivatives activities involving "accredited counterparties", including an exemption from the dealer and adviser registration requirements under the act. Significantly, the Act does not contain any corresponding exemptions for exchange-traded derivatives activities. This is a significant departure from the existing "accredited investor" exemptions under Québec securities legislation on the basis of which many Canadian, U.S. and other foreign dealers have historically engaged in exchange-traded derivatives activities outside of Québec for Québec-resident institutional investors.
It is expected that the draft regulations will bridge the Act with proposed National Instrument 31-103 Registration Requirements (Proposed NI 33-103) of the Canadian Securities Administrators (CSA). Proposed NI 31-103 is an attempt by the CSA to streamline and harmonize securities dealer and adviser registration requirements across all jurisdictions2.
The regulations will have to address a number of open issues, including, for example, whether dealers that are not fully-registered "investment dealers" (e.g., "exempt market dealers") could also benefit from a deemed or short-form registration procedure, whether the passport system for registration will permit registrants registered in other Canadian jurisdictions to access a deemed or short-form registration procedure, and whether exemptions equivalent to the "international dealer" and "international adviser" exemptions under Proposed NI 31-103 will be adopted to enable the continuation of existing cross-border trading and advisory arrangements into which Québec institutional investors have entered with U.S. and other foreign financial intermediaries.
Recognition of "regulated entities"
The Act will also provide for the recognition by the AMF of "regulated entities" seeking to carry on derivatives-related activities in Québec as an exchange, alternative trading system, published market, clearing house, regulation services provider, information processor or self-regulatory organization. Recognized regulated entities would be subject to various requirements covering their operating rules, activities, governance practices, information disclosure and the filing with the AMF of annual audited financial information. The AMF has not issued any guidance on what will constitute derivatives-related activities in Québec. This is an important jurisdictional issue for U.S. and international exchanges, ATSs, clearing organizations, etc. Hopefully, this will be clarified in the draft regulations.
Qualification of non-regulated and non-registered entities
Any person other than a recognized "regulated entity" or a registered dealer would have to be "qualified" by the AMF in the manner to be prescribed by regulation before offering standardized or OTC derivatives. The exact nature and scope of this "qualification" procedure remains to be seen.
Carve-out for OTC derivatives involving "accredited counterparties"
As noted above, the Act carves out OTC derivatives "involving accredited counterparties only or in any other cases specified by regulation" from the application of certain specified provisions. These include the dealer and adviser registration and qualification procedure and certain limited procedural and enforcement-related provisions, except with respect to market manipulation and fraud. The remaining provisions of the proposed legislation, including the offence provisions and the broad rulemaking authority which is delegated to the AMF to, among other things, "make rules concerning derivatives transactions", will equally apply to OTC derivatives. The OTC derivatives industry had hoped for a blanket carve-out for non-retail OTC derivatives activities, subject to market manipulation and fraud. Going forward, the extent to which the AMF regulates OTC derivatives using this broad-rule making authority to limit the scope of the OTC derivatives exemption under the Act will be an important issue affecting the enforceability of OTC derivatives contracts involving Québec counterparties.
The list of "accredited counterparties" includes governments, municipalities, "financial institutions" (which may be defined by regulation), dealers and advisers registered in and outside Québec, as well as certain qualified persons (to be defined by regulation), certain qualified investment funds, charities, persons wholly owned by "accredited investors" within the meaning of National Instrument 45-106 and "hedgers". It will be important for the regulations or the AMF to provide for the ability to rely on factual representations as to a party's status as an "accredited counterparty" within the meaning of the Act.
Federally regulated banking products
One of the perennial areas of concern with the proposal to broadly regulate derivatives in Québec has been the extent to which the legislation would purport to regulate products, services and activities that are subject to the exclusive federal jurisdiction over banks and other financial institutions. Certain comments in response to the earlier proposals had urged the government to adopt the more targeted definition of OTC derivatives recommended by the Ontario Commodity Futures Act Advisory Committee in its final report of January 20073 in conjunction with the principles-based approach to derivatives regulation generally favoured by the industry. The Québec government, however, has elected to adopt the "catch and release" approach to the definition and regulation of derivatives recommended by the AMF. The Act does not expressly exclude federally regulated financial products, so the draft regulations will be of critical importance in ensuring that any jurisdictional and related characterization issues are clearly resolved.
The "hybrid product" test
One important feature of the Act in the resolution of such issues is the concept of "hybrid product", which has been imported from the United States Commodity Exchange Act. The concept is principally designed to eliminate any legal uncertainty in the regulatory characterization of structured securities products with embedded derivatives. The hybrid product test under the Act sets out a three-pronged test to establish whether any given instrument can be "presumed to be predominantly a security". The presumption applies (1) if the offeror receives payment of the purchase price upon delivery of the product; (2) if the purchaser is under no obligation to make any payment in addition to the purchase price (e.g., as margin deposit, margin, settlement) during the term of the product or at maturity; and (3) if the terms of the instrument do not include margin requirements based on a market value of the underlying interest. The "hybrid product" test will be of critical importance for structured products issued by federally regulated banks that currently rely on broad-brush exemptions from the dealer registration and prospectus filing requirements under Québec securities legislation to distribute principal protected notes and other structured products on a retail basis.
Once the proposed regulations are published, it will be important to review specific derivatives contracts or activities in the Québec derivatives market to identify potential jurisdictional, legal and operational issues that may be raised by the new derivatives legislation.