On October 3, 2008, the Autorité des marchés financiers (the AMF) published for comment a draft of the Derivatives Regulation (the Regulation) under the Derivatives Act (Québec) (the Act). The draft Regulation follows the June adoption by the Québec government of the Act, which provides a legislative framework that will govern derivatives activities within the province of Québec. We summarized the key principles of that legislation in our July 2008 BLG Investment Management Advisory Québec National Assembly Adopts Legislation to Govern Derivatives, which is available on our website www.blgcanada.com.

The comment period on the draft Regulation ends on November 3, 2008.

As a complement to the Act and the draft Regulation, the AMF intends to publish policy statements to provide, among other things, (i) guidelines applicable to regulated entities relating to their internal governance and the transmission of information; (ii) details and clarification on the notion of “accredited counterparty”, and (iii) guidelines to determine if hybrid products (as defined in the Act) qualify as derivatives. In addition, a draft regulation governing registration requirements under the Act should be published for comment by the AMF shortly.

The coming into force of the Act and the draft Regulation is still scheduled for early 2009, except for certain chapters of the Act concerning registration requirements that should come into force concurrently with National Instrument 31-103 Registration Requirements.

Derivatives Covered by the Act and the Draft Regulation

The Act defines a "derivative" as an option, swap, futures contract or any other contract or instrument whose market price, value, or delivery or payment obligations are derived from, referenced to, or based on an underlying interest, or any other contract or instrument designated by regulation or considered equivalent to a derivative on the basis of criteria determined by regulation. Once in force, the Act will apply to "standardized derivatives" (essentially derivatives traded on a published market) as well as over-the-counter (OTC) derivatives.

While neither the draft Regulation nor the Act contains a list of derivatives that will be subject to the legislation, staff at the AMF have confirmed that certain novel OTC products including contracts for difference (CFDs) and foreign exchange spot trading would likely be considered "derivatives" for the purposes of the legislation.

The Draft Regulation

The draft Regulation is intended to implement certain provisions described in the Act, in particular, the minimum assets proposed for an accredited counterparty as well as the process governing self-certification of the operating rules of regulated entities. Moreover, the draft Regulation sets out the proposed qualification rules in respect of a person who creates or markets a derivative, as well as rules regarding the communication of information to clients of a derivatives dealer.

Minimum Assets of an Accredited Counterparty

Pursuant to the Act, no person will be permitted to act as a dealer or adviser in derivatives unless registered with the AMF in this capacity. Also, a person who creates or markets a derivative must be qualified by the AMF and the derivative must be authorized by the AMF, both before the derivative is offered to the public.

However, advising and dealing activities in OTC derivatives with "accredited counterparties" (a defined term in the Act) will not trigger the registration requirement under the Act and issuers of OTC derivatives will not be required to obtain qualification from the AMF. These exemptions are based on a client having the status of an "accredited counterparty".

The definition of "accredited counterparty" in the Act includes both named entities (that is, governments, municipal administrations, financial institutions or subsidiaries thereof and dealers or advisers registered under the Act or under securities legislation) and entities which meet certain eligibility criteria.

Specifically, a person who has established in a conclusive and verifiable manner, among other things, that the person has assets equal to or in excess of the minimum assets specified by regulation will be considered an "accredited counterparty". The draft Regulation proposes that the minimum assets for these purposes must consist of cash, securities, insurance contracts or deposits having an aggregate realizable value, before taxes, but after deduction of the corresponding liabilities, of more than $10 million or an equivalent amount in another currency. In the case of an individual, the minimum assets held by that person personally or through other persons under his or her control must consist of more than $5 million or an equivalent amount in another currency.

Regulated Entities and the Self-Certification Process

No regulated entity will be authorized to carry on derivatives activities in Québec unless it is recognized by the AMF. Pursuant to the Act, a "regulated entity" is an exchange, an alternative trading system not registered as dealer in derivatives, or another published market, a clearing house, a regulation services provider, an information processor, a self-regulatory organization or any other person designated as such by the AMF.

The Act will require a recognized regulated entity, when it is making an amendment to its operating rules, to complete a self-certification process established by regulation and file a notice with the AMF confirming that the amendment was made in accordance with the regulation. This self-certification process is provided for in the draft Regulation. Among other things, the recognized regulated entity will be required to publish its amendments to its operating rules for a minimum 30-day consultation period, along with a notice of publication. The draft Regulation also sets out a mandated list of items that must be contained in the notice of self-certification of a material rule.

Qualification Process

A person, other than a recognized regulated entity, who creates or markets a derivative will have to be qualified by the AMF before offering derivatives to the public (a Qualified Person). The derivative product itself will also have to be authorized by the AMF.

The draft Regulation sets out the required information to be provided to the AMF by a person seeking qualification as a Qualified Person, which will include

  • name, head office address, its method and date of incorporation, the name and principal occupation of its directors
  • a complete description of the activities of the Qualified Person, including its management of derivatives marketing and the risks the activities may involve and
  • audited financial statements for the three most recent fiscal years, as well as the most recent interim financial statements, if applicable.

The draft Regulation also will establish the process that a Qualified Person must follow in order to be authorized by the AMF to create or market a particular derivative in Québec. Among other things, the Qualified Person must send specified information as it relates to the derivative to the AMF for its review and approval, including a detailed description of the derivative with a focus on risks, a complete description of the proposed method of trading in the derivative and disclosure of all related costs.

Continuous Reporting and Disclosure Requirements for Qualified Persons

The draft Regulation mandates certain on-going disclosure requirements for a Qualified Person, including an annual filing of its audited financial statements, together with an annual update of the information presented in its original application for qualification. A Qualified Person will also have to annually provide the AMF with the number of contracts entered into in Québec for all derivatives offered to the public during its latest fiscal year.

Communication with Clients

The Act will require that a dealer give its client a specified risk information document before a first trade in a derivative on behalf of the client. If trades on behalf of the client are in a derivative created and marketed by a Qualified Person, the dealer must also give the client the qualification information submitted to the AMF by the Qualified Person.

The draft Regulation sets out the required disclosure for the risk information document. A generic description of the risks common to trading in derivatives will be necessary, which must cover the effect of "leverage" or "gearing"; undisclosed commissions and charges; currency risks and risks associated with offexchange transactions.

The draft Regulation also will require that a dealer obtain from the client a written acknowledgement of receipt of the risk information document. Exemptions to this requirement will reflect circumstances where a client is an accredited counterparty and the dealer has been mandated with full discretion over the client’s account.

Under the draft Regulation, a dealer and an adviser must obtain certain specified know-your-client information from the client, so that the dealer or adviser can determine the client’s identity and assess the client’s needs. The dealer or adviser must then use this information to recommend a suitable derivatives product or a related service.

Commenting on the Draft Regulation

The comment period for the draft Regulation ends on November 3, 2008.