As another fall-out from the international credit crisis, securities known as Principal-Protected Notes (PPNs) have “come unstuck.”  

PPNs are debt instruments with variable interest payments that depend on the underlying investments to which the notes are linked. Investments can range from a relatively straightforward basket of equities to more complex investments such as hedge funds. In all cases, PPNs guarantee repayment of principal at maturity. Typically, PPNs have a seven- to eight-year term and are marketed to investors with long-term investment objectives. Because these notes are guaranteed by Canadian chartered banks, they are exempt from the registration and prospectus requirements under Canadian securities laws.  

The market event that some PPNs have recently experienced is a so-called “protection event,” i.e., now that the opportunity to earn a return in excess of the principal-protected portion of the notes has become unrealistic, issuers of PPNs are required by the terms of their securities to cease the activities that would generate such returns and to simply pay out principal at the time of maturity, which may be a number of years in the future. An investor wishing to sell its PPNs will incur both a significant discount and redemption fees.  

On July 26, the Canadian Securities Administrators (CSA) issued Notice 46-303 Principal-Protected Notes, in which it identified its concerns about the distribution and sale of PPNs, including:  

  • the failure to provide sufficient disclosure to allow investors to make an important investment decision;  
  • the failure of investors to understand all of the fees associated with the product;
  • the lack of liquidity for PPNs because an investor cannot sell them before maturity without significant penalty; and  
  • the failure of some sellers of PPNs to meet the “know your client” and suitability requirements in exposing retail investors to these complex investments.  

In the same notice, the CSA announced its proposed course of action: to consult with industry and other stakeholders in order to determine the form and content of any new regulatory requirements or guidance needed to regulate the offering and sale of PPNs.  

One year later, in July 2007, the CSA issued Notice 46-304 Update on Principal-Protected Notes, which described consultations the CSA had held with, among others, those issuing and selling PPNs, industry associations, and the federal Department of Finance. At that juncture, the CSA advised that it would await the federal PPN regulations in the expectation that they would address the CSA’s key disclosure concerns. It referred to the federal government’s March 2007 release of Budget Plan 2007, in which the federal government had announced that it would soon release for comment principles-based regulations for banks that issue PPNs.  

In August 2008, in CSA Notice 46-305 Second Update on Principal-Protected Notes, the CSA noted that the federal PPN regulations had come into force on July 1, 2008 and that the federal PPN regulations specify requirements for the content, manner and timing of disclosure for PPNs issued by federal financial institutions, including banks. It concluded that the federal PPN regulations, together with the CSA’s regulatory initiatives in discussions with the Investment Dealers Association (now the Investment Industry Regulatory Organization of Canada), and the Mutual Fund Dealers Association with respect to their respective supervision of their members, addressed the CSA’s key concerns with PPNs.