As promised in the federal government’s most recent budget, in response to the explosive growth in the retail market for principal protected notes (PPNs), the Department of Finance recently published for comment new regulations that will apply to all federally regulated financial institutions (FRFI). The Principal Protected Notes Regulations are expected to come into force on April 1, 2008 and will apply to all PPNs issued by FRFIs. The 30-day comment period ends on December 23, 2007. Please click here to obtain a copy of the Regulations.
The Regulations are the federal government’s response to, among other things, concerns raised by the Canadian Securities Administrators (CSA) in their July 2006 Notice 46-303 Principal Protected Notes. The CSA highlighted their on-going consultations with the federal government on the appropriate regulatory response to PPNs in CSA Notice 46-304 Update on Principal Protected Notes released earlier this summer. The CSA’s main concerns about PPNs fall into four main areas:
- Inadequate, overly complex and inappropriate disclosure in PPN information statements and marketing materials.
- Compliance with KYC and suitability obligations by registrants in connection with sales of PPNs.
- Use of PPNs as a vehicle for selling alternative investment products to retail investors.
- Registrant referrals to purchase PPNs without a determination by a registrant that the referral is in the best interests of the client.
The Regulations are designed to address the CSA’s first and third points, through enhanced and more effective disclosure to investors. The remaining issues raised by the CSA are being dealt with through the CSA’s Registration Reform Project and the CSA’s on-going oversight of the self-regulatory organizations (SROs) that regulate dealer firms and advisors. PPNs that are issued by Québec-based caisses populaires will not be covered by the Regulations. Instead, the Autorité des marchés financiers has announced its intention of "considering the appropriateness of regulating PPNs" issued by these entities.
The CSA’s second concern has been partially addressed by the SROs. The Investment Dealers Association of Canada (IDA) has confirmed that its regulations and by-laws regarding KYC and suitability apply to the sale of PPNs and has issued a paper providing guidelines for performing due diligence on PPNs.1 The Mutual Fund Dealers Association of Canada (MFDA) and the CSA are discussing changes to MFDA rules that will confirm the application of KYC and suitability obligations to dealings in PPNs by MFDA members. In Québec, mutual fund dealers are subject to the Regulation respecting the rules and ethics in the securities sector, which applies the KYC and suitability obligations to PPNs.
The Regulations are intended to build on and replace the 2002 federal government Index-linked Deposits Interest Disclosure Regulations. The 2002 regulations are viewed as no longer sufficient to address the increasingly sophisticated and complex PPNs available to retail customers.
PPNs that fall within the defined term "principal protected note" will be subject to the Regulations. A PPN is defined as a financial instrument that is issued by a FRFI to an investor and that provides for a payment to be made by the FRFI that is determined, in whole or in part, by reference to any index or reference point and provides that the principal amount that the FRFI is obligated to repay at the note’s maturity is equal to or more than the total paid by the investor for the note. The Regulations are intended to cover both market-linked GICs and market-linked notes.
The Regulations specify the content, manner and timing of disclosure that FRFIs must provide to investors. Subject to a few exceptions, a FRFI must provide an investor with a plain language ("clear and simple") summary (a "synopsis") of specified information, both in writing and orally by a person who is knowledgeable about the terms and conditions of the PPN, at least two days prior to contracting with an investor to issue a PPN. This information must also be available on the FRFI’s website and be sent to any person who requests it.
The required synopsis is an expansion from the disclosure regime under the 2002 regulations. Additional information about the PPN will be required, including fees and their impact on interest payable, risks, the circumstances in which the PPN could be an appropriate investment, any redemption or other liquidity features, how a purchase can be cancelled, conflicts of interest, together with any other information that could reasonably be expected to affect an investor’s decision to purchase the PPN.
An investor will be able to waive his or her right to receive disclosure at least two days prior to entering into a contract to acquire a PPN, but only if the investor contracts with the FRFI "in person". A FRFI can also publicly commit to giving an investor a minimum two day withdrawal right, in which case, provided the FRFI gives the investor the required disclosure statement at some point before entering into the contract, the investor can immediately acquire a PPN. In a typical retail situation, the requirement that the disclosure be provided to an investor two days prior to purchase, means that a customer will attend at a branch to receive the required disclosure and then return two days later to sign the subscription, unless both the FRFI and the investor agree to waive the 2- day notice period at the time that the investor initially attends at the branch. This exception will give FRFIs flexibility in dealing with their clients.
If an investor enters into a contract for the issuance of a PPN via electronic means, the investor must still receive the required disclosure at least two days before the contract date, but the FRFI does not have to give the requisite oral disclosure. However, the FRFI must, at the same time as giving the required synopsis, provide the investor with the telephone number of a person who is knowledgeable about the PPN. We expect that FRFIs will want to provide the telephone number of their call centres in order to comply with this obligation.
The Regulations impose new requirements for on-going disclosure by FRFIs:
- Any changes to the terms of a PPN that may have an impact on interest payable under the PPN must be disclosed in advance to the investor. This is an expansion from the 2002 regulations where the notice provisions were triggered off a "material change" to the determination of interest payable under the PPN. If notice cannot be provided in advance of making the amendment, the disclosure must be provided without delay after it is made.
- If, for reasons beyond the FRFI’s control, the PPN’s index or reference point can no longer be used to determine the return under the PPN, the FRFI must disclose this fact to investors without delay.
- The FRFI must provide the investor with written disclosure of the total amount of the principal and interest payable under the PPN, and the amount of any penalty or fee, before the FRFI purchases or redeems the PPN prior to maturity.
- FRFIs must provide specified disclosure about the value of a PPN on any particular day, at the request of investors.
Advertisements for PPNs must explain how more information about the PPNs can be obtained. Specific disclosure requirements will apply to advertisements that refer to features of PPNs or interest payable under them, including
- the manner in which interest is to be accrued and any limitations in respect of interest;
- requirements relating to how interest and/or guaranteed interest amount examples must be shown;
- if the PPN is not eligible for CDIC coverage, this fact must be disclosed; and
- historical market information may only be used in an advertisement in respect of a period in which the PPN, or type of PPN, was offered by the FRFI.
While the Regulations impose obligations on FRFIs, they do not speak to the obligations of distributors, whether affiliated or not, who are selling PPNs (e.g. deposit brokers or dealers). We expect that FRFIs will ensure compliance with their obligations under the Regulations either by delivering the required disclosures directly to investors, or by contractually obligating their distributors to adhere to the requirements on the FRFI’s behalf.
Given the intense regulatory and media scrutiny of PPNs over the past few years, and the rapid expansion of this market-place, we expect that the federal government will be under pressure to adopt the Regulations as quickly as possible. We will continue to monitor for other regulatory developments, including the additional regulatory responses to the remaining issues in the CSA’s PPN notices.