Register today for OSC Dialogue 2024: Inviting, thriving and secure capital markets
Proposed Rule: OSC Rule - 91-504 & 91-504CP - Over-The-Counter Derivatives and Companion Policy 91-504CP
Proposed Rule: OSC Rule - 91-504 & 91-504CP - Over-The-Counter Derivatives and Companion Policy 91-504CP
NOTICE OF PROPOSED RULE AND POLICY
UNDER THE SECURITIES ACT
PROPOSED RULE 91-504
OVER-THE-COUNTER DERIVATIVES
AND
COMPANION POLICY 91-504CP
Introduction
On November 1, 1996, the Commission published the proposed Rule and Companion Policy for comment at (1996), 19OSCB 5929. Those versions of the those documents are called the "Draft Rule" and "Draft Policy" in this Notice.
During the comment period on the Draft Rule and the Draft Policy, which expired on March 3, 1997, the Commissionreceived 8 submissions. The names of commenters providing the submissions, a summary of their comments and theresponse of the Commission are contained in Appendix A to this Notice. The Commission thanks all commenters forproviding their comments on the Draft Rule and Draft Policy. The Draft Rule and the Draft Policy have been amendedto reflect many of the comments, and are being republished for further comment. The republished versions of theseinstruments are called the "Proposed Rule" and "Proposed Policy" in this Notice.
In addition to a number of specific drafting comments, the commenters raised some general issues pertaining to the DraftRule and Draft Policy. The principal issues raised in the comments concerned the scope and application of the DraftRule and concerns over the complexity and difficulty of interpretation of the Draft Rule. The Draft Rule and Draft Policyhave been revised to attempt to alleviate these concerns and, in particular, to clarify the Commission's views on theterritorial application of the Proposed Rule. The Proposed Policy now states that, in the view of the Commission, theinvestor protection aspects of the Proposed Rule are designed for the benefit of Ontario persons or companies. Anumber of drafting changes designed to clarify the interpretation of these instruments have also been made.
The Draft Rule and Draft Policy arose out of a Commission staff report published in 1994 (the "1994 Report") on theregulation of over-the-counter ("OTC") derivatives under Ontario law.(1) The 1994 Report stated that "the most immediateconcern for the Commission [in respect of OTC derivatives transactions in Ontario] should be to remove, to the extentpossible, the uncertainty surrounding the relationship of OTC derivatives to the [Securities] Act." The Commissionremains of the view that this goal continues to be valid and will be achieved with the changes from the Draft Rule andDraft Policy embodied in the Proposed Rule and Proposed Policy. The Commission is also of the view that the investorprotection measures contained in the Proposed Rule will protect people and companies in need of protection withoutimpacting negatively on the OTC derivatives market.
Substance and Purpose of Proposed Rule
The Proposed Rule deals with the regulation of transactions consisting of over-the-counter ("OTC") derivatives in Ontarioand provides complete exemptions from Ontario securities law for some transactions and provides exemptions from theregistration and prospectus requirements of the Act for other transactions. Derivatives products are, generally speaking,instruments the value of which is dependent, wholly or partially, upon the price, level or value of an external benchmarksuch as a security, financial instrument, interest rate, foreign exchange rate, index or commodity price. The ProposedRule pertains only to the OTC derivatives market, which is a general term given to the market in which parties contractdirectly with each other off-exchange and without the interposition of a clearing corporation. The most commonderivatives products used in the OTC market are swaps, options and forwards on a variety of underlying interests. TheProposed Rule does not pertain to trades in debt-like derivatives, which is the subject of a review being conducted bya Task Force consisting of an industry representative, legal practitioners, a member of the Commission and Commissionstaff.
Purpose of Proposed Policy
The Proposed Policy sets out the Commission's interpretation of certain provisions of the Proposed Rule and theapplicability of certain aspects of the Act to transactions consisting of OTC derivatives.
Summary of Changes to the Proposed Rule
This section of this Notice describes changes proposed to be made in the Proposed Rule and Proposed Policy.
For additional background, and a summary of the Draft Rule and Draft Policy, reference should be made to the noticethat accompanied the publication of the Draft Rule and Draft Policy at (1996) 19 OSCB 5929.
Section 1.1
Section 1.1 defines several key terms used in the Proposed Rule.
Changes from the Draft Rule
The definitions of "commercial user" and "exempt transaction" have been amended to replace references to transactions"involving" derivatives to transactions "consisting of" OTC derivatives. This change was made in response to a commentsuggesting that an amendment to the terminology be made to make clear that the phrase is not designed to catch a largetransaction of which only one component is a derivative. The Commission intends that this phrase only catch atransaction that consists of derivatives.
The definition of "contract for differences" has been amended to exclude "a spot currency contract" in response to acomment.
The definition of "interest rate/foreign exchange derivative" has been amended to exclude derivatives whose underlyinginterest is the debt of corporations. This change was made in response to a comment that noted that transactionsinvolving interest rate/foreign exchange derivatives generally are exempt transactions under the Proposed Rule, andtherefore exempt from Ontario securities law, including provisions relating to trading with material inside informationconcerning an issuer. The commenter noted that an OTC derivative based on corporate debt instruments would beincluded in the definition of "interest rate/foreign exchange derivatives" under the Draft Rule, and that this approachappeared to be inconsistent with the fact that equity derivatives were not exempt transactions and the special relationshiprules would apply to trades in those instruments.
The definition of "OTC derivative" has been amended so as to restrict the scope of the definition to options, forwardcontracts or contracts for differences "of a type commonly considered to be a derivative". This change was made inresponse to a comment that the definitions of "forward contract" and "contracts for differences" could be interpreted topertain to a wide range of contracts having no relation to derivatives.
Section 2.2
Section 2.2 provides that, subject to section 2.1, sections 25 and 53 of the Act apply to a transaction consisting of anOTC derivative that does not constitute a trade in a security as if, and to the same extent as those sections would applyif, the transactions did constitute a trade in a security.
Changes from the Draft Rule
Section 2.2 has been amended to change the a reference to a transaction "involving" a derivative to a transaction"consisting of" an OTC derivative.
Section 2.3
Section 2.3 provides an exemption from section 25 of the Act for OTC derivatives transactions between qualified parties,or persons or companies that enter into the transaction with or though an OTC derivatives dealer whose representativehas successfully completed the courses listed in the section, and if the person or company has been provided with acopy of the Risk Disclosure Statement for OTC Derivatives.
Changes from the Draft Rule
A reference in section 2.3 to a transaction "involving" an OTC derivative has been changed to a reference to atransaction "consisting of" an OTC derivative.
Clause 2.3(a)(ii)(A) has been amended by the addition of the Chartered Financial Analysts Course as a course thatsatisfies the educational requirement of a representative of an OTC derivatives dealer under section 2.3.
Section 2.4
Section 2.4 corresponds to section 2.3, and provides an exemption from section 53 of the Act for the same OTCderivatives transactions to which section 2.3 relates.
Changes from the Draft Rule
Section 2.3 of the Draft Rule has been divided into two sections in response to a comment that suggested that section2.3 of the Draft Rule be amended to ensure that the registration and prospectus exemptions provided by that sectioncould operate independently of each other.
Appendix A
Appendix A sets out the persons or companies that are "qualified parties" under the Proposed Rule.
Changes from the Draft Rule
Subsection (2) has been added to the Appendix to clarify that all requirements contained in the Appendix that are basedon the amounts shown on the balance sheet of an entity apply to the consolidated balance sheet of the entity.
The capital requirements of banks, loan companies, trust companies and insurance companies subject to the regulatoryregime of Basle Accord countries, and insurance companies licensed to do business in Canada have been reduced from$150 million to $100 million.
Summary of Changes to the Proposed Policy
Section 2.2
Section 2.2 of the Proposed Policy pertains to the requirements of clauses 2.3(a)(ii)(B) and 2.4(a)(ii)(B) of the ProposedRule that require the delivery of a Risk Disclosure Statement for OTC Derivatives by the OTC derivatives dealer this isinvolved with a transaction as a condition to the availability of respective exemptions contained in those provisions forthe transaction.
Section 2.2 notes that it is possible that the OTC derivatives dealer will not be a principal to the transaction and that theprincipal would want to receive comfort that the risk disclosure statement had been received by the appropriate party.Section 2.2 states the view of the Commission that the principal may, in those circumstances, rely on representationsfrom the intended recipient of the risk disclosure document that the statement was in fact received.
Changes from the Draft Policy
Section 2.2 is new.
Section 3.1
Section 3.1 of the Proposed Policy deals with the territorial scope of the Proposed Rule, and states the view of theCommission concerning the application of Ontario securities law to OTC derivatives transactions in which one party isnot an Ontario person. The section states that persons or companies entering into an OTC derivatives transaction inwhich some parties are not located in Ontario are entitled to consider the connecting factors of the transaction withOntario in order to determine whether the transaction is subject to the Proposed Rule and any other applicable Ontariosecurities law. The section notes that the Commission is of the view that the investor protection aspects of the Rule aredesigned for Ontario persons or companies. The Commission has taken the administrative position that it does notconcern itself with an OTC derivatives transaction, if
(a) the transaction involves one or more Ontario parties and one or more non-Ontario parties;
(b) each Ontario party to the transaction is a qualified party under the Proposed Rule; and
(c) there is no reason to believe that the rights and obligations of the non-Ontario parties to the transactionwill be transferred to, and assumed by, Ontario parties that are not qualified parties under the ProposedRule.
Changes from the Draft Policy
Section 3.1 is new and has been included in order to alleviate some of the concerns expressed by commenters aboutthe territorial scope of the Draft Rule.
Part 5
Section 5.1
Section 5.1 of the Proposed Policy clarifies the application of the universal registration regime of Ontario securities lawto OTC derivatives transactions. Section 5.1 provides that transactions effected through the exemptions provided in theProposed Rule are not subject to the universal registration regime because the exemptions contained in the Rule arenot removed by Part XI of the Regulation to the Act ("the "Regulation"). OTC derivatives transaction not effected underan exemption in the Proposed Rule will be subject to the application of the ordinary registration and universal registrationrules contained in the Act.
Section 5.2
Section 5.2 of the Proposed Policy clarifies the steps that an OTC derivatives dealer is required to take in order to satisfythe requirements of clauses 2.3(a)(ii)(A) and 2.4(a)(ii)(A) that a person or company entering into an OTC derivativestransaction must do so with or through an OTC derivatives dealer. Section 5.2 states that the Commission is of the viewthat the condition is satisfied
(a) if an OTC derivatives dealer acts as principal in the transaction; or
(b) if the OTC derivatives dealer is not acting as principal in the transaction, the OTC derivatives dealer hastaken the steps required of dealers under subsection 114(4) of the Regulation for the transaction.
Changes from the Draft Policy
Part 5 is new.
Section 6.1
Section 6.1 of the Proposed Policy clarifies the effect of section 2.2 of the Proposed Rule, which is to put all OTCderivatives transactions on the same footing for purposes of the Proposed Rule, whether or not the transactionsconstitute trades in a security.
Changes from the Draft Policy
Section 6.1 is new.
Specific Request for Comments
The Commission received comments concerning difficulties with some of the definitions contained in the Draft Rule, tothe effect that some of the definitions were too broad and could encompass transactions substantially removed fromderivatives trading. These comments were particularly applicable to such definitions as "contract for differences","forward contracts" and "option". The Commission requests comments on whether these terms should be undefinedin the Proposed Rule and allowed to be interpreted in accordance with ordinary commercial usage.
Comments
Interested parties are invited to make written submissions with respect to the proposed Rule and Companion Policy.Submissions received by Feb 1, 1999 will be considered.
Submissions should be made to:
Daniel P. Iggers, Secretary
Ontario Securities Commission
20 Queen Street West
Suite 800, Box 55
Toronto, Ontario M5H 3S8
A diskette containing an electronic copy of the submissions (in DOS or Windows format, preferably WordPerfect) shouldalso be submitted. As the Act requires that a summary of written comments received during the comment period bepublished, confidentiality of submissions received cannot be maintained.
Questions may be referred to:
Randee Pavalow
Policy Coordinator/Advisor and
Manager of Advisory Services
Ontario Securities Commission
(416) 593-8259
Tracey Stern
Legal Counsel
Ontario Securities Commission
(416) 593-8167
Text of Proposed Rule and Proposed Policy
The text of each of the Proposed Rule and Proposed Policy, together with footnotes that are not part of the ProposedRule or Proposed Policy but have been included to provide background and explanation.
ONTARIO DRAFT RULE 91-504 AND ONTARIO DRAFT POLICY 91-504CP
AND
RESPONSE OF THE ONTARIO SECURITIES COMMISSION
1. INTRODUCTION
In November 1996, the Ontario Securities Commission (the "Commission") released for public comment Draft Rule 91-504 (the "Draft Rule"), together with proposed Companion Policy 91-504CP (the "Draft Policy").
During the comment period on the Draft Rule and the Draft Policy, which expired on March 3, 1997, the Commissionreceived 8 submissions. The commenters providing the submissions can be grouped as follows:
| Law Firms | 3 | |
| Trade Associations | 3 | |
| Insurance Companies | 1 | |
| Other (Toronto Stock Exchange) | 1 | |
| TOTAL | 8 |
Two of the three trade associations listed, being the Canadian Bankers Association (the "CBA"), the International Swapsand Derivatives Association ("ISDA"), each made extensive submissions in respect of the Draft Rule and the Draft Policyon behalf of their respective members.
Copies of the comment letters may be viewed at the office of Micromedia, 20 Victoria Street, Toronto, Ontario (416) 312-5211 or (800) 387-2689.
The following is a summary of the comments received, together with the Commission's responses and, where applicable,the changes in response to the comments that are contained in the proposed Rule (the "Proposed Rule") and proposedCompanion Policy (the "Proposed Policy") being published with this notice.
2. GENERAL COMMENTS
Several commenters raised a number of concerns with the Draft Rule, questioning both the need for the Draft Rule andthe jurisdiction of the Commission in making the Draft Rule. Several commenters also raised the constitutional issueof whether the Draft Rule could apply to federally chartered banks. One commenter was supportive of the initiative andstated that it had no material concerns with the proposals contained in the Draft Rule.
a. Need for Regulation
Four commenters, including the CBA and ISDA, argued that legal uncertainty surrounding the OTC derivatives marketin Ontario is not a significant issue at this time and that the making of a rule to eliminate uncertainty is not justified. Thecommenters indicated that, given their view that there was no compelling reason for the Draft Rule to be made, thecomplexity they perceived in the Draft Rule led them to conclude that the net effect of the Draft Rule would be to increaseuncertainty in the OTC derivatives market in Ontario, rather than decrease it.
Two commenters supported the principle of a rule that reduced regulatory uncertainty.
Response:
The Commission has consulted further with industry participants in order to try to determine whether, on balance,the reduction of uncertainty concerning the application of the prospectus and registration provisions of the Actto OTC derivatives transactions is a useful objective. On balance, the Commission is of the view that the goalof reducing regulatory uncertainty remains valid. The Commission notes that the direct experience of Commissionstaff with the issue suggests that there remains some uncertainty concerning the applicability of the Act to OTCderivatives transactions. Staff receive public inquiries on this matter on a regular basis, from a number of smallerfinancial institutions that participate in the OTC derivatives market. The Commission has also granted a numberof orders in the last few years providing formal relief from the prospectus and registration provisions of the Actfor the OTC derivative activities of some institutions.(2) The Commission also notes that one commenter suggestedthat the Draft Rule go further than it does and specify how all of the provisions of the Act either apply or do notapply to OTC derivatives transactions; this comment suggests that there is some utility in clarifying the applicationof the Act to these transactions.
The Commission has therefore decided to continue with the Proposed Rule, but hopes that proposedamendments now contained in the Proposed Rule and Proposed Policy, together with discussion contained inthis Notice, will clarify ambiguities that have created concerns to date.
Several commenters also stated that there is no existing need to protect retail investors in respect of OTC derivativestransactions on the basis that sophisticated individuals, who are capable of evaluating the suitability of derivativestransactions, currently dominate the OTC derivatives market. The CBA stated that it is not aware of any complaintsabout the lack of protection from retail OTC investors, and has not observed any noticeable growth in the involvementof retail investors in OTC derivatives transactions. The CBA also stated that it sees "no advantage in initiating investorprotection in the OTC derivatives retail market in Ontario, particularly in the absence of any demonstrated need".
Response:
It is generally recognized that the retail market now constitutes, and may always constitute, a small segment ofthe OTC derivatives market. However, the Commission remains of the view that the protection of unsophisticatedpersons that may use certain OTC derivatives transactions is properly a matter of concern, and that it isappropriate that the Commission implement some measures designed to protect those persons.
The Commission emphasizes that the investor protection measures contained in the Proposed Rule, as in theDraft Rule, have been designed to affect a small portion of the OTC derivatives market in Ontario, in a mannerthat is as unobtrusive as possible. The Commission notes three issues in that regard.
First, the Commission notes that the Proposed Rule does not impose investor protection measures on all OTCderivatives transactions involving "non-qualified parties"; rather the Proposed Rule imposes requirements onlyon OTC derivative transactions with "non-qualified parties" that are not exempt transactions. Because of thebreadth of the definition of exempt transactions in the Proposed Rule, many transactions involving interest rateor foreign exchange derivatives will be exempt transactions, even if one of the counterparties is a non-qualifiedparty.
The only OTC derivative transactions involving non-qualified parties that would be subject to the investorprotection measures of the Proposed Rule are interest rate/foreign exchange derivatives entered into for non-hedging purposes, commodity derivatives entered into by a person or company other than a "commercial user",and equity derivatives. Therefore, in effect, the dealer/risk disclosure statement requirements imposed by theProposed Rule will only apply, in the case of interest rate, currency or commodity derivatives, when non-qualifiedparties enter into those transactions for investment or speculative purposes.
Second, the Commission notes that it has taken enforcement action in the past to protect retail investors inrespect of each of these types of products; equity products are clearly the emphasis of the Commission'straditional mandate, but the Commission has also acted in cases of currency and commodity speculation schemesas well. Given this background, the Commission is of the view that the Proposed Rule, as it relates to investorprotection, does not represent an incursion into new regulatory territory.
Third, the nature of the investor protection measures required by the Proposed Rule are not onerous. Therequirements are two-fold; namely the participation of a dealer in the process in order that the non-qualified partyreceives the benefit of the "suitability" and "know your client" analysis provided by the dealer, together with therequirement that a generic risk disclosure statement be provided to the non-qualified party. These measures areentirely consistent with investor protection measures imposed in other contexts by the Commission.
b. Effect of the Draft Rule on the Ontario OTC Derivatives Market
A number of commenters, including the CBA and ISDA, stated that the effect of the Draft Rule would be to drive OTCderivatives transactions out of Ontario because of the perceived complexities of the Draft Rule and associated legal costsfor market participants, particularly foreign counterparties, in complying with the Draft Rule. ISDA suggested that ensuinglegal uncertainty could inhibit the development and use of derivatives, such as credit derivatives, as a risk-managementtool for Ontario-based entities. ISDA and the CBA also stated that no other major jurisdiction has similar regulatoryrequirements and that, given the portability of the OTC market, transactions may move offshore.
Given the international nature of the market and the current developments in the United States, the CBA stated that itbelieves it is prudent for the Commission to wait for U.S. regulatory initiatives with the view to adopting a compatibleapproach, so that the Ontario market is not put at a competitive disadvantage. The CBA also stated that regulators inthe other relevant jurisdictions have affirmatively decided not to take the approach set out in the Draft Rule and DraftPolicy. The CBA raised the issue of regulatory arbitrage that it believes could result from the Draft Rule.
Response:
The Commission does not intend to take any action that will have a damaging effect on the OTC derivativesmarket in Ontario and has no evidence that the Proposed Rule would have that effect. The Commission believesthat this Notice, and the revisions to the Draft Rule and Draft Policy described in this Notice, will clarify ambiguitiesso that the concerns discussed by some of the commenters will be appropriately dealt with.
The Commission reminds the market that the Proposed Rule is intended to intervene as little as possible in theOTC derivatives market. New regulatory requirements, namely, the dealer and risk disclosure statementrequirements, are imposed only on the small segment of transactions that involve the use of certain OTCderivative products by non-qualified parties. As noted above, commenters have confirmed that this aspect of themarket is relatively small and insignificant.
Those parts of the Proposed Rule that do not pertain to the retail market provide exemptions from the entire Act,or from the prospectus and registration requirements of the Act, for other OTC derivative transactions. A rule that,for the most part, only provides exemptions should not have the detrimental effects on the market suggested bysome of the comment letters.
The Commission also notes that the regulatory regime contained in the Proposed Rule was based on Part 35 ofthe Regulations to the U.S. Commodity Exchange Act, and therefore does not believe that the structure of theProposed Rule is as unprecedented as suggested by some commenters. The Commission is aware that theCommodity Futures Trading Commission in the U.S. has issued a concept release concerning its regulation ofthe over-the-counter derivatives market, and the Commission will consider carefully the results of that review.
The CBA found the cost-benefit analysis in the Notice to be lacking in detail, and questioned whether or not a morequantitative study would have supported the necessity of the Draft Rule. The CBA stated that if the Draft Rule has thepotential to discourage foreign counterparties from doing business with Ontario counterparties, the Draft Rule could notbe said to promote fairness and efficiency in Ontario's capital markets. The CBA took the position that the Commissionshould not proceed with the Draft Rule until it has more thoroughly evaluated the implications of the Draft Rule on theOTC derivatives business in Ontario.
Response:
The Commission undertook a study, the 1994 Report, before proposing the Draft Rule. As noted above, the 1994Report emphasized the importance of clarifying regulation of the OTC derivatives market. Certainty in the market,along with investor protection, particularly of retail investors, are the primary considerations associated with theProposed Rule. The Commission believes that further cost-benefit analysis is not warranted, given theclarifications that have been made since the publication of the Draft Rule, as well as the overall minimal effect ofthe Proposed Rule.
c. Constitutional Issues
Several commenters raised the issue of whether the Draft Rule would apply to federally chartered banks. The CBAreiterated its 1994 position that the Commission has no jurisdiction over the OTC derivatives activities of federallychartered banks. The CBA stated that it felt that the operations of a Canadian chartered bank in OTC derivatives arean integral part of the business of banking, subject to the exclusive jurisdiction of the federal government, and do notconstitute an activity that is subject to provincial regulation.
The CBA argued that the derivatives activities of Canadian banks are already heavily supervised and adequatelyregulated. The CBA noted that Canadian banks are already subject to the supervision of the Office of the Superintendentof Financial Institutions ("OSFI"), which is "well aware" of bank activities in the OTC derivatives market. The CBA alsostated that banks are subject to the Standards of Sound Business and Financial Practice of the Canada DepositInsurance Company, which deals with financial instruments including OTC derivatives. Finally, the CBA stated thatCanadian banks are also subject to international agreements reached by the Bank for International Settlements andimplemented by OSFI.
The CBA and one other commenter stated that OTC derivatives transactions are primarily credit transactions and theCBA stated that the Commission should not attempt to sweep the credit market into its regulatory purview. The CBAalso stated that the Commission has no jurisdiction over an interest rate swap transaction between banks, although ifone of the banks involved were a non-Basle Accord jurisdiction bank, the Draft Rule would apply to that transaction,unless that bank had entered into the transaction for OTC derivatives hedging purposes. The CBA also stated it wasunclear whether or not index-linked deposit notes would be exempt from the Draft Rule, although the CBA acknowledgedthat a debt-like derivatives rule is forthcoming.
The law firms commenting on the Draft Rule questioned whether the Draft Rule would apply to banks, although in lessdefinitive terms on the issue than the CBA. One law firm raised the issue of whether the publication of the Draft Rulewas the best forum in which to deal with the complex issue of the interplay between federal and provincial jurisdictionin respect of the capital market activities of banks. Another law firm suggested that the Commission should consult withthe federal government before attempting to regulate the OTC derivatives activities of Canadian banks.
Response:
The Commission has the authority to make the Proposed Rule under the Act. The Proposed Rule has beencarefully tailored to focus on investor protection in the retail market and is therefore designed to protect thoseleast able to protect themselves. It is not aimed at ensuring the financial soundness of financial institutions, thesubject matter and primary concern of federal legislation pertaining to derivatives.
d. Scope of Authority to Regulate Derivatives
A number of commenters took the view that the Act, by its terms, does not give the Commission the power to regulatederivatives that are not securities under traditional tests, despite the words in section 1.1 and in paragraph 35 ofsubsection 143(1) of the Act. One commenter stated that, absent express statutory authority, the Commission's rule-making authority in respect of derivatives should be exercised within the traditional normative framework of the Act,restricting any regulation of the OTC derivatives market to OTC derivatives that constitute trades in securities undertraditional tests. The commenter took the position that rules are a subordinate regulatory instrument, and the authorityto make rules should not be construed as authority to regulate in areas outside the existing statutory framework of theAct.
Response:
The Commission notes that the plain meaning of the word "derivatives" includes instruments that are notsecurities, and that the scheme of the Act permits the Commission to define the term "derivatives" for purposesof the Act, the regulations and the rules, a step taken by the Commission in implementing Rule 14-501Definitions.(3) The Legislature, in drafting the amendments to the Act in which these provisions were included,meant to provide the Commission with the ability to deal in a flexible manner with the derivatives market, a marketthat did not fit easily into traditional categories.
The CBA questioned whether or not the Commission has the authority to define the types of derivatives transactions itproposes to regulate without first consulting with OSFI.
Response:
The Commission notes that its rule-making authority does not stem from consulting other parties; rather, itsauthority is found in the Act.
e. Extra-Territorial Effect of the Draft Rule
Several comments were made concerning the effect of the Draft Rule on transactions effected with counterpartieslocated outside Ontario. One commenter expressed the view that there is nothing in the Draft Rule that requires an OTCderivatives transaction to have any nexus in Ontario to be subject to the Draft Rule. This commenter stated that the DraftRule expressly reaches outside both Ontario and Canada, and that, in its view, the Draft Rule "should provide anexemption from the application of the Rule where a Qualified Party or "hedging party" in Ontario enters into an OTCderivatives transaction with anyone outside of Ontario." One commenter asked that the geographical scope of the DraftRule be clarified. The CBA suggested that the Draft Rule could be restructured to clarify that "the requirements inparagraph (a) of section 2.3 apply only to Ontario counterparties".
The CBA also expressed concern that the Draft Rule would be onerous for non-Ontario counterparties, which currentlydo not find it necessary to seek local legal advice. As a result, the CBA stated, foreign counterparties may decide toconduct their derivatives business elsewhere.
Response:
The Commission notes that the Draft Rule was prepared without specific reference to its extra-territorial effect;this is consistent with the preparation of legislation generally and the Act in particular. For instance, neither ofsection 25 or 53 of the Act explicitly limit their scope to trades or distributions in Ontario.
However, notwithstanding this fact, the Commission recognizes the concern of commenters and notes that itagrees with the principles expressed in these comments; namely, that the Draft Rule was not designed to protectcounterparties located outside of Ontario or to apply to OTC derivatives transactions that do not raise Ontarioinvestor protection concerns.
In response to these comments, the Commission has added section 3.1 to the Proposed Policy to clarify theCommission's views of its administrative practice concerning the territorial scope of the Proposed Rule. Thatsection outlines that principles analogous to those enunciated in the Interpretation Note replacing OSC Policy 1.5in respect of OTC derivatives transactions.
Specifically, section 3.1 of the Proposed Policy states that the Commission is of the view that parties entering intoan OTC derivatives transaction with a non-Ontario counterparty are entitled to consider the connecting factorsof the transaction with Ontario in order to determine whether the transaction is subject to the Proposed Rule andany other applicable Ontario securities law. The section notes that the Commission is of the view that the investorprotection aspects of the Rule are designed for Ontario persons or companies.
Section 3.1 also notes that the ISDA master agreements provide that the rights and obligations thereunder arenot transferable except in certain prescribed circumstances, such as default or reorganization. It is noted that theCommission is of the view that those provisions do not lead to any inferences that would make the third conditionnoted above inapplicable.
f. Structure of the Draft Rule
Several commenters commented on the structure of the Draft Rule and raised two general points. The first point wasthat the Draft Rule was too complex and would create ambiguities, thereby increasing rather than decreasing uncertainty.The CBA was of the view that the level of complexity would require potential counterparties to make additional recourseto legal counsel, thereby increasing transaction costs. The second point was that the Draft Rule would avoid some ofthe perceived problems described above if it did not have as wide a scope. Some commenters suggested that the DraftRule simply impose restrictions on OTC derivatives transactions involving retail counterparties, and be silent ontransactions between sophisticated parties.
Response:
The Commission considered the possibility of an alternative structure in conjunction with the comment that thereis no need to resolve regulatory uncertainty in this area. The Commission is of the view that the alternativeapproach (i.e. having the Proposed Rule silent on transactions not involving retail counterparties) would be usefulif a determination had been made not to provide exemptions for OTC derivatives transactions that the Commissionbelieves should not be subject to the Act or the prospectus or registration provisions of the Act. As describedabove, the Commission has determined to continue with that approach on the basis that it is useful to resolveuncertainty, and so the Proposed Rule continues to be structured in the same manner as the Draft Rule.
ISDA and the CBA opposed the Draft Rule's "arbitrary" division of derivatives into three categories, depending upon theunderlying interest, as well as the imposition of different regulatory treatments to each category. Their opposition wasbased upon their view that the Commission had set out no principled reason for making these distinctions. The CBAremarked on the definition of "exempt transaction", which contains a distinction between "interest rate/foreign exchangederivatives" and "specified commodity derivatives", leaving out OTC derivatives transactions with other types ofunderlying interests. The CBA also expressed concern that additional legal advice would be required to categorizetransactions properly. Another commenter was of the view that the proposed Rule should include a generic exemptionfrom the application of the Act for specified commodity transactions. The commenter proposed that as the Commissionbecomes aware of problems with these transactions, it could create rules to clarify the application of the Act or to protectcertain parties.
Response:
The Commission is of the view that the most rational way of categorizing derivatives for the purpose of theProposed Rule is according to their underlying interest, rather than according to the nature of the instrument. Thisapproach to categorization also integrates most easily with the desire of the Commission to restrict the ambit ofthe Proposed Rule to traditional areas of its jurisdiction.
The CBA also suggested that if the OTC derivatives market develops a significant retail aspect, the Commission couldbetter protect retail investors by structuring the Draft Rule to define "retail investors" and then applying the registrationand prospectus provisions to those transactions. The CBA advocated this approach on the basis that it would beimpossible to maintain a current and comprehensive list of qualified parties; any delay associated with the updating ofthe list of qualified parties could cause confusion in the market and discourage OTC derivatives business in Ontario.In the context of this proposal to define retail investors, the CBA suggested that a regulatory framework for OTCderivatives could be extended to investors transacting through small businesses by adding a second category to thedefinition of retail investor. This category could be based on paragraph (n) of Appendix A - Qualified Parties, designedto catch companies, partnerships and other associations with total assets of less than $100 million.
Similarly, another commenter suggested that only those OTC derivatives transactions and parties requiring protection,such as transactions involving less sophisticated individuals, should be regulated from the start. The Draft Rule couldthen set out only those parties and transactions to which it applies. The commenter pointed out that this approach wouldbe consistent with the 1994 Staff Report, which noted that the Commission's interest in regulating trades in the OTCderivatives market would be largely confined to unsophisticated parties.
Two commenters, including ISDA, observed that the Draft Rule subjects all derivatives transactions to the Draft Rule andthen exempts specific transactions. ISDA took the view that the Commission was therefore determining that derivativestransactions yet to be created should be subject to the Commission's regulatory purview. ISDA objected to thisregulatory approach on the grounds that there was no evidence that current market practice and dealers' self regulatoryrequirements do not sufficiently protect participants. The ISDA also stated that this approach has no intuitive securitieslaw rationale or justification and cannot be found in other countries with highly developed financial markets.
One commenter suggested that the Commission should avoid imposing unnecessary regulatory requirements andincreasing transaction costs on the chiefly sophisticated parties to OTC derivatives transactions. The commenterproposed that the Commission could do so by providing a blanket exemption for all derivatives transactions and thenidentifying and regulating the specific parties and transactions that warrant regulation.
Response:
The Commission has considered alternate methods of structuring the Proposed Rule, but has determined thatthe approach adopted in the Proposed Rule would provide the most certainty to the OTC derivatives market.
One approach considered by the Commission was the providing of a general exemption for OTC derivativestransactions from the prospectus and registration requirements of the Act, followed by the imposition ofrequirements on those transactions involving unsophisticated parties. The Commission believes that approachraises two problems. First, the difficulties of defining terms in the whole area of derivatives would make it difficultto define properly the scope of such an exemption; the Commission in making such an exemption would have togenerate a definition of "derivatives" that did not extend to such instruments as conventional convertible securities,warrants, depositary receipts, mutual fund securities and a large number of other instruments not commonlyconsidered to be derivatives but whose value is derived from some underlying interest. Second, that alternativeapproach would ultimately not result in a materially different structure from the approach used in the ProposedRule.
The Commission notes that the Proposed Rule, as was the Draft Rule, is structured as it is in order to eliminatethe need to determine whether an OTC derivatives transaction is or is not a trade in a security. Therefore, section2.2 of the Proposed Rule makes all OTC derivative transactions, other than exempt transactions, subject to theregistration and prospectus requirements of the Act, even if they do not constitute trades in securities. TheCommission considers this approach important to eliminate the need for market participants to make thedetermination of whether a particular instrument or transaction constitutes a security or trade in a security. Thisapproach is also consistent with the Commission's view that determining whether investor protection is requiredin a specific type of transaction should not depend upon the transaction representing a trade in a security.
Another approach considered by the Commission was to attempt to define only "retail" counterparties rather than"qualified" parties. The Commission did not use this approach for two reasons. First, in the interests of investorprotection, the Commission's past practice has been to presume that parties are not sophisticated unless sodetermined by the Commission and the current approach is consistent with this traditional approach. Second,it is the Commission's view that adopting the suggestion to define non-qualified parties would prove no easier thandefining the qualified parties, since the lists of parties would simply mirror each other.
In the case of non-Ontario parties, the Commission has clarified the extra-territorial effects of the Proposed Rule,so that it will likely have no application to many international derivatives transactions. The Commission has alsoclarified the entire Proposed Rule as much as possible, and expects that changes made from the Draft Rule,together with the clarifications described in the Proposed Policy and this Notice, will assist in eliminatinguncertainty with respect to the Proposed Rule.
The Commission has therefore not made changes to the structure of the Proposed Rule requested by thesecomments.
g. Debt-Like Derivatives
One commenter observed that the Notice stated that the Draft Rule does not pertain to trades in "debt-like derivatives".The commenter also pointed out that the Notice contained no specification of the characteristics of a debt-like derivative.
Response:
The Commission notes that a definition of debt-like derivative is being developed in connection with a draft ruleon Debt Like Derivatives on the regulation of those instruments in Ontario and will shortly be published forcomment.
h. Credit Derivatives
One commenter noted that it is unclear how credit derivatives would be treated under the Draft Rule.
Response:
The Commission believes that credit derivative transactions are likely to fall within the definition of "interestrate/foreign exchange derivatives" and would therefore generally be exempt transactions under the ProposedRule.
i. Grandfathering of Outstanding Transactions
One commenter suggested that the Draft Rule should neither permit enforcement action by the Commission nor theexercise of civil remedies in respect of OTC derivative transactions entered into prior to, and that are outstanding on,the date that the Draft Rule comes into force.
Response:
The Commission does not consider this amendment necessary, since the Proposed Rule does not provide for,and will not have, retroactive application. The Commission does not expect to enter into enforcement action inrespect of transactions that could not violate the Proposed Rule, as it was not in force at the time they wereentered into. The Commission is also not dealing with civil remedies in the Proposed Rule.
B. COMMENTS ON SPECIFIC PROVISIONS OF THE DRAFT RULE AND DRAFT POLICY
Part 1 - Definitions
General
A number of comments received on various definitions contained in the Draft Rule raised the possibility that thedefinitions used in the Draft Rule could technically apply too broadly, encompassing transactions substantially removedfrom derivatives trading. For instance, one comment suggested that the definition of "forward contract" contained in theDraft Rule could technically apply to many transactions in which a party agreed to buy something from another party ata later date. A number of these comments were essentially drafting suggestions, and the changes made by theCommission are noted below. The Commission also refers to the main part of this Notice in which comment is requestedon whether it would be of assistance to delete a number of problematic definitions from the Proposed Rule and rely onthe normal commercial meaning given to these terms.
Section 1.1 - definition of "commercial user" and "contract for differences"
One commenter questioned the use of the phrase "transactions involving" in the definition of "commercial user" andelsewhere in the Draft Rule. The commenter suggested that an amendment to this terminology be made to make clearthat the phrase is only designed to pertain to a component of a larger transaction that may consists of a derivative, ratherthan to the entire transaction.
Response:
The Commission agrees with this comment, and has amended the words "involving" to "consisting of" to clarifythis issue.
One commenter suggested that these two definitions could encompass transactions that are not ordinarily consideredto be derivatives, such as business acquisition agreements containing price adjustment clauses.
Response:
The Commission notes that these definitions "feed into" the definition of "OTC derivative" and that the Commissionhas amended the definition of "OTC derivative" to restrict its application only to instruments "commonly consideredto be derivatives". The Commission believes that this approach will avoid the problem that instruments notconsidered to be derivatives could be considered to be caught by the definitions contained in the Proposed Rule.
Section 1.1 - definition of "contract for differences"
A few commenters expressed concern that the definition of "contract for differences", as it appeared in the Draft Rule,could be interpreted to include spot currency contracts.
Response:
The Commission agrees with this comment and has amended the definition to exclude spot currency contracts.
One commenter suggested deleting clause (a) - "an exchange of principal amounts".
Response:
The Commission understands this clause to be useful to catch currency swap transactions, and therefore has notmade this change.
Section 1.1 - definition of "conventional floating rate debt security"
The CBA objected to applying the Draft Rule to conventional floating rate debt securities if they are based on anunderlying interest that is not a "benchmark commonly used in commercial lending arrangements". The CBA arguedthat the structure of commercial lending arrangements will evolve over time and therefore any attempt by theCommission to freeze the structuring arrangements for the purposes of defining OTC derivatives would be impracticable.
Response:
The Commission has not frozen the benchmarks that could satisfy this definition. The Commission notes that arule, like legislation in general, is interpreted as at the time it is read. Therefore, the use of the phrase "abenchmark commonly used" will include benchmarks that are commonly used at the time that the rule isinterpreted, not just at the time that the rule is adopted.
Section 1.1 - definition of "exempt transaction"
The CBA questioned why the definition of "exempt transaction" left out OTC derivatives transactions involving underlyinginterests other than "interest rate/foreign exchange derivatives" and "specified commodity derivatives".
Response:
The rationale for the scope of the definition of "exempt transaction" is described in Paragraph 1(a) - "Need forRegulation".
Section 1.1 - definition of "forward contract"
On commenter stated that the definition of "forward contract" in the Draft Rule was broad enough to catch a typical assetand share purchase agreement or other types of executory agreement where performance involves making or takingof delivery of an asset on terms specified when the agreement is entered into.
Response:
As described above, the Commission has amended the definition of "OTC derivative" to include transactionscommonly considered to be derivatives. The Commission has also requested comments on whether it would bepreferable to eliminate some of the definitions for terms used in the Proposed Rule.
Section 1.1 - definition of "interest rate/foreign exchange derivative"
One commenter noted that, generally in the Draft Rule, transactions involving interest rate/foreign exchange derivativesare exempt transactions, and therefore exempt from Ontario securities law. As a result, these transactions would beexempted from any application of the rules concerning trading with material inside information concerning an issuer.The commenter noted that OTC derivatives based on corporate debt instruments would be included in the definition of"interest rate/foreign exchange derivatives" and that this approach appeared to be inconsistent with the fact that equityderivatives were not exempt transactions and the special relationship rules would apply to trades in those instruments.
Response:
The Commission agrees with this comment, and has amended the definition of "interest rate/foreign exchangederivatives" to exclude derivatives whose underlying interest is the debt of corporations.
Section 1.1 - definition of "OTC derivative"
Two law firms objected to the breadth of the definition of "OTC derivative", saying that it could be interpreted to includeinstruments not considered to be OTC derivatives, such as spot foreign exchange transactions, as well as typical assetand share purchase agreements or other types of executory agreements where performance involves the making ortaking of delivery of an asset on terms specified at the time the agreement is entered into.
Response:
As described above in the discussion of comments on the definition of "commercial user", the Commission hasamended the definition of "OTC derivative" to include transactions commonly considered to be derivatives.
The TSE also expressed concern about the broad nature of the definition of "OTC derivative", stating that it may notcreate a level playing field with respect to customized exchange-traded derivative products. Derivatives contracts tradedon the exchange are subject to prospectus requirement or approval under Rule 91-502 Trades in Recognized Options,or the Commodity Futures Act, as the case may be. Under the Draft Rule, identical contracts could be traded with littleor no restriction. The TSE recommended that the Commission consider developing an expedited review process for theapproval for new exchange-traded derivative products, similar to the recent CFTC initiative, to ensure that the exchangesare not at a competitive disadvantage in the derivatives market.
The TSE also suggested that the definition of "OTC derivative" should be amended to provide that an OTC derivativemust not have identical or substantially similar terms to contracts traded on an exchange.
Response:
The purpose of the Proposed Rule is to allow the OTC derivatives market to flourish with a minimum of regulatoryintervention, with investor protection measures imposed only where necessary. The regulation of the exchange-traded market is outside the scope of the Proposed Rule. The Commission does not wish to deny the benefitsof the Proposed Rule to derivatives transactions that are similar or identical to exchange-traded products.
Section 1.1 - definition of "OTC derivatives dealer"
One commenter objected to the requirement that transactions to which clause 2.3(a)(ii) of the Draft Rule would applymust be entered into by a non-qualified party with or through an OTC derivatives dealer. The commenter stated that OTCderivatives are credit-driven and that the Canadian and global markets are dominated by banks, yet banks do not qualifyas OTC derivatives dealers. Another commenter also objected to the exclusion of international dealers, banks, and otherfinancial institutions from this definition, pointing out that there are no restrictions in securities laws preventing theseentities from engaging in activities relating to derivatives that are not securities. In addition, the commenter observedthat these entities would be permitted to trade in derivatives that are securities with other entities.
Response:
The Commission's response to these comments is contained under "Section 2.3 - Universal Registration" and"Section 2.3 - Sale to Non-Qualified Parties" in this Appendix.
Section 1.1 - definition of "qualified party"
Comments on the specific parties included in the list of "qualified parties" are included in the discussion of "AppendixA" in this Appendix.
One commenter questioned the structure of the definition of "qualified party". Rather than listing the parties to whomthe Draft Rule does not apply, that is, the qualified parties, the commenter advocated setting out the parties andtransactions that are in fact subject to the Draft Rule. Counterparties could then determine whether or not the proposedtransaction was subject to the Draft Rule. The commenter also pointed out the difficulty involved in drafting languagethat does not exclude entities outside Canada that should actually be included as qualified parties.
Response:
As described above under "Part 2(f) - Structure of the Draft Rule", the Commission believes that the existingstructure is necessary to achieve the purpose of the Proposed Rule. The Commission also believes that itsclarification of the territorial scope of the Proposed Rule should alleviate some of these concerns.
Part 2 - Application of the Act
Section 2.2
The comments concerning section 2.2 of the Proposed Rule have been dealt with under the general discussion of thestructure of the Proposed Rule, found above in "Paragraph 2(f) - Structure of the Draft Rule".
Section 2.3
One commenter suggested that the word "if" at the beginning of paragraph 2.3(a) should be moved to the end of the firstparagraph of paragraph 2.3(a) following the words "a transaction involving an OTC derivative".
Two commenters proposed that paragraph 2.3(b) should be amended to ensure that it achieved its intended purpose.Paragraph 2.3(b) was designed to ensure that the exemptions provided by sections 25 and 53 of the Act were availableto all OTC derivatives transactions, whether or not the transactions constituted trades in securities. The commenter alsoproposed that the language of paragraph 2.3(b) be amended to ensure that the exemptions contained in section 25 and53 of the Act could operate independently.
Response:
The Commission agrees with these comments, and has amended paragraph 2.3(b) and has divided section 2.3of the Draft Rule into two sections of the Proposed Rule.
The CBA argued that section 2.3 of the Draft Rule would effectively require Ontario-based OTC derivatives counterpartiesto conduct transactions with counterparties that are not qualified parties through a non-bank subsidiary registered underthe Act or the Commodity Futures Act. The CBA was of the view that this requirement would increase the cost ofdelivering the transactions to this customer base. In addition, the CBA stated that not only was it unclear as to what typeof derivatives dealer participation the Commission envisaged, there was no indication of the potential legal implicationsof involvement for the dealer. In the case of a transaction between a qualified party and an unqualified party, the CBAquestioned why the qualified party should not be permitted to provide the risk disclosure statement, since the Draft Rulemandates the involvement of a third party.
Response:
The Commission has added section 5.2 to the Proposed Policy to clarify the role of the OTC derivatives dealerreferred to in clauses 2.3(a)(ii) and 2.4(a)(ii) of the Proposed Rule. The Proposed Policy now states that an OTCderivatives dealer may satisfy the requirements of the Proposed Rule by acting as principal opposite itscounterparty who is a non-qualified party or, if the OTC derivatives dealer is not acting as principal in thetransaction, it has taken the steps required of dealers under subsection 114(4) of the Regulation. This involvessatisfying "know your client" and "suitability" responsibilities.
ISDA stated that the "know your client" and "suitability" requirements are inconsistent with the fundamental principle thatprivately negotiated derivatives transactions between sophisticated investors, whether or not they are qualified parties,are characterized by an "arm's length" relationship. These counterparties must retain responsibility for the transactionand ensure that they understand the risk. The commenter also stated that it may be difficult for a dealer to determinethe "know your customer" issues because parties may not be willing to provide the necessary information.
The issue of suitability was also of concern to ISDA, which agreed with the regulatory authorities that have concludedthat this requirement should not be imposed upon privately negotiated derivatives transactions. Citing the concerns ofregulators and academics that suitability requirements will create moral hazard concerns in the form of counterpartiesengaging in aggressive trading strategies, ISDA predicted that these counterparties will fail to develop risk managementpolicies. ISDA also expressed concern that suitability requirements would impose highly unpredictable legal risks onintermediaries, which could heighten the level of residual risk to the financial system, as well as increase the cost ofusing derivatives as a risk management tool. ISDA recommended that parties not be required to seek investment advice,particularly given the limited scope of the definition of "qualified party".
Response:
The Commission intends that the "know your client" and "suitability" responsibilities will be carried out for OTCderivatives transactions in the same manner as securities transactions generally. The Commission is notrethinking the utility of that approach in connection with the Proposed Rule.
Another commenter observed that the familiarity of dealers with OTC derivatives transactions varies significantly, leadingto the conclusion that dealers should not be interposed in transactions. Instead, non-qualifying parties should berequired to deliver a Risk Disclosure Statement directly to the non-qualifying party.
Response:
The Commission intends that the "know your client" and "suitability" obligations be performed in thesetransactions, and does not wish to rely simply upon a financial institution providing a copy of the risk disclosurestatement to the non-qualified party.
The Canadian Council of Financial Analysts Inc. ("CCFA") requested the recognition of the Canadian Financial Analysts("CFA") Course as an alternative to the courses referred to in section 2.3 of the Draft Rule. The CCFA commented onthe rigour of the CFA designation and the amount of derivatives instruction contained in the CFA course materials.
Response:
The Commission agrees that a CFA designation is an appropriate alternative to the courses mentioned in section2.3 of the Draft Rule, and has added references to the CFA designation in sections 2.3 and 2.4 of the ProposedRule.
The TSE took the position that changes in the content of industry educational courses would be required to properlyqualify registrants to deal with the complex and different risks associated with OTC derivatives. The TSE welcomedefforts by the Canadian Securities Institute ("CSI") to enhance their derivatives-related courses, and suggested that theCommission should work with the CSI to ensure that both existing and new courses prepare registrants for theirresponsibilities.
One commenter requested clarification on the relationship between the universal registration requirements of Part XIof the Regulation and the Draft Rule. The commenter stated that it was unclear whether a qualified party that is aninternational dealer may engage in an OTC derivatives transaction that is not an exempt transaction with a qualified partyfor the purpose of section 204(1) of the Regulation.
Response:
The Commission has added section 5.1 to the Proposed Policy to clarify the relationship between the ProposedRule and the universal registration regime. In summary, the relationship is as follows:
First, the universal registration regime operates by removing certain registration exemptions contained inthe Act; a person trading in OTC derivatives through the exemptions provided in the Proposed Rule is notsubject to universal registration in respect of those trades because the exemptions contained in theProposed Rule are not removed by Part XI of the Regulation.
Second, sections 208 through 211 of the Regulation contain a number of specific limitations on the tradingactivity of certain categories of registrant. The Commission is of the view that the registrants are notsubject to those limitations if they are engaged in OTC derivatives transactions effected under eithersection 2.1 or 2.3 of the Proposed Rule.
Third, OTC derivatives transactions not effected under an exemption in the Proposed Rule will be subjectto the application of the ordinary registration and universal registration rules contained in the Act.Therefore, a person engaged in effecting OTC derivatives transactions under, for instance, the $150,000private placement exemption may be a market intermediary and therefore required to be registered as alimited market dealer.
One commenter questioned why the Draft Rule requires that OTC derivatives dealers satisfy both the futures and optionsproficiency requirements regardless of the nature of the OTC derivative involved. The commenter noted that in NationalPolicy Statement No. 39, options proficiency only was required for persons advising mutual funds in connection withoptions trading, and futures proficiency only was required in connection with futures trading.
Response:
As a result of the complexity of some derivatives instruments, and the varied ways in which derivativesinstruments can be structured, the Commission is of the view that a simple bifurcation of derivatives transactionsinto either options or futures is undesirable, and has therefore mandated that derivatives dealers must meet fullderivatives expertise requirements.
The TSE stated that if the retail trading of OTC derivative products is not brought within the traditional regulatorysafeguards, it is questionable whether sales personnel could adequately assess the suitability of investments for theirclients. The TSE was of the view that this issue would be of particular concern if the responsibilities of broker-dealersto assess suitability are relaxed in recognition of the expanded use of discount brokers and on-line trading services.
The TSE expressed concern that the Draft Rule permits sales of OTC derivatives to non-qualified parties, subject onlyto minimal requirements. The TSE was of the view that the OTC derivatives market should only be available to non-sophisticated investors if the trading, prospectus, registration and suitability protection applicable to other securitiesmarkets are applied.
One commenter suggested that in the case of a transaction between a qualified and a non-qualified party, theCommission should consider permitting the qualified party, instead of a dealer, to provide the risk disclosure statement.Another commenter was concerned that banks do not qualify as OTC derivatives dealers.
Response:
As described above, the Commission is of the view that dealers are the appropriate persons to discharge the"know your client" and "suitability" functions, as dealers discharge these functions as a normal part of theirbusiness. Therefore, the Commission has not changed the Proposed Rule in that regard.
Several commenters stated that the interposition of a dealer in cases in which counterparties were not qualified partieswould increase costs and cause delay.
Response:
The Commission has discussed this issue with some of the commenters and believes that this issue issubstantially dealt with by the Commission's clarification of the territorial extent of the Proposed Rule. In practicalterms, the Commission expects that the risk disclosure statement will only be provided to Ontario residents, andthat counterparties will not have to provide the statement, or involve an OTC derivatives dealer with non-Ontarioparties. In the case of Ontario residents, the Commission believes that the benefits of protecting those partiesoutweighs any incremental transaction costs resulting from the involvement of a dealer and the delivery of a riskdisclosure statement.
Part 3 - Designation of Specified Commodities
Section 3.1 - Designation
One commenter disagreed with the requirement of paragraph 3.1(a) of the Proposed Rule that required that a matternot be designated as a specified commodity unless an OTC derivative of which the matter is an underlying interest maybe used by a person or company for OTC derivatives hedging purposes. The commenter stated that this requirementappeared to be unnecessary.
Response:
The Commission is of the view that this requirement is appropriate and has not made a change in the ProposedRule. The definition of "specified commodity" relates ultimately to the definition of "commercial user" in theProposed Rule; a commercial user receives exempt treatment for its derivative activities in specified commoditytransactions on the basis that those transactions are primarily commercial, rather than investment, in nature. Thespecified commodity derivative must therefore be capable of being used for hedging purposes, i.e., offsettingcommercial risks.
Two commenters expressed concern that there was no procedure contained in Part 3 of the Proposed Rule concerningthe designation procedure. They also took the position that a cumbersome designation process could impede the abilityof the market to complete transactions. In general, the CBA took the position that the designation process was simplynot needed in the current OTC derivatives market, since it would create needless administrative and legal issues, notto mention its potential limiting effect on the growth of this business in Ontario. However, if the designation process isto remain, the CBA suggested that the Draft Rule should set out a flexible process for designating additional matters asspecified commodities.
Response:
The Commission does not contemplate a protracted designation procedure for recognizing new commodities tobe included in the list of "specified commodities". The Commission anticipates using the normal applicationprocedure, so that any application of this nature could be brought by market participants or by Commission staff.The Commission expects that these applications would be published for comment, and that interested partieswould have an opportunity to be heard in a publicly transparent process.
Section 3.2 - Revocation of Designation
One commenter expressed concern about the Commission's discretion to revoke a designation under section 3.2retroactively. The commenter suggested that the Draft Rule should be clearer as to when a designation may be revoked.
Response:
The Commission expects that the power to revoke would rarely be used, probably only in circumstances in whicha particular type of specified derivative was being marketed in a way that the Commission consideredinappropriate. Any such revocation would only occur with appropriate notice, giving the interested parties anopportunity to be heard through a process transparent to the public.
Appendix A - List of Qualified Parties
ISDA suggested that determining whether a counterparty falls within the definition of qualified party would involve a"protracted legal and factual inquiry".
Response:
The list of qualified parties contained in Appendix A to the Draft Rule is no more difficult to deal with than otherlists of sophisticated parties used in Ontario securities legislation, such as section 72(1)(a) of the Act.
A number of commenters suggested that additional parties should be added to the list of qualified parties. In particular,they proposed that financial institutions from non-Basle Accord countries, U.S. investment advisers and U.S. pensionfunds should be added to the list.
Response:
The Commission has not added additional parties to the list of qualified parties. Given the Commission'sclarification of the territorial scope of the Proposed Rule, the Commission does not believe that such additionswould be necessary; the Commission expects that most transactions effected with non-Ontario counterpartieswould be made in reliance on the approach described in section 3.1 of the Proposed Policy. Therefore, it is notnecessary to ensure that all non-Ontario counterparties with whom Ontario parties might deal are listed inAppendix A.
In addition, a number of commenters questioned whether the numerical thresholds in Appendix A should be amended,in some cases to make them more consistent with each other, and in other cases to increase or decrease themdepending upon the commenter's position concerning the sophistication of the particular qualified party. The TSEpointed out that the definition in the Draft Rule differs from the definitions of "acceptable institution" and "acceptablecounterparties" that are contained in the Joint Regulatory Financial Questionnaire and Report ("JRFQR"). The TSEexpressed concern that thresholds in the Draft Rule for particular persons, companies or entities, such as credit unions,to be a "qualified party" are sometimes higher and sometimes lower than the thresholds in the JRFQR definitions. TheTSE's position was that the JRFQR definitions of "acceptable institution" and "acceptable counterparty" should be usedunless there exists a clear reason not to use them. Furthermore, the TSE suggested that the Draft Rule should clarifythe basis upon which a person, company or entity would be considered to be sophisticated.
One commenter also stated that the list was inconsistent with the list contained in section 204 of the Regulation. Anothercommenter noted that Canadian institutions are clearly "favoured" over foreign institutions, which may be inappropriatefor a rule with its focus on investor protection.
Response:
The Commission recognizes that there are no universally accepted criteria for establishing a list of qualifiedparties. The purpose of the list is to identify parties that are considered by the Commission not to requireregulatory protection when they enter into OTC derivatives transactions. A number of lists having similar purposesexists in Ontario securities legislation, including clause 72(1)(a) of the Act, section 204 of the Regulation andOntario Securities Commission Policy 4.8. Meanwhile, the JRFQR references institutions considered creditworthyfor capital purposes. These various lists are not identical, and so it is impossible for the list in the Proposed Ruleto be the same as each of them.
In order to provide greater consistency to the list, the Commission has amended the list of Qualified Party in theproposed Rule to change all capital requirements to $100 million from $150 million.
One commenter asked if the capital requirements were consolidated or unconsolidated.
Response:
The Commission has amended Appendix A to clarify that the requirements are to be based on consolidatednumbers.
The following specific comments were made about particular parties on the list.
Credit Unions and Insurance Companies. One commenter wondered whether a minimum capital threshold should berequired for credit unions, taking into account a significant heavy loss in exchange-traded derivatives trading experiencedby an Ontario credit union in recent years. The commenter noted that the definition of "acceptable counterparty"contained in the JRFQR included only credit unions with a paid-up capital and surplus or net worth in excess of tenmillion dollars. One commenter also noted that the only insurance companies licensed to do business in Canadaincluded in the list were those with a minimum paid-up capital and surplus in excess of $150,000,000. The commenternoted that this seemed inconsistent with the provision that any unregulated company need have only a $100,000,000threshold to be consider a Qualified Party.
Response:
Clause 72(1)(a) of the Act provides a prospectus exemption for transactions in which any credit union subject tothe Credit Unions and Caisses Populaires Act, 1994, or any insurance company licensed under the InsuranceAct, purchases as principal without a minimum capital requirement. The Commission has therefore amended theProposed Rule to remove any capital requirements for credit unions and insurance companies. The Commissionconsiders this approach to be consistent with the Act.
Individuals. One commenter thought the $5 million net worth requirement for individuals is too high.
Response:
The Commission disagrees with this comment and has not amended the list in this respect. The $5 millionrequirement corresponds to the requirement for individuals to be permitted clients of international advisersregistered as advisers, contained in paragraph III.1(k) of Ontario Securities Commission Policy 4.8.
Appendix B
One commenter suggested changing a reference in the statement from "Companies Creditor Arrangement Act" to a moregeneric reference to the applicable insolvency legislation.
Response:
The Commission agrees with the comment and has made this change.
C. COMMENTS ON THE PROVISIONS OF THE DRAFT POLICY
Comment on Section 2.3 of the Draft Rule
One commenter recommended that the Draft Policy be amended to clarify that the intent of section 2.2 of the Draft Ruleis to only cause OTC derivative transactions that are not trades in securities to be subject to sections 25 and 53 of theAct. The commenter also proposed that the Draft Policy should specify that the remaining provisions of the Act onlyapply to the extent that the OTC derivatives transaction is a trade in a security.
Response:
The Commission agrees with this comment and has added section 6.1 to the Proposed Policy to reflect thiscomment.
Two commenters suggested that the Draft Policy should discuss which provisions of the Act, other than the registrationand prospectus requirements, apply to OTC derivatives transactions that are not exempt transactions.
Response:
The determination of whether those instruments will be subject to the Act will depend on whether or not they aresecurities. Moreover, the determination of what other provisions of the Act apply will often be fact-specific,depending upon the structuring of the particular instrument. As a result, the Commission is not following thissuggestion. The purpose of the Proposed Rule and the Proposed Policy is only to deal with exemptions from theprospectus and registration provisions of the Act. These instruments do not deal with the application of otherprovisions of the Act to OTC derivatives.
Comment on Section 2.1 of the Draft Policy
Section 2.1 of the Draft Policy stated the Commission's view that counterparties are entitled to rely upon representationsof their counterparties to OTC derivatives transactions respecting qualified party status. That provision also stated thatstaff of the Commission will therefore normally not take any enforcement actions in respect of a transaction against aparty that has relied in that manner on representations of its counterparty.
One commenter suggested the Draft Policy should make clear that, while proper reliance on representations of acounterparty may avoid an enforcement action by the Commission, a misrepresentation by a party as to its status as aqualified party would not deprive the other party of any remedies available to it at law. These remedies would includecivil remedies available to a purchaser of securities under section 133 of the Act. The commenter also feared that failureto comply with a prospectus obligation could render a transaction void or voidable. Furthermore, the commenter tookthe view that the Draft Rule should provide relief against these risks if there is reasonable reliance upon therepresentations.
Response:
The Commission has not adopted this comment. The Commission does not have the authority to amend the civilremedy sections of the Act through a rule.
The CBA stated it had concerns about the implications of imposing a requirement to make these representationsbecause it might invite a counterparty that was in breach of its own representation to subsequently claim that it had notbeen authorized to enter into the transaction, or that the transaction was illegal, or otherwise challenge the validity of thetransaction.
Response:
The Commission notes that the Proposed Policy does not impose any requirements; a party may satisfy itselfabout the status of its counterparty in any manner that it considers appropriate. The Proposed Policy is onlyintended to assist market participants by indicating that the Commission will not take action against a counterpartythat has relied in good faith upon a representation. The Commission is leaving it to the business judgment ofparties to determine how best to satisfy themselves on the status of their counterparties.
One commenter expressed its concern that the Draft Policy does not give an indication of the circumstances under whichthe Commission may take enforcement action against a party. The commenter predicted that the result of this additionalrepresentation in OTC derivatives documentation would be to delay transactions, particularly those involving foreigncounterparties with little knowledge of the Draft Rule.
Response:
The Commission notes that a decision by the Commission staff to take enforcement action in any manner isalways a discretionary one, based on the facts of a particular situation.
Other commenters believed that the Commission's position with respect to reliance on representations is significant andshould be set out in the Draft Rule.
Response:
The Commission notes that the provision in question deals with the practices generally followed by theCommission or Director in the performance of duties and responsibilities under the Act and is thus a matter fora policy, not a rule, in accordance with section 143.8 of the Act.
Another comment concerned the ability of a party to rely upon a counterparty's representation that it had received a riskdisclosure statement in accordance with the Draft Rule. The commenter suggested that a provision similar to section2.1 of the Draft Policy be added to the Draft Policy to recognize the legitimacy of relying upon these representations.
Response:
The Commission agrees with this comment and has added section 2.2 to the Proposed Policy.
Two commenters were concerned that obtaining representations concerning the qualified status of a party could slowdown transactions. In this context, one commenter objected to the notion that the Commission proposed to required thatthe representations be obtained on a transaction-by-transaction basis.
Response:
The Commission reminds market participants that parties may satisfy themselves in any way they see fit aboutthe status of a counterparty. The Commission would expect that, if necessary, the necessary representationscould be contained in master agreements, and therefore would not need to be obtained for each transaction.
Comment on Section 5.2 of the Draft Policy
One commenter noted that section 5.2 of the Draft Policy spoke of the availability of existing private placementexemptions if the exemptions provided under the Draft Rule are not available. The commenter stated that the languageof the Draft Policy is a clear invitation to structure transactions into private placement exemption if other exemptionsunder the Draft Rule are not available. The commenter requested that the Commission clarify that such practices areacceptable.
Response:
The Commission notes that the ordinary principles on the use of exemptions apply.
ONTARIO SECURITIES COMMISSION RULE 91-504
OVER-THE-COUNTER DERIVATIVES
TABLE OF CONTENTS
PART TITLE
PART 1 DEFINITIONS
1.1 Definitions
PART 2 APPLICATION OF THE ACT
2.1 Non-Application of the Act
2.2 Application of Provisions of the Act
2.3 Registration Exemption
2.4 Prospectus Exemption
PART 3 DESIGNATION OF SPECIFIED COMMODITIES
3.1 Designation
3.2 Revocation of Designation
PART 4 EXEMPTION
4.1 Exemption
APPENDIX A - QUALIFIED PARTIES
APPENDIX B - RISK DISCLOSURE STATEMENT FOR OTC DERIVATIVE TRANSACTIONS
ONTARIO SECURITIES RULE 91-504
OVER-THE-COUNTER DERIVATIVES
PART 1 DEFINITIONS(4)
1.1 Definitions - In this Rule
"Canadian Futures Examination, Parts I and II", "Canadian Options Course" and "Canadian Securities Course"each means an examination or a course, as applicable, prepared and conducted by The Canadian SecuritiesInstitute and so named by that Institute on the date on which this Rule comes into force, every predecessor tothat course, and every successor to that course that does not narrow the scope of the significant subject matterof the course;
"commercial user" means a person or company that enters into a specified commodity derivative transaction,if
(a) the person or company deals in its business with a specified commodity, and
(b) the transaction consists of a specified commodity derivative of which the underlying interest, or a materialcomponent of the underlying interest, is
(i) a specified commodity referred to in paragraph (a),
(ii) a related specified commodity to a specified commodity referred to in paragraph (a), or
(iii) a specified commodity derivative, the underlying interest of which is
(A) a specified commodity, or
(B) a related specified commodity to a specified commodity referred to in paragraph (a);
"contract for differences" means an agreement, other than an option(5), a forward contract, a spot currencycontract or a conventional floating rate debt security, that provides for
(a) an exchange of principal amounts, or
(b) the obligation or right to make or receive a cash payment based upon the value, level or price, or onrelative changes or movements of the value, level or price of, an underlying interest;
"conventional floating rate debt security" means an evidence of indebtedness of which the interest obligationsare based upon a benchmark commonly used in commercial lending arrangements;
"exempt transaction" means a transaction consisting of
(a) an interest rate/foreign exchange derivative in which each party to the transaction is
(i) a qualified party for that transaction, or
(ii) a person or company entering into the transaction for OTC derivatives hedging purposes; or
(b) a specified commodity derivative in which each party to the transaction is a qualified party for thattransaction;
"forward contract" means an agreement, not entered into or traded on or through an organized market, stockexchange or futures exchange and cleared by a clearing corporation(6), to do one or more of the following onterms or at a price established by or determinable by reference to the agreement and at or by a timeestablished by or determinable by reference to the agreement:
1. Make or take delivery of the underlying interest of the agreement.
2. Settle in cash instead of delivery;
"futures exchange" means an association or organization operated to provide the facilities necessary for thetrading of commodity futures";
"interest rate/foreign exchange derivative" means an OTC derivative of which the underlying interest consistsentirely of
(a) an interest rate, Canadian or foreign currency, a foreign exchange rate, an evidence of indebtedness ofan entity other than a corporation that is not exchangeable for or convertible into another security, or somerelationship between, or combination of, any of them, or
(b) an interest rate, Canadian or foreign currency, a foreign exchange rate, an agreement or instrument thathas as its underlying interest an evidence of indebtedness of an entity other than a corporation that is notexchangeable for or convertible into another security, or some relationship between, or combination of, anyof them;
"OTC derivative" means an option, a forward contract, or a contract for differences of a type commonlyconsidered to be a derivative, in which
(a) the agreement relating to, and the material economic terms of, the option, forward contract or contract fordifferences have been customized to the purposes of the parties to the agreement and the agreement isnot part of a fungible class of agreements that are standardized as to their material economic terms,
(b) the creditworthiness of a party having an obligation under the agreement would be a material considerationin entering into or determining the terms of the agreement, and
(c) the agreement is not entered into or traded on or through an organized market, stock exchange or futuresexchange and cleared by a clearing corporation;
"OTC derivatives dealer" means a person or company registered under the Act as a dealer in the category ofbroker or investment dealer or under the CFA(7) as a dealer in the category of futures commission merchant;
"OTC derivatives hedging" means the entering into of a transaction, or a series of transactions, the intendedeffect of which, or the intended cumulative effect of which, is to offset or reduce a risk to which a person orcompany is, or can reasonably expect to be, exposed, and which transaction or series of transactions
(a) involves an OTC derivative, or a series of OTC derivatives, for which there is a high degree of negativecorrelation between changes in the value of the position or positions being hedged and changes in thevalue of the instrument or instruments with which the position or positions are hedged, and
(b) is intended to no more than offset the effect of changes in value in the position or positions being hedged;
"qualified party" means, for any transaction
(a) a company, person or entity described in Appendix A, or
(b) a commercial user for that transaction;
"related specified commodity" means a specified commodity that is part or all of an underlying interest of aspecified commodity derivative that is used by a commercial user to hedge its exposure to a risk resulting fromits use of another specified commodity in its business;
"Risk Disclosure Statement for OTC Derivatives" means the statement attached to this Rule as Appendix B;and
"specified commodity" means
(a) whether in the original or a processed state, an agricultural product, forest product, product of the sea,mineral, metal, hydrocarbon fuel product or precious stone or other gem,
(b) a pollutant emission level,
(c) electricity,
(d) a liability from an insurance contract, and
(e) a matter designated by the Commission as a specified commodity, if that designation has not beenrevoked; and
"specified commodity derivative" means an OTC derivative of which an underlying interest is
(a) a specified commodity, or
(b) another OTC derivative of which the underlying interest is a specified commodity.
PART 2 APPLICATION OF THE ACT
2.1 Non-Application of the Act - The Act does not apply to an exempt transaction.
2.2 Application of Provisions of the Act - Subject to section 2.1, sections 25 and 53 of the Act apply to atransaction consisting of an OTC derivative that does not constitute a trade in a security as if, and to the sameextent as those sections would apply if, the transaction did constitute a trade in a security.
2.3 Registration Exemption - Despite section 2.2, section 25 of the Act does not apply to a transaction consistingof an OTC derivative if
(a) each party to the transaction is either
(i) a qualified party for that transaction; or
(ii) a person or company
(A) that enters into the transaction with or through an OTC derivatives dealer, if each person actingas a representative of the OTC derivatives dealer for that transaction has successfully completedthe Chartered Financial Analysts Course, or each of the Canadian Futures Examination, PartsI and II, the Canadian Options Course and the Canadian Securities Course, and
(B) that has been provided with a copy of the Risk Disclosure Statement for OTC Derivatives by theOTC derivatives dealer; or
(b) in the case of a transaction that does not constitute a trade in a security, the transaction would have beenexempt from section 25 of the Act if the transaction did constitute a trade in securities.
2.4 Prospectus Exemption - Despite section 2.2, section 53 of the Act does not apply to a transaction consistingof an OTC derivative if
(a) each party to the transaction is either
(i) a qualified party for that transaction; or
(ii) a person or company
(A) that enters into the transaction with or through an OTC derivatives dealer, if each person actingas a representative of the OTC derivatives dealer for that transaction has successfully completedthe Chartered Financial Analysts Course, or each of the Canadian Futures Examination, PartsI and II, the Canadian Options Course and the Canadian Securities Course, and
(B) that has been provided with a copy of the Risk Disclosure Statement for OTC Derivatives by theOTC derivatives dealer; or
(b) in the case of a transaction that does not constitute a trade in a security, the transaction would have beenexempt from section 53 of the Act if the transaction did constitute a trade in securities.
PART 3 DESIGNATION OF SPECIFIED COMMODITIES
3.1 Designation - The Commission may designate any matter as a specified commodity, subject to the terms orrestrictions that may be contained in the designation, if
(a) an OTC derivative of which the matter is an underlying interest may be used by a person or company forOTC derivatives hedging purposes; and
(b) the matter is not included in paragraph (a) or (b) of the definition of "interest rate/foreign exchangederivative".
3.2 Revocation of Designation - The Commission may revoke a designation given under section 3.1 if thecontinuation of the designation
(a) may adversely expose persons or companies to unfair, improper or fraudulent practices; or
(b) may be prejudicial to the public interest.
PART 4 EXEMPTION
4.1 Exemption - The Director may grant an exemption to this Rule, in whole or in part, subject to such conditionsor restrictions as may be imposed in the exemption.
OVER-THE-COUNTER DERIVATIVES
APPENDIX A
QUALIFIED PARTIES
Interpretation
(1) The terms "subsidiary" and "holding body corporate" used in paragraphs (w), (x) and (y) of subsection (2) of thisAppendix have the same meaning as they have in the Business Corporations Act.
(2) All requirements contained in this Appendix that are based on the amounts shown on the balance sheet of anentity apply to the consolidated balance sheet of the entity.
Qualified Parties Acting as Principal
(3) The following are qualified parties for all OTC derivatives transactions, if acting as principal:
Banks
(a) A bank listed in Schedule I or II to the Bank Act (Canada).
(b) The Business Development Bank of Canada incorporated under the Business Development Bank of Canada Act(Canada).
(c) A bank subject to the regulatory regime of a country that is a member of the Basle Accord if the bank has aminimum paid up capital and surplus, as shown on its last audited balance sheet, in excess of $100 million or itsequivalent in another currency.
Credit Unions and Caisses Populaires
(d) A credit union central, federation of caisses populaires, credit union or regional caisse populaire, located, in eachcase, in Canada.
Loan and Trust Companies
(e) A loan corporation or trust corporation registered under the Loan and Trust Corporations Act or under the Trustand Loan Companies Act (Canada), or under comparable legislation in any other province or territory of Canada.
(f) A loan company or trust company subject to the regulatory regime of a country that is a member of the BasleAccord if the loan company or trust company has a minimum paid up capital and surplus, as shown on its lastaudited balance sheet, in excess of $100 million or its equivalent in another currency.
Insurance Companies
(g) An insurance company licensed to do business in Canada or a province or territory of Canada if the insurancecompany has a minimum paid up capital and surplus, as shown on its last audited balance sheet, in excess of$100 million or its equivalent in another currency.
(h) An insurance company subject to the regulatory regime of a country that is a member of the Basle Accord if theinsurance company has a minimum paid up capital and surplus, as shown on its last audited balance sheet, inexcess of $100 million or its equivalent in another currency.
Sophisticated Entities
(i) A person or company that
(i) has entered into one or more transactions involving OTC derivatives with counterparties that are not itsaffiliates, if
(A) the transactions had a total gross dollar value of or equivalent to at least $1 billion in notionalprincipal amount; and
(B) any of the contracts relating to one of these transactions was outstanding on any day during theprevious 15-month period, or
(ii) had total gross marked-to-market positions of or equivalent to at least $100 million aggregated acrosscounterparties, with counterparties that are not its affiliates in one or more transactions involving OTCderivatives on any day during the previous 15-month period.
Individuals
(j) An individual who has a net worth of at least $5 million, or its equivalent in another currency, excluding the valueof his or her principal residence.
Governments/Agencies
(k) Her Majesty in right of Canada or any province or territory of Canada and each crown corporation, instrumentalityand agency of a Canadian federal, provincial or territorial government.
(l) A national government of a country that is a member of the Basle Accord and each instrumentality and agencyof that government or corporation wholly-owned by that government.
Municipalities
(m) Any Canadian municipality with a population in excess of 50,000 and any Canadian provincial or territorial capitalcity.
Corporations and other Entities
(n) A company, partnership, unincorporated association or organization or trust, other than an entity referred to inparagraph (a), (b), (c), (d), (e), (f), (g) or (h), with total assets, as shown on its last audited balance sheet, inexcess of $100 million or its equivalent in another currency.
Pension Plan or Fund
(o) A pension fund that is regulated by either the Office of the Superintendent of Financial Institutions (Canada) ora provincial pension commission, if the pension fund has total net assets, as shown on its last audited balancesheet, in excess of $100 million, provided that, in determining net assets, the liability of a fund for future pensionpayments shall not be included.
Mutual Funds and Investment Funds
(p) A mutual fund or non-redeemable investment fund if each investor in the fund is a qualified party.
(q) A mutual fund if the management company of the fund is registered under the Act or securities legislationelsewhere in Canada as an adviser, other than a securities adviser.
(r) A non-redeemable investment fund if the person responsible for providing investment advice to the fund isregistered under the Act or securities legislation elsewhere in Canada as an adviser, other than a securitiesadviser.
Brokers/Investment Dealers
(s) A person or company registered under the Act or securities legislation elsewhere in Canada as a broker or aninvestment dealer or both.
(t) A person or company registered under the Act as an international dealer if the person or company has totalassets, as shown on its last audited balance sheet, in excess of $100 million or its equivalent in another currency.
Futures Commission Merchants
(u) A person or company registered under the CFA as a dealer in the category of futures commission merchant, orin an equivalent capacity elsewhere in Canada.
Charities
(v) A registered charity under the Income Tax Act (Canada) with assets not used directly in charitable activities oradministration, as shown on its last audited balance sheet, of at least $5 million or its equivalent in anothercurrency.
Affiliates
(w) A wholly-owned subsidiary of any of the organizations described in paragraph (a), (b), (c), (d), (e), (f), (g), (h), (n),(s), (t) or (u).
(x) A holding body corporate of which any of the organizations described in paragraph (w) is a wholly-ownedsubsidiary.
(y) A wholly-owned subsidiary of a holding body corporate described in paragraph (x).
(z) A firm, partnership, joint venture or other form of unincorporated association in which one or more of theorganizations described in paragraph (w), (x) or (y) have a direct or indirect controlling interest.
Guaranteed Party
(aa) A party whose obligations in respect of the OTC derivatives transaction for which the determination is made isfully guaranteed by another qualified party.
Qualified Party Not Acting as Principal
(4) The following are qualified parties, in respect of all OTC derivative transactions:
Managed Accounts
1. Accounts of a person, company, pension fund or pooled fund trust that are fully managed by a portfolio manageror financial intermediary referred to in paragraphs (a), (d), (e), (g), (s), (t) or (u) of paragraph (2) or a broker orinvestment dealer acting as a trustee or agent for the person, company, pension fund or pooled fund trust undersection 148 of the Regulation.
Subsequent Failure to Qualify
(5) A party is a qualified party for the purpose of any OTC derivatives transaction if it, he or she is a qualified partyat the time it, he or she enters into the transaction.
APPENDIX B
RISK DISCLOSURE STATEMENT FOR OTC DERIVATIVE TRANSACTIONS
This risk disclosure statement sets out general information relevant to entering into transactions in over-the-counter derivative products ("OTC derivatives").
There are many different types of OTC derivatives. OTC derivatives include options, forwards, swaps, swaptions,caps, floors, collars and forward rate agreements and combinations or variations upon these transactions. Thisdisclosure statement does not disclose all of the risks and other significant aspects of entering into these transactions.In light of the risks, you should undertake these transactions only if you understand the nature of the product, thecontractual relationships into which you are entering and the extent of your exposure to risk. Entering into OTC derivativetransactions is not suitable for many investors. You should carefully consider whether these transactions are appropriatefor you in light of your experience, investment objectives, financial and operational resources, ability to bear risk,understanding of the products and other relevant circumstances. Your exposure to risk of loss may significantly exceedthe amount of any payment you make.
Over-the-Counter Derivatives
(a) General
You should confirm with the firm with which you deal the terms and conditions of the specific OTC derivative youare entering into and associated obligations (including such things as the circumstances under which you may becomeobligated to make payments or to make or take delivery of the underlying interest, expiration dates and any restrictionson exercise).
You should, as well, familiarize yourself with the terms and conditions of any agreement that you may be requiredto enter into with the firm with which you deal so that you fully understand the nature of your relationship with the firmwith which you deal and your rights and obligations under that agreement.
The value of OTC derivatives may be influenced by a number of inter-related factors. The relationship amongthese factors is complex. Factors that can be expected to affect the value of OTC derivatives include: time remainingto expiry (or maturity) of the instrument, the level of interest rates, the credit rating of the counterparty, the price or levelof the underlying interest of the derivative component and the volatility of the underlying interest of the derivativecomponent.
You should calculate the extent to which the value of the derivative component must increase for your positionto become profitable, taking into account the imputed cost of the component and all transaction costs.
You will also be exposed to risks which are specific to the underlying interest of the OTC derivative and you shouldfamiliarize yourself with those risks prior to entering into the transaction.
(b) Effect of Leverage
Transactions in OTC derivatives can carry a high degree of risk. Certain OTC derivatives are leveraged so thata relatively small market movement in the price of the underlying interest will have a proportionately larger impact on yourposition. This may work against you as well as for you.
(c) Risk Reducing Strategies
Certain strategies intended to reduce the risk of entering into a transaction in OTC derivatives may not be effectivebecause market conditions may make it impossible to implement the strategy. Strategies using combinations of positionsmay be as risky as taking simple 'long' or 'short' positions.
Hedging transactions may require constant monitoring. A failure to adjust a hedging transaction in light ofchanging market conditions can result in the position becoming either unhedged or overhedged and losses can ensue.
(d) Risk of Options
Purchasers and sellers of options should familiarize themselves with the type of option (i.e. put or call) that theycontemplate entering into and the associated risks.
The purchaser of an over-the-counter option may be able to offset or exercise the option or allow the optionposition to expire. The exercise of an option results in either a cash settlement or in the purchaser acquiring or deliveringthe underlying interest. If the purchased option expires worthless you will suffer a total loss of your investment that willconsist of the option premium paid plus transaction costs.
If you are purchasing deep out-of-the-money options you should be aware that the chance of these optionsbecoming profitable ordinarily is remote.
Selling ("writing" or "granting") an option generally entails greater risk than purchasing an option. Although thepremium received by the seller is fixed, the seller may sustain a total loss well in excess of that amount. The seller maybe liable for additional margin to maintain the position if the market moves unfavourably. The seller will also be exposedto the risk of the purchaser exercising the option and the seller will be obligated to either settle the option in cash or toacquire or deliver the underlying interest. If the seller is 'covered', by holding a corresponding position in the underlyinginterest, the risk may be reduced. If the option is not covered, the risk of loss may be unlimited.
(e) Liquidity and Restrictions of Pricing Relationships
OTC derivatives are not traded on an exchange or other organized market and permit precise customization toaccomplish particular financial and risk management objectives that might otherwise be unachievable. Customizationcan introduce significant liquidity risk and other risk factors of a complex character. As a result, it may be difficult orimpossible to effect transactions or to liquidate or offset positions. The customized nature of many derivatives may alsoadd to illiquidity. If you have sold options, an illiquid market may increase the risk of loss, particularly where you do nothold the underlying interest or an equivalent amount of cash.
Normal pricing relationships between the underlying interest and the OTC derivative may not exist. This can occurwhen, for example, there are market interruptions or circuit breakers in effect. The lack of availability of an underlyingreference price may make it difficult to judge 'fair' value.
(f) Credit Risk
You should assess the creditworthiness of the firm with which you deal and any other counterparty. Most OTCderivatives transactions are direct obligations of the counterparty.
You should also determine how easily your OTC derivatives position can be assigned in the event of a bankruptcyor insolvency and at what cost. In the case of OTC derivatives transactions where there are mutual obligations, youshould determine whether the netting of payments is supportable under bankruptcy and insolvency legislation.
You should also note that your right to enforce your counterparty's obligations under your agreement may becompromised if your counterparty receives protection under insolvency legislation in relevant jurisdictions.
You should familiarize yourself with the protections accorded to cash or other property you deposit for domesticand foreign OTC derivatives transactions, particularly in the event of the insolvency or bankruptcy of the counterpartywith whom you deal. The extent to which you recover may be governed by specific legislation or local rules. In somejurisdictions, property that had been specifically identifiable as your own will be pro-rated in the same manner as cashfor purposes of distribution in the event of a shortfall.
(g) Commissions and Other Charges
Before you enter into an OTC derivatives transaction, you should obtain a clear explanation of all commissions,fees and other charges for which you will be liable. These charges will affect your net profit (if any) or increase your loss.
(h) Transactions in Other Jurisdictions
Transactions with institutions in other jurisdictions, including institutions with formal links to the domestic market,may expose you to additional risk. Those institutions may be subject to regulation that may offer different or diminishedinvestor protection.
Before you enter into an OTC derivative transaction, you should enquire about any rules relevant to your particulartransaction. You should ask the firm with which you deal or your legal adviser for details about the types of redressavailable in both your home jurisdiction and other relevant jurisdictions before you start to trade.
(i) Currency Risks
The profit or loss in foreign currency denominated OTC derivatives products (whether they are traded in your ownor another jurisdiction) will be affected by fluctuations in currency rates.
(j) Legal Risks
As in any financial transaction, you should ensure that you understand the requirements (including investmentrestrictions), if any, applicable to you that are established by your regulators or by your board of directors or othergoverning body. Certain entities may not be permitted to enter into derivatives transactions pursuant to their incorporatingdocuments or governing legislation. You should ensure that counterparty with which you deal is empowered to deal withyou using derivatives and you should be aware of the legal implications of default in the jurisdiction in which thecounterparty resides.
You should also consider the legal and accounting implications of entering into any OTC derivative transactionand consulting such advisers as may appropriate to assist you in understanding the risks involved.
(k) Management Risks
You should inform yourself about the risks and ongoing monitoring requirements of the specific OTC derivativestransactions into which you propose to enter.
OTC derivatives are complex instruments that can be difficult to value and to monitor. Before entering into atransaction involving OTC derivatives you should ensure that you have supervisory procedures and analytical systemscommensurate with the level of activity you contemplate so that you are able to keep track of your OTC derivativesexposure.
(1) Tax Risks
Before entering into a transaction in OTC derivatives you should understand the income tax implications of doingso. Different OTC derivatives transactions may have different income tax implications. The income tax implications ofusing OTC derivatives are dependent upon the nature of your business activities and the transaction in question. Youshould, therefore, consult your tax adviser to understand the relevant income tax considerations.
ONTARIO SECURITIES RULE 91-504
OVER-THE-COUNTER DERIVATIVES
TABLE OF CONTENTS
PART TITLE
PART 1 INTRODUCTION
1.1 Purpose
1.2 Definition of "OTC derivative"
1.3 Definition of "OTC derivatives hedging"
PART 2 ESTABLISHING QUALIFICATION
2.1 Qualified Parties
2.2 Receipt of Risk Disclosure Statement
2.3 Hedging
PART 3 APPLICATION OF ONTARIO SECURITIES LAW
3.1 Territorial Scope of the Rule
3.2 Exemption from the Act
PART 4 USE OF OTHER EXEMPTIONS
4.1 Use of Other Exemptions
PART 5 ISSUES RELATING TO DEALERS
5.1 Universal Registration
5.2 Responsibilities of OTC Derivatives Dealers
PART 6 APPLICATION OF THE ACT
6.1 Effect of Section 2.2 of the Rule
6.2 Circumstances of Mutual Obligation
6.3 Paragraph 5 of Subsection 35(1) and Clause 72(1)(d) of the Act
6.4 Form 20 Requirements
COMPANION POLICY 91-504CP TO
ONTARIO SECURITIES RULE 91-504
OVER-THE-COUNTER DERIVATIVES
PART 1 INTRODUCTION
1.1 Purpose - The purpose of this Policy is to state the Commission's interpretation of
(a) certain provisions of Rule 91-504 Over-the-Counter Derivatives (the "Rule"); and
(b) the applicability of certain aspects of the Act to trades in OTC derivatives.
1.2 Definition of "OTC derivative" - The definition of "OTC derivative" contained in the Rule requires, among otherthings, that the agreement relating to an OTC derivative not be "part of a fungible class of agreements that arestandardized as to their material economic terms". The Commission is of the view that a master agreement,such as the ISDA form of agreement, and any supplements to the master agreement, should not be consideredto be an agreement that is standardized as to its material economic terms.
1.3 Definition of "OTC derivatives hedging" - One component of the definition of "OTC derivatives hedging"contained in subsection 1.1 of the Rule is the requirement that hedging transactions must have a "high degreeof negative correlation between changes in the value of the position or positions being hedged and theinstrument or instruments with which the position or positions are hedged". The Commission is of the view thatthere need not be complete congruence between the hedging instrument or instruments and the position orpositions being hedged if it is reasonable to regard the one as a hedging instrument for the other, taking intoaccount the closeness of the relationship between fluctuations in the price of the two.
PART 2 ESTABLISHING QUALIFICATION
2.1 Qualified Parties - The Rule provides exemptions from the Act or specified sections of the Act if one or bothparties to the transaction is a qualified party for the relevant transaction. The Commission is of the view thata party entering into a transaction with a person or a company claiming to be a qualified party for the transactionis entitled to rely upon representations by that person or company to the effect that that person or company isa qualified party in those circumstances unless the party has reason to believe otherwise. Staff of theCommission will therefore normally not take any enforcement action in respect of a transaction against a partythat has reasonably relied, in the manner described, on representations of its counterparty.
2.2 Receipt of Risk Disclosure Statement - Clauses 2.3(a)(ii)(B) and 2.4(a)(ii)(B) of the Rule require the deliveryof a risk disclosure statement by the OTC derivatives dealer that is involved with the transaction as a conditionto relying on the respective exemptions contained in those provisions. It is possible that the OTC derivativesdealer will not be a principal in the transaction, and that the principal would want to receive comfort that the riskdisclosure statement had been received by the appropriate party. The Commission is of the view that theprincipal may, in those circumstances, rely on representations from the intended recipient of the risk disclosurestatement that the statement was in fact received.
2.3 Hedging - Section 2.1 of the Rule provides that the Act does not apply to an "exempt transaction"; this includes,among other things, certain transactions which one of the parties enters into for OTC derivatives hedgingpurposes. The Commission is of the view that a party entering into an OTC derivatives transaction is entitledto rely, for purposes of establishing that the transaction is an "exempt transaction" under the Rule, uponrepresentations by the other party to the effect that that party is entering into the transaction for OTC derivativeshedging purposes within the meaning of the Rule unless the party has reason to believe otherwise. Staff of theCommission will therefore normally not take any enforcement action in respect of a transaction against a partythat has relied, in the manner described, on representations of its counterparty.
PART 3 APPLICATION OF ONTARIO SECURITIES LAW
3.1 Territorial Scope of the Rule
(1) Many OTC derivatives transactions have an international component, in which one party may be locatedin Ontario and other parties located elsewhere. This raises the issue of whether, or in what circumstances,those transactions should be considered to have taken place in Ontario and be therefore subject to theRule or any other applicable Ontario law.
(2) The Commission is of the view that the persons or companies entering into an OTC derivative transactionin which some parties are not located in Ontario are entitled to consider the connecting factors of thetransaction with Ontario in order to determine whether the transaction is subject to the Rule and any otherapplicable Ontario securities law.
(3) The Commission notes that the investor protection aspects of the Rule are designed for the benefit ofOntario persons or companies.
(4) The Commission notes that the ISDA master agreements provide that the rights and obligations thereunderare not transferable except in certain prescribed circumstances, such as default or reorganization. TheCommission is of the view that those provisions do not lead to any inference that would make paragraph(4)(c) above inapplicable.
3.2 Exemption from the Act - Section 2.1 of the Rule provides that the Act does not apply to an exempttransaction. This provision is designed to remove exempt transactions entirely from Ontario securities law inall respects.
PART 4 USE OF OTHER EXEMPTIONS
4.1 Use of Other Exemptions - A party conducting an OTC derivatives transaction under an exemption providedby the Rule is not required to come within the scope of any of the exemptions contained in the Act or theRegulation. However, a party conducting an OTC derivatives transaction that is not exempt from the prospectusand registration provisions of the Act under the Rule is not precluded from using an exemption contained in theAct, the Regulation or another rule when available, despite the Rule.
PART 5 ISSUES RELATING TO DEALERS
5.1 Universal Registration
(1) The universal registration regime contained in Part XI of the Regulation operates by removing certainregistration exemptions contained in the Act; a person or company entering into OTC derivativestransactions through the exemptions provided in the Rule is made not subject to universal registration bythose transactions because the exemptions contained in the Rule are not removed by Part XI of theRegulation.
(2) OTC derivatives transactions not effected under exemptions in the Rule will be subject to the applicationof the ordinary registration and universal registrations rules contained in the Act. Therefore, a person orcompany engaged in effecting OTC derivatives transactions under, for instance, the $150,000 privateplacement exemption may be a market intermediary and therefore required to be registered as a limitedmarket dealer.
5.2 Responsibilities of OTC Derivatives Dealers
(1) Clauses 2.3(a)(ii)(A) and 2.4(a)(ii)(A) require as a condition to the exemptions provided in those sectionsthat a person or company entering into the transaction must do so with or through an OTC derivativesdealer. The Commission is of the view that this requirement is satisfied
(a) if an OTC derivatives dealer acts as principal in the transaction, or
(b) if the OTC derivatives dealer is not acting as principal in the transaction, the OTC derivatives dealerhas taken the steps required by dealers under subsection 114(4) of the Regulation for that transaction.
PART 6 APPLICATION OF THE ACT
6.1 Effect of Section 2.2 of the Rule - The Rule is structured so that it is unnecessary to determine whether agiven OTC derivatives transaction involves a trade in a security. Section 2.2 of the Rule is a technical provisiondesigned to achieve this purpose; this section causes OTC derivatives transactions that are not exempttransactions or trades in securities to be subject to sections 25 and 53 of the Act. This puts those transactionson the same footing in respect of the registration and prospectus provisions of the Act as OTC derivativetransactions that are trades in securities. These transactions, however, are subject to provisions of the Actother than the prospectus and registration provisions only if they are trades in a security.
6.2 Circumstances of Mutual Obligation - In an OTC derivatives transaction, both parties may be issuingsecurities. The Commission is of the view that each party to the transaction needs to ensure either that the Actdoes not apply to that transaction or that appropriate exemptions are available, either under the Rule or the Act.
6.3 Paragraph 5 of Subsection 35(1) and Clause 72(1)(d) of the Act - The exemptions contained in paragraph5 of subsection 35(1) and clause 72(1)(d) of the Act are available where the "aggregate acquisition cost" to apurchaser of a security is not less than $150,000. The Commission is of the view that those exemptions areavailable for OTC derivatives transactions only if an amount of at least $150,000 is paid as premium, orpurchase price, at the time that the OTC derivative position is created, the payment of cash or otherimmediately available funds or the incurrence or assumption of liabilities. These payments or commitmentsmust be in consideration for the security being issued, rather than constituting part of the payment of thepurchase price of the underlying interest. These exemptions would not be available, therefore, for transactionsentered into "at-the-money" where no premium is paid, as is typically the case for swaps and forwards,regardless of the notional amount of the OTC derivative. These exemptions should not be interpreted as beingavailable where only the notional amount of the transaction, or the value of the underlying interest, equals orexceeds $150,000.
6.4 Form 20 Requirements
(1) A transaction effected pursuant to the exemptive relief provided by the Rule does not trigger Form 20 filingrequirements or the payment of any fee.
(2) Any OTC derivative transaction effected in reliance upon a paragraph of section 72 of the Act enumeratedin subsection 72(3) triggers the requirement of the filing of a Form 20 and payment of the requisite filingfee. At the effective date of this Policy, section 22 of Schedule 1 to the Regulation provides, in effect, thatthe fee payable in respect of a Form 20 filing is the greater of $100 and 0.02 per cent of the aggregategross proceeds to be realized in Ontario from the distribution of the securities to which the Form 20 relates.
(3) The Commission is of the view that the "aggregate gross proceeds to be realized in Ontario from thedistribution of the securities" will be, in the case of an OTC derivative, the consideration paid for theinstrument, such as the amount of premium paid for an option. The "aggregate gross proceeds to berealized" is not the amount, notional or otherwise, of the underlying interest.
(4) In the case of "at-the-money" swaps and forwards, no proceeds are realized from the distribution of thesecurities, and, therefore, the fee payable in respect of any Form 20 filed in respect of transactions of thisnature is $100 at the date of issuance of this Policy.
Footnotes
1. (1994), 17 OSCB 394.
2. In the Matter of N.M. Rothschild & Sons Limited, (1995) 18 OSCB 5965; In the Matter of Ontario Pork Producers' MarketingBoard, (1997) 20 OSCB 2941; In the Matter of Agriculture and Agrifood Canada, (1997) 20 OSCB 3726.
3. Rule 14-501 defines a "derivative" for the purpose of the Act, the regulations and the rules, as "an instrument, agreement or security,the market price, value or payment obligation of which is derived from, referenced to, or based on an underlying interest, other than acontract as defined for the purposes of the Commodity Futures Act".
4. A general definition rule has been adopted as Rule 14-501 Definitions. It contains definitions of certain terms used in more than onerule. Rule 14-501 also provides, among other things, that terms used in a rule and defined in section 1 of the Securities Act orsubsection 1(2) of the Regulation will have the respective meaning given to them in the Securities Act or regulation, as appropriate.
5. The term "option" is defined in Rule 14-501. The definition is "an agreement that provides the holder with the right, but not theobligation, to do one or more of the following on terms or at a price determinable by reference to the agreement at or by a timeestablished by the agreement:
1. Receive an amount of cash determinable by reference to a specified quantity of the underlying interest of the option.
2. Purchase a specified quantity of the underlying interest of the option.
3. Sell a specified quantity of the underlying interest of the option."
The term "underlying interest" is also defined in Rule 14-501. The definition is "for a derivative, the security, commodity, financialinstrument, currency, interest rate, foreign exchanges rate, economic indicator, index, basket, agreement or benchmark, and, ifapplicable, the relationship between any of the foregoing, from or on which the market price, value or payment obligations of thederivative are derived or based".
6. The term "clearing corporation" is defined in Rule 14-501. The definition is "an association or organization through which options orfutures contracts are cleared and settled".
7. The term "CFA" is defined in Rule 14-501. The definition is "the Commodity Futures Act".