Recent Developments in Derivative Instruments

Transcription

1 Recent Developments in Timothy Baron Daniel McGruder Alain Roberge

2 B- 1. Practice Area Definition TABLE OF CONTENTS 2. Recent Developments in prepared by A. Timothy Baron, Daniel McGruder and Alain Roberge of Davies Ward Phillips & Vineberg LLP 3. Leading Law Firms & Practitioners derivatives are bilateral contracts with non-standard, privately negotiated terms. Exchange-traded derivatives are traded on standard terms over recognized exchanges and guaranteed by clearing agencies. Canadian Regulatory Framework The derivatives market in Canada is largely composed of sophisticated counterparties entering into OTC derivatives transactions based on standard-form contracts developed by the International Swaps and Derivatives Association, Inc. ( ISDA ), often utilizing the amendments suggested by the ISDA Canadian Legal and Regulatory Affairs Committee. PRACTICE AREA DEFINITION Derivative instruments work is generally understood to incorporate both the private and public derivative markets. On the private side, legal work will cover preparation of documentation for negotiation and assisting in the development of a wide range of products including interest rate, basis and cross-currency swaps; equity index and commodity swaps and forwards; over-the-counter options on government bonds (domestic and foreign), commodities, equity indices and other underlying interests; warrant products; caps, collars, floors, swaptions; forward rate agreements; foreign exchange contracts; and structured notes and hybrid securities. On the public side of the derivatives market activities will include, in addition to the work noted above, a presentation of issuers or agents in public derivative product offerings and preparation of documentation for and assisting in the development of a variety of different financings involving the use of derivative products, including asset and inventory securitizations and oil, gold and other commodity monetization programs. RECENT DEVELOPMENTS OF IMPORTANCE Prepared by: A. Timothy Baron Tel: (416) Fax: (416) tbaron@dwpv.com Daniel McGruder Tel: (416) Fax: (416) dmcgruder@dwpv.com & Alain Roberge Tel: (514) Fax: (514) aroberge@dwpv.com Davies Ward Phillips & Vineberg LLP 1 First Cdn Pl, 44th Fl Toronto, ON M5X 1B McGill College Ave, 26th Fl Montréal, QC H3A 3N9 A derivatives contract is a financial instrument or security that derives its value from something else, such as an asset, reference price, interest rate, measurement, circumstance, index or other underlying interest. Derivatives contracts are generally classified as either over-the-counter ( OTC ) or exchange-traded. OTC The Canadian regulatory approach to derivatives currently suffers from a dearth of consistency, given that each province regulates trading in derivatives contracts independently. The Canadian Securities Administrators ( CSA ), an umbrella organization of Canada s provincial and territorial securities regulators, often develop national instruments aimed at harmonizing Canadian securities laws, but no such instrument exists with respect to the regulation of derivatives. Any such instrument would only be binding on the provinces that chose to adopt it, though CSA rules are typically adopted for use by all provinces and territories. In February 2008, Canada s Minister of Finance appointed the Expert Panel on Securities Regulation in Canada (the Expert Panel ) to examine, among other things, the feasibility of a federal Securities Act which would regulate derivatives at a national level. In its submissions to the Expert Panel, the Bank of Canada stated that regulation of derivatives markets in Canada had fallen well behind new types of derivatives products and current trading practices. The Expert Panel agreed in its 2009 Final Report that a lack of sound settlement, legal and operational infrastructure in the OTC derivatives markets is a source of risk to Canada s financial system, and recommended wide-ranging reforms to modernize Canada s regulatory scheme. OTC Derivatives Contracts OTC derivatives contracts generally fall within the definition of security under Alberta and BC securities legislation but, with the exception of the retail market, are excluded from most aspects of regulation through the use of blanket exemptions. The approaches in these provinces have been criticized for creating uncertainty regarding whether a particular type of derivative falls within the definition of security, rather than focusing on the counterparties or the types of derivatives contracts that warrant regulatory oversight. The application of securities legislation to OTC derivatives contracts in Ontario and Manitoba is unclear as the applicable securities legislation in those provinces contains a more restrictive definition of what constitutes a security. There is disagreement regarding whether certain types of OTC derivatives contracts, such as those involving physical settlement of underlying equities, fall within the definition of a security, and therefore are subject to the prospectus and registration requirements. In Ontario, recent amendments to provincial securities legislation, yet to be proclaimed in force, will clarify the treatment of OTC derivatives in the province. The New Brunswick Securities Commission ( NBSC ) recently published Local Rule and attendant amendments to the Securities Act (New Brunswick), which regulate exchange traded contracts and amend the definition of security to include futures PrActice Sections 2011 LEXPERT DIRECTORY

3 B-2 contracts and options that are not exchange traded. The rule exempts trades in derivatives between qualified parties from various provisions of New Brunswick securities law, including the prospectus requirement, and otherwise imposes registration and risk disclosure obligations in respect of such trades. Exchange-Traded Derivatives Contracts The inconsistency in regulation of exchange-traded derivatives is due largely to differing views on whether they should be treated as securities under provincial securities laws. At present, the provinces of Alberta, British Columbia, Saskatchewan, Manitoba, New Brunswick, Ontario and Québec regulate exchange-traded derivatives contracts. In Alberta, BC, Saskatchewan and New Brunswick exchangetraded derivatives contracts are regulated directly through securities legislation, using the concept of an exchange contract which, while distinct from the definition of a security, imposes similar registration requirements for dealers and advisers, and a requirement that exchanges on which exchange contracts are traded be recognized and approved by the provincial regulator. In Ontario and Manitoba these same requirements are imposed in respect of commodity futures contracts and options pursuant to separate commodity futures legislation. International Harmonization and the G-20 Commitments In the aftermath of the financial crisis, the G-20 countries agreed to increase regulation of their respective OTC derivatives markets based on certain common themes, including central clearing, trade reporting and electronic trading, where appropriate. The Canadian Government committed at the Pittsburgh and Toronto G-20 meetings to reform the Canadian OTC derivatives markets by the end of In keeping with these G 20 Commitments, the CSA issued Consultation Paper in November 2010, which outlines five major proposals for Canadian regulatory reform: Central clearing of OTC derivatives that are determined to be appropriate and capable of clearing. Reporting of derivatives transactions to trade repositories. Electronic trading of OTC derivatives that are sufficiently standardized and post a systemic risk to the market. Adoption of a risk-based approach to capital and collateral requirements. Increased enforcement of conduct standards and ongoing monitoring of the markets. Each of these proposals has its merits and drawbacks and requires further refinement and consideration in consultation with market participants and industry stakeholders. Despite Canada s commitments to sweeping reform, recent efforts have focused on relatively narrow aspects of derivatives regulation. Many of these efforts are generally viewed as interim measures pending the promulgation of a Canadian securities act or, failing that, harmonization of derivatives regulation on a voluntary basis by the provinces. Specific rules concerning the regulation of derivatives to give effect to Canada s G-20 commitments have not yet been included as part of recent reforms; such detailed requirements will be outlined in regulations promulgated under the applicable legislation. It is vital to the interests of market participants, both Canadian and international, that incipient reform on a Canadian scale be properly informed by international developments in derivatives regulation. The Canadian derivatives market represents two per cent of the global market, and the vast majority of Canadian derivatives contracts are entered into with non-canadian counterparties. Canada is a relatively small market despite calls for a made in Canada solution Canada s capital markets, and all market participants will suffer harm if Canada is substantially out of step with the international community. International harmonization is crucial to the competitiveness of Canadian markets and market participants. The approach taken in international jurisdictions, especially the US, will not only influence Canadian regulation, but will have a direct impact on market participants cross-border derivatives activities. American regulators are well ahead of Canada in terms of developing the specific and detailed rules which will undoubtedly have a significant impact on Canadian market participants in the global derivatives market. Harmonized National Regulation In January 2009, the Expert Panel released a draft national securities act, which was followed in May 2010 by the release of a proposed Canadian Securities Act by the federal Department of Finance. The substance of the new derivatives regulatory regime will largely be contained in the relevant regulations and policies, though the proposed Act does establish the broad framework for regulation. In an effort to preserve flexibility commensurate with the nature of the derivatives markets, the proposed Act contemplates a broad regulation-making power with respect to derivatives, including prescribing categories, exemptions, requirements and conditions. The proposed Act takes a flexible approach to the regulation of derivatives, dispensing with uniform prospectus requirements and rigid classification of instruments into categories that do not accord with the reality of derivatives markets. The foundation of derivatives regulation under the proposed Act is the categorization of derivatives into three classes: exchange-traded derivatives, designated derivatives and a prescribed class of derivatives each category is dealt with in a different way. Prescribed derivatives, which are likely to be hybrid products with securities-like features, are treated like traditional securities and are included under the definition of security in the proposed Act. Exchange-traded derivatives may only be traded on approved exchanges. Neither exchange-traded derivatives nor designated derivatives will be subject to the prospectus requirement under the proposed Act, though they will be subject to registration, unless exempted under the regulations. The proposed Act includes a definition of derivatives that is sufficiently broad to include the entire range of exchange-traded and over-the-counter derivatives products, including products which have not traditionally been considered to be subject to derivatives regulation (such as insurance contracts) or as some commentators have noted, are arguably not best dealt with by a one-size-fits-all regime (such as employee stock option plans). Certain types of contracts or instruments that do not engage any securities or capital markets regulatory concerns will be caught under the proposed Leading Canadian Law Firms & Practitioners

4 B- Act. The approach is to bring as many derivatives instruments as possible within the authority of the proposed Act, then to allow exemptions where deemed appropriate. With respect to designated derivatives, there are likely to be exemptions from regulation for various classes of instruments similar to the current approach in some provinces exempting bilateral OTC derivatives transactions between qualified parties from registration and prospectus requirements. A non-exempt trade in a designated derivatives transaction may only be undertaken after a prescribed disclosure document has been filed with the national regulator and delivered to the purchaser. Given that designated derivatives are exempt from the prospectus requirement, such a disclosure document may be akin to a prospectus, at least in the case of trades to retail investors. The proposed Act has been referred to the Supreme Court of Canada to determine whether it falls within the legislative authority of the federal government, and will not be introduced as a bill until the question is resolved. As with CSA recommendations, provinces have been given the choice to opt in to the federal scheme. As a result, should the Court confirm that the federal government has authority to proceed, provinces that elect not to participate in the federal regime will continue with their existing provincial regulatory system, and capital markets participants dealing with investors in such provinces would continue to be subject to that province s securities laws. Most Canadian provinces, with the notable exceptions of Québec and Alberta are expected to opt-in to the national scheme. In the short term, the outcome could be a mix of federal, and more limited provincial regulation. Perhaps an indication of provincial securities regulators views on the impendency of this national regime, while these issues are being resolved there has been a simultaneous increase in regulatory scrutiny of derivatives transactions at the provincial and interprovincial levels. Recent Developments Ongoing Regulatory Reform Amendments to Securities Act (Ontario) On December 8, 2010, amendments to the Securities Act (Ontario) ( OSA ) relating to the regulation of OTC derivatives received royal assent, though as of the date of publication have yet to be proclaimed in force. While the scope and details of the new Ontario regime will take shape in the form of rules and regulations which have yet to be released, the general approach is similar to other provincial regimes, and the proposed federal regime, in that it covers a broad range of OTC derivatives but provides an array of specific exemptions to remove particular types of derivatives, transactions and counterparties from some or all aspects of regulation. Substantively, the amendments to the OSA are more responsive to the G-20 Commitments than the current proposed national Act. Based on the broad framework of the amendments, notable aspects of the Ontario regime are likely to include (i) dealer/adviser registration requirements for parties trading or advising in respect of derivatives, (ii) additional transactional documentation for OTC derivatives transactions, (iii) a broad regulation-making power, with a view to implementing regulations relating to trading, clearing, settlement and reporting of derivatives transactions, (iv) usage of trade repositories or trading platforms, and (v) an extended scope for insider reporting requirements to apply to derivatives that are materially tied to securities of a reporting issuer. The amendments to the OSA go beyond the proposed national regime described above in terms of specificity and express regulatory powers and, given the end-of-2012 timeline contemplated for implementation of the G-20 Commitments, this scheme is likely to influence the development of the national regulatory regime. Proposed Amendments to NI National Instrument Mutual Funds ( NI ) is the main instrument which regulates the mutual funds industry in Canada. On June 25, 2010, the CSA published for comment proposed amendments to NI Among these proposed amendments are several changes relating to specified derivatives (as defined in NI ) and the use of short selling by mutual funds. The CSA are proposing the removal of the term limit on specified derivatives. Currently, mutual funds are limited in the term to maturity of the fixed income securities in which they invest. Under the proposed amendments, mutual funds may choose to enter into derivatives that match the term to maturity of fixed income holdings (e.g., a corporate bond hedged by a credit default swap). Additionally, mutual funds may offset derivatives positions by entering into an opposing transaction. This development will be of benefit to both investors in mutual funds and to counterparties to a mutual fund s derivatives transactions as it eliminates the risk of early termination of a fund s derivatives positions as required under the current term restrictions. The CSA also propose to codify frequently granted exemptive relief to allow mutual funds to engage in limited short selling of securities, reducing the costs and delays associated with applications for such relief. The proposed amendments to Part 2 of NI would permit a mutual fund to sell securities short, subject to it having borrowed the security being sold short, and to certain other conditions including a cap on short selling of 20 per cent of the mutual fund s net asset value. Total exposure to any one issuer that could be achieved through short selling would be limited to five per cent of the net asset value of the mutual fund. The mutual fund would also be required to hold cash cover that is at least 150 per cent of the aggregate market value of all securities sold short by the mutual fund on a daily marked-to-market basis. Proceeds of short sales received by the mutual fund could not be used to enter into long positions in securities other than cash cover. The proposed amendments also expand the definition of cash cover to provide mutual funds more flexibility in selecting securities for use as cash cover. New Insider Reporting Regime On April 30, 2010, National Instrument Insider Reporting Requirements and Exemptions ( NI ) and its Companion Policy NI CP came into force across Canada, launching a new insider reporting regime that will significantly reduce the number of persons required to file insider reports, while, in some cases, increasing such persons reporting obligations. With this new regime, the CSA have introduced several significant changes to insider reporting of derivatives transactions. NI brings the reporting of derivatives transactions in line with the reporting of transactions involving conventional securities. PrActice Sections 2011 LEXPERT DIRECTORY

5 B- For purposes of the insider reporting regime, the CSA have expanded the meaning of derivatives instruments through the concept of related financial instruments. A related financial instrument includes traditional derivatives and any other instrument, agreement or understanding that affects, directly or indirectly, a person or company s economic interest in a security or exchange contract. The CSA have addressed uncertainty relating to reporting obligations for derivatives transactions by identifying a broad range of instruments they consider to be related financial instruments, even though certain of them do not, as a matter of law, constitute securities. Under the new regime it is not necessary to determine whether a particular derivatives contract is a security or a related financial instrument since the insider reporting requirements in Part 3 of NI apply equally to both. The supplemental insider reporting obligations set out in Part 4 of NI are intended to capture derivatives transactions, including equity monetization transactions, that may not otherwise be captured by Part 3 of NI Part 4 utilizes the threshold of economic exposure to trigger these supplemental reporting obligations. Economic exposure refers to the link between a person s economic or financial interests and the economic or financial interests of the reporting issuer. As the CSA cast economic interest broadly in the sense of the potential for gain or loss, it is clear the CSA intend for reporting insiders to report all transactions affecting their interests in the issuer. Developments in Provincial Regulation In February 2009, the Derivatives Act (Québec) (the QDA ), came into force, establishing a legislative framework governing derivatives activities in the Province of Québec. As with other provincial schemes, the QDA defines derivatives broadly as a contract or instrument whose value is based on an underlying interest, as well as any other contract or instrument designated pursuant to regulation. Neither the QDA nor the regulation enacted thereunder defines the term underlying interest. The QDA also governs hybrid products that are predominantly derivatives but incorporate elements of traditional securities. Among other instruments, certain rights to securities, investment contracts, insurance contracts and employee stock options are excluded from the application of the QDA. The QDA imposes certain recognition and registration requirements on market participants. No regulated entity (such as a stock exchange or SRO) may engage in or intermediate derivatives transactions in Québec unless it is recognized by the Autorité des marchés financiers. Dealers and advisers engaging in derivatives trading or management activities are required to be registered unless the transactions undertaken can be characterized as overthe-counter derivatives activities solely involving accredited counterparties. Dealers and advisers are also exempt from registration in respect of activities relating to certain negotiable options and various types of futures contracts provided that they deal only with accredited investors. On October 30, 2009, the Ontario Securities Commission ( OSC ) issued Staff Notice , intended to provide guidance on the applicability of securities laws to offerings of Contracts for Difference ( CFDs ), foreign exchange ( forex ) contracts and similar OTC derivatives products. The notice states that OSC staff considers CFDs to be securities, and as such, these products are subject to securities regulatory requirements, including registration and prospectus requirements, absent the availability of statutory or exemptive relief. The guidance recognizes, however, that the prospectus requirement is not well suited to certain types of OTC derivatives products, and OSC staff may be prepared to recommend exemptive relief from the requirement in appropriate situations. With this clarification, Ontario has joined British Columbia in regulating CFD and forex trading as securities trading. While not binding, the OSC staff views CFDs as derivatives under Ontario securities law. On December 4, 2009, the BC Securities Commission published a Companion Policy to Blanket Order Short Term Foreign Exchange Transactions to clarify the circumstances under which a foreign exchange contract may be considered a security for the purposes of the Securities Act (British Columbia). The Companion Policy states that a contract or other obligation to purchase or sell the currency of any jurisdiction, where the terms of the transaction require settlement not later than three business days after the transaction was entered into, is not a futures contract, provided that the contract or obligation is not otherwise a security under the Securities Act. A forex contract may still be a security if it falls under any of the other relevant branches of the definition. On November 26, 2009, the Saskatchewan Financial Services Commission, Securities Division, citing similar Blanket Orders in BC and Alberta, issued General Order exempting OTC derivatives traded among qualified parties from the registration and prospectus requirements under the Saskatchewan Securities Act, 1988 (the Saskatchewan Act ). The Saskatchewan Act s definition of security now includes futures contracts and options that are not exchange-traded, and thus, parties that enter into futures contracts or options are subject to registration and prospectus requirements. Recent Issue of Interest Empty Voting and Hidden Ownership The phenomena of empty voting and negative voting have been receiving increased attention from regulators as well as reporting issuers, investors, corporate directors and other market participants as the effects of sophisticated investors utilizing derivatives instruments to alter their exposure to an issuer s common equity become increasingly recognized and understood. Empty voting occurs when an investor has the right to vote, but has reduced or eliminated its economic exposure to the stock. This can be achieved through the use of derivatives and swap transactions to alter a party s exposure to the shares it acquires in order to obtain voting rights without economic exposure. Negative voting occurs when an investor has established negative economic exposure to a corporation s share price, but has retained the right to vote. In such a case, the investor will benefit from the value of the issuer s shares going down. When the investor votes, their incentive is to vote in a way that is contrary to the economic best interests of the corporation (although consistent with the investor s interests). Negative voting is typically purposeful intended to influence the vote in a manner that is economically beneficial to the shareholder with the negative position, and potentially deleterious to the corporation and its long-term beneficial shareholders. Hidden ownership is often referred to in the discussions relating to empty voting, although the two issues are quite different. Hidden ownership refers to a situation in which the investor has economic Leading Canadian Law Firms & Practitioners

6 B- exposure to a security, but not the right to vote. It allows the investor to avoid certain disclosure obligations which would alert the marketplace to its interest in the issuer. It is also typically effected through derivatives instruments. Hidden ownership, and the issues it raises relating to disclosure requirements for interests held through synthetic instruments, have recently received increasing attention. The decision in Sears Canada Inc. (2006) is illustrative, as it suggests Canadian regulators may be willing to intervene in circumstances where derivatives are utilized to alter shareholder voting dynamics, similar to the decision in CSX Corporation v. The Children s Investment Fund Management (2008) in the US. In the Sears decision, while there was no finding of wrongdoing in respect of the transactions entered into by Pershing Square, the OSC did consider the issue of parking securities in the context of a party entering into total return swaps with respect to the shares of a target company, which had the effect of giving such party economic exposure to the performance of the target s shares without legal ownership. Shortly thereafter, a take-over bid was made to acquire all of the outstanding shares of Sears Canada. The OSC found that the swaps were not entered into for an improper purpose, and that Pershing Square did not retain the ability to direct the voting of the underlying securities of Sears Canada held by the counterparty to the swap. The OSC did note, however, that: this finding is based on the evidence and circumstances of this case. We wish to underscore that there might well be situations, in the context of a take-over bid, where the use of swaps to park securities in a deliberate effort to avoid reporting obligations under the Act and for the purpose of affecting an outstanding offer could constitute abusive conduct sufficient to engage the Commission s public interest jurisdiction. One question arising from the Sears decision is whether the finding would have differed had the total return swap been physically settled rather than cash-settled, entitling the hedge fund to delivery of common shares. The Canadian insider reporting regime, even subsequent to the April 2010 amendments, would not capture a physically settled total return swap until actual transfer of ownership of the underlying equities. The larger challenge posed by derivatives instruments in this context is to understand the possible effects of using derivatives to separate voting rights from beneficial ownership. Negative voting and hidden ownership, particularly, deserve further study from an abuse of the markets perspective. Given the growing importance that market participants, and institutional investors in particular, attach to these issues, regulatory intervention may be inevitable. Recent Case of Importance The Supreme Court of Canada ( SCC ) decision in Caisse populaire Desjardins de l Est de Drummond v. Canada ( Drummond ) has received a great deal of attention, and criticism, since its release in June The issue in the case was whether an agreement between debtor and creditor regarding set-off against a term deposit constituted a security interest for the purposes of the Income Tax Act ( ITA ) and the Employment Insurance Act ( EIA ), giving rise to Crown priority in respect of at-source deductions and employment insurance remittances. In a split decision, the majority of the Court held that the rights Desjardins had against the borrower s deposit account did in fact constitute a security interest, which was defeated by the deemed trust in favour of the federal government. Discussion The decision has affected commercial set-off arrangements generally, and collateralized derivatives transactions in particular, as it suggests that a cash set-off arrangement originally intended to provide credit support (though not security) for a loan or other obligation may give rise to a security interest in the cash, consequently denying the parties the benefit of an absolute transfer of the cash. Under Canadian law, security interests in cash must be perfected by registration, exposing the counterparty to priority risk in respect of other perfected interests in the same collateral. The preferred option for counterparties to derivatives transactions is to use the Canadian variant of the ISDA Credit Support Annex ( ISDA CSA ), which establishes a debtor-creditor relationship, provides for a right of set-off and requires no registration under any provincial personal property security regime ( PPSA ). The risk now exists that an arrangement whereby cash is transferred to a counterparty to provide credit support, even where clearly and unambiguously established as an absolute transfer, could be recharacterized as the grant of a security interest, negating the advantages of using set-off. This risk is magnified if such recharacterization causes the recipient of the cash payment to be further subordinated to the counterparty s existing secured creditors. Credit support provided pursuant to the ISDA Transfer Annex, or margin posted for securities lending and repurchase transactions are equally vulnerable to the reasoning in Drummond. Practically speaking, what can legal counsel, financial institutions and counterparties to derivatives transactions do to minimize recharacterization risk? The majority in Drummond found that if the substance of the agreement demonstrates that the parties intended an interest in property to secure an indebtedness, then a security interest exists... Though likely not decisive in the case, the Agreement to Give Savings as Security in Drummond made multiple references to securing repayment. In preparing documentation evidencing credit support, language implying rights in property and security interest language should be avoided. As is becoming common practice for cash credit support, consideration should be given to expressly disclaiming the intention to create a security interest in such documentation. Additionally, while the majority holds that the term security interest should be read expansively for the purposes of the ITA, the definition in provincial personal property security legislation is substantially similar. Thus, parties who enter into cash collateral set-off arrangements are well advised to make a precautionary filing under provincial personal property security legislation. While the Ontario PPSA provides that the registration of a financing statement does not give rise to the presumption that the PPSA applies, it would be beneficial to specify in the collateral description that the financing statement is filed as a precaution only, and without prejudice to the agreement of the parties that no security interest has been created. This is advisable both in view of the fact-dependent nature of the characterization analysis undertaken in Drummond, and also because other provincial PPSAs do not include an equivalent no presumption provision. Similar without prejudice language to the effect that any filing under personal property security legislation is simply a precaution could also be added to an ISDA CSA. PrActice Sections 2011 LEXPERT DIRECTORY