Defining the scope of the law as it relates to derivatives is difficult given the extent of the market, the variety of market participants and the paucity of jurisprudence related to derivatives. Derivatives take two forms: (i) exchange-traded derivatives, which are traded on recognized exchanges, and (ii) over-the-counter ("OTC") derivatives, which are privately negotiated and customized bilateral contracts under which two parties agree to complete transactions specific to the parties, the obligations under which may only be transferred to a third party under the terms agreed to by the parties. As is common elsewhere, the Canadian OTC derivatives market is substantially larger than the exchange-traded derivatives market.
Most OTC derivatives in Canada are documented using standard-form contracts developed by the International Swaps and Derivatives Association, Inc. ("ISDA"). In January 2003, ISDA introduced the 2002 Master Agreement ("2002 Agreement"). Although fundamentally consistent with the widely accepted 1992 Master Agreement ("1992 Agreement"), the 2002 Agreement contains several key amendments.
The most significant amendment in the 2002 Agreement is the approach to calculating payments upon the occurrence of an event of default or termination event. The market quotation and loss payment calculation methods in the 1992 Agreement are replaced by a single method, the closeout amount. The determining party calculates the amount, using commercially reasonable procedures to produce a commercially reasonable result. The determination of the amount will occur as of the early termination date or a subsequent date, whichever is commercially reasonable. The calculation may consider (i) quotations from one or more third parties; (ii) other external market data, such as rates, prices, yields, volatilities and spreads; and (iii) information available from internal sources similar to that described in (i) and (ii).
Additionally, the 2002 Agreement no longer permits parties to elect between limited two-way payments ("First Method") and full two-way payments ("Second Method") on early termination. Instead, the 2002 Agreement allows only for full two-way payments on early termination. Another important amendment in the 2002 Agreement is the introduction of a force majeure termination event. This new provision applies to events beyond the control of the parties, other than an illegality, that hinder or prevent performance. Termination is only available after giving effect to all other provisions in the 2002 Agreement, the parties having tried to overcome the force majeure and a period of eight local business days having expired.
The 2002 Agreement also includes a set-off clause based on the model provision in the User's Guide to the ISDA 1992 Master Agreement, which many market participants already included in the schedules to the 1992 Agreement.
The 2002 Agreement is not yet widely used in Canada. However, ISDA has devoted considerable resources to educating market participants on the benefits of the new provisions and published the User's Guide to the 2002 ISDA Master Agreement, with the expectation that the 2002 Agreement will eventually be accepted as the market standard.
On May 28, 2004, the Canadian Securities Administrators' ("CSA") Uniform Securities Transfer Act Task Force released a revised consultative draft of a proposed provincial Uniform Securities Transfer Act ("USTA") for public comment. The USTA is intended to replace current provincial laws dealing with transfer and pledging of securities.
The proposed USTA is a commercial property-transfer law governing the transfer and holding of securities and interests, whether certificated or under a book-based electronic system. The USTA addresses the problems associated with the collateralization of OTC derivatives by creating an effective legal regime for constructive possession of book-based securities. The current regime in Ontario and many other provinces does not adequately address the issues that arise when pledging book-based securities, including determining which jurisdiction's laws govern such a pledge.
The USTA generally adopts the language of revised Article 8 of the Uniform Commercial Code. Like revised Article 8, a new form of property called a "security entitlement," meaning "the rights and property interest of an entitlement holder with respect to a financial asset," is created. This term captures the bundle of rights that a beneficial owner of a security has against its securities intermediary and replaces the fiction of "deemed possession" of an immobilized certificate held with a clearing agency (currently in effect in Ontario ), with the concept of "control." The USTA also sets out clear "conflict of laws" rules that eliminate the ambiguity as to where to perfect a security interest in a security entitlement and details methods by which a secured party can exercise the "control" over security entitlements necessary to perfect its security interest.
In recognition of a uniform North American capital market, one of the USTA's key objectives is uniformity across Canada. Moreover, as revised Article 8 has been adopted in all 50 states, the similarities between the USTA and revised Article 8 will remove the competitive disadvantages now faced by Canadian counterparties in the collateralization of OTC derivatives.
Regulating Trades in Derivatives
In Canada, the regulation of exchange-traded derivatives is the responsibility of the provinces and falls within the jurisdiction of provincial securities commissions. For example, in Ontario, the Commodity Futures Act ("CFA") regulates all commodity futures contracts trading on commodity exchanges. The CFA also provides for the registration of traders in commodity futures contracts. In respect of the OTC derivatives market, debate with respect to the need for regulation has focused on the expansion of the market into all sectors of the economy and the use of OTC derivatives by less sophisticated parties.
On September 17, 2004 the Ontario Securities Commission (OSC) published Proposed Rule 14-502 for comment. The proposed rule would replace Section 2 of the Regulation to the CFA with a longer list of additional designated commodities that, in the opinion of the OSC, better reflects the breadth of the commodity market. The additional commodities designated under the proposed rule include electricity, weather, emissions, credit or mortgage obligations, water, securities and the occurrence of a specific future event (such as a credit default). Additionally, interest rates, indices and economic indicators, all of which are designated under Section 2 of the Regulation, are also designated under the proposed rule. Although contracts referencing many of the newly designated additional commodities are not currently traded on Canadian commodity exchanges, by clarifying the regulatory framework the OSC hopes to encourage the development of a broader Canadian exchange traded derivatives market. For instance, the proposed rule may facilitate the growth of the single stock futures market by clarifying that commodity futures contracts which reference securities are to be regulated as commodity futures under the CFA rather than as securities.
Currently, there is no rule governing OTC derivative transactions as a separate category in Ontario. However, OTC derivatives that qualify as securities are subject to the Securities Act (Ontario ) ("OSA") and all other applicable securities regulations. As such, market participants who wish to avoid the application of the prospectus and registration requirements of the OSA should be aware of the exempt market regime set out in Rule 45-501.
Among other things, Rule 45-501 creates an exemption from the registration and prospectus requirements of the OSA for a trade in a security where the purchaser is an "accredited investor." The rule does not impose any minimum investment requirements or limit the number of times an issuer may rely upon the accredited investor exemption. The definition of "accredited investor" includes the usual list of financial institutions, such as banks, credit unions and trust companies, as well as government entities. However, this list is supplemented by the addition of individuals who meet certain financial tests.
Other elements of the definition of "accredited investor" that are applicable in the OTC derivatives context include: (i) a company, limited liability company, limited partnership, limited liability partnership, trust or estate, other than a mutual fund or non-redeemable investment fund, that had net assets of at least $5 million as reflected in its most recently prepared financial statements; and (ii) a mutual fund or non-redeemable investment fund that, in Ontario, distributes its securities only to persons or companies that are accredited investors.
Two other Canadian provinces have taken measures to regulate the OTC derivatives market on the basis of protecting unsophisticated investors. Alberta and British Columbia each passed a Securities Amendment Act (R.S.A. 1999 c.15 and S.B.C. 1999, c.20, respectively), the effect of each being that derivative contracts fall within the definition of securities under their respective Securities Acts.
In response to the request by OTC derivative market participants for relief from the prospectus and registration requirements of the British Columbia Securities Act ("BCSA"), the British Columbia Securities Commission ("BCSC") issued Blanket Order 91-501, with respect to OTC derivative transactions between qualified parties, 91-502, which provides an exemption from the registration and prospectus requirements for short-term foreign exchange transactions, and 91-503, which clarifies that OTC contracts for the physical delivery of commodities are not futures contracts under the BCSA.
BOR 91-501, together with its companion policy, provides an exemption from the registration and prospectus requirements under the BCSA with respect to OTC derivatives where the principals are "qualified parties." An OTC derivative is defined as any non-exchange-traded futures contract or option. The companion policy provides further guidance that an OTC derivative is any "instrument commonly considered to be an OTC derivative." The definition of qualified party in BOR 91-501 includes domestic banks, banks in Basel Accord jurisdictions, domestic and Basel Accord jurisdiction insurance companies, trust companies, sophisticated users, pension funds, registered portfolio managers, high-net-worth individuals ($5 million in wealth, excluding a principal residence), business organizations with over $25 million in assets and the Canadian, provincial and foreign governments. "Qualified party" also includes a party entering into an OTC derivative where a material component of the underlying interest is, or is related to, a commodity used in such party's business.
In connection with the upcoming adoption of a new BCSA, the basic contents of BOR 91-501 and 91-503 have been adopted as securities rules. Rule 161 corresponds to BOR 91-501, and Rule 2 excludes the same transactions from the application of the new BCSA as does BOR 91-503. Additionally, Rule 3 deems certain compensation arrangements not to be derivatives for the purposes of the new BCSA. Finally, Rule 162 exempts trades in derivatives by Canadian financial institutions, designated foreign financial institutions and dealers registered in other provinces from the registration and prospectus requirements of the new BCSA. British Columbia-registered dealers are exempt from the prospectus requirements of the new BCSA. Customers of a financial institution who are trading as principal with such financial institution are also exempt. However, this exemption does not apply in circumstances where the derivative traded would be considered a security, even if the definition of "security" did not explicitly include derivatives.
On November 18, 2004, the government of British Columbia announced that the implementation of the new BCSA would be delayed indefinitely. Until the new BCSA is implemented, BOR 91-501, BOR 91-502 and BOR 91-503 will remain in force.
In September 2004, in response to comments from market participants, the CSA clarified that the proposed Uniform Securities Rules dealing with OTC derivatives would be substantially identical to the new British Columbia Securities Rules. The CSA stated that their intention was for the Uniform Securities Rules dealing with OTC derivatives to be adopted by every province except Ontario, which would retain its current regulatory regime.
On August 4, 2000, the Alberta Securities Commission ("ASC") issued Blanket Order 91-502 ("BOR 91-502"). BOR 91-502 narrows the definition of "futures contracts" to exclude OTC derivative transactions where the principals of the OTC derivative contract are "qualified parties." "OTC derivative" is defined as an option, forward contract, contract for differences or any other agreement commonly known as a derivative where (i) the material economic terms of the agreement have been customized, (ii) the credit-worthiness of the counter-party is a material consideration in deciding to enter into the agreement and (iii) the agreement does not trade on an exchange. The definition of "qualified party" includes essentially the same parties as Blanket Order 91-501 issued by the BCSC.
National Instrument 81-102 ("NI 81-102") applies to mutual funds that are reporting issuers and, among other things, imposes restrictions on mutual funds investing in derivative instruments. NI 81-102 and its companion policy came into force on February 1, 2000, and have since been adopted by all Canadian provinces and territories except Newfoundland and Labrador. NI 81-102 has been amended a number of times; however, these amendments have not had a significant effect on the sections relating to derivative investments.
Under NI 81-102, mutual funds are prohibited from purchasing, selling or using a "specified derivative" other than in compliance with sections 2.7 to 2.11 of the instrument. Additionally, mutual funds are prohibited from purchasing derivatives in respect of physical commodities other than gold.
NI 81-102 divides specified derivative transactions into two categories: hedging-related and non-hedging-related. In general, the instrument adopts a less restrictive approach toward hedging transactions. Sections 2.7 to 2.11, as applied to both hedging and non-hedging transactions, provide for certain restrictions and limitations on the types and quantity of specified derivatives that a mutual fund may enter into. In addition, a mutual fund must provide disclosure, through its simplified prospectus, of its intention to use specified derivatives at least 60 days prior to doing so.
In the case of non-hedging transactions, the instrument imposes more rigorous restrictions. These restrictions include a 10% limit on the concentration of the fund's assets in a single issuer, a 10% limit on control of the voting rights or equity securities of any issuer, a limit on illiquid assets to 10% of the fund's assets (an illiquid asset includes a specified derivative other than an option issued by a clearing corporation or a standardized future) and a restriction on writing put on call options unless the fund has sufficient quantity of the underlying interest to cover the trade. Finally, the fund may not enter into swaps unless the fund segregates sufficient assets, or possesses a sufficient quantity of the underlying interest, to cover the market exposure of the swap.
On November 1, 2002, Multilateral Instrument 81-104 ("MI 81-104") and its companion policy dealing with commodity pools came into effect in Ontario and have since been adopted in much the same form across Canada. In Ontario, MI 81-104 replaces OSC Policy 11.4 and creates a regime that treats commodity pools as specialized mutual funds that should follow general mutual fund rules except where their unique structure necessitates otherwise. MI 81-104 defines a commodity pool as any mutual fund, other than a precious metals fund, whose objectives permit the use of specified derivatives or physical commodities in a manner not permitted by NI 81-102. MI 81-104 applies to all commodity pools that offer securities by way of a prospectus or are in the process of filing a preliminary or first prospectus.
MI 81-104 exempts commodity pools from the restrictions on investing in specified derivatives and commodities found in NI 81-102 and permits commodity pools to employ leverage despite the limitations in NI 81-102. In return for this looser derivatives and leverage regime, commodity pools are required to abide by a set of specialized rules. These rules include seed capital requirements which align the pool sponsor's and investors' interests, additional proficiency requirements for pool salespeople and enhanced prospectus disclosure of the risks of derivatives usage and leverage.
Early in 2004, Multilateral Instrument 55-103 ("MI 55-103") came into force in all Canadian provinces and territories other than British Columbia. MI 55-103 requires insiders of reporting issuers to file reports for equity monetizations and similar derivatives transactions.
Under MI 55-103, an insider must file a report in the prescribed form within ten days of entering into, materially amending or terminating an agreement, arrangement or other transaction that changes the insider's "economic exposure" to the reporting issuer, or changes the insider's "economic interest in a security" of the reporting issuer, unless the insider is required to file an insider report under any other provision of Canadian securities law.
"Economic exposure" means the extent to which the economic or financial interests of a person or company are aligned with the trading price of securities of the reporting issuer or the economic or financial interests of the reporting issuer. "Economic interest in a security" means (i) the right to receive or the opportunity to participate in a reward, benefit or return from a particular security; or (ii) exposure to a loss or risk of loss in respect of the security.
Section 2.2 of MI 55-103 sets out exemptions to the reporting requirement. Arrangements that do not involve an interest in a security of the reporting issuer or a derivative in respect of which the underlying security, interest, benchmark or formula is, or includes as a material component, a security of the reporting issuer need not be reported. Compensation arrangements between the issuer and the insider are exempt if (i) the compensation arrangement is disclosed in the financial statements or other public document of the reporting issuer; or (ii) the material terms of the compensation arrangement are set out in writing and the alteration to economic exposure or economic interest occurs as a result of the satisfaction of pre-established conditions or criteria described in the document and does not involve a discrete investment decision by the insider. An exemption is also available for a pledge of securities as security for a debt, so long as recourse is not limited to the securities of the reporting issuer. MI 55-103 also exempts the acquisition or disposition of a security of an investment fund by an insider and credit derivatives arrangements by an insider who is not an individual. Lastly, the application of MI 55-103 to the securities of issuers that hold securities of a reporting issuer is limited to insiders who are "control persons" (persons holding sufficient voting rights to control an issuer, with a rebuttable presumption that a 20% holding is sufficient to exercise control) or persons with investment control over the securities of the reporting issuer.
At the federal level, the Office of the Superintendent of Financial Institutions ("OSFI") released Ruling 2004-05, which clarified that federally-regulated financial institutions ("FRFIs") may trade physically-settled commodity ("PSC") derivatives. A foreign bank branch proposed to enter into a PSC derivative with a natural gas producer, whereby the producer would sell and the bank would purchase a specified quantity of natural gas for an agreed price on a specified delivery date. The bank would then be responsible for finding a purchaser to take physical delivery on the delivery date. Upon delivery by the producer, the bank would accept transitory title of the natural gas, which would subsequently be relinquished to the purchaser. The ruling's determination focused on whether PSC derivatives trading could be characterized as a financial service (a permitted activity), or as "a dealing in goods, wares or merchandise, or an engagement in a trade," which is prohibited under federal financial institutions statutes.
The ruling seemed heavily influenced by the May 2003 ruling of the U.S. Comptroller of the Currency Administrator of National Banks (the "OCC"), which allowed financial intermediaries to enter certain transitory title transfer transactions that do not entail the physical possession of commodities or involve risks associated with commodity ownership. OSFI, like the OCC, determined that PSC derivatives would not expose FRFIs to risks substantially different than the risks FRFIs incurred while trading cash-settled commodity derivatives, which OSFI had always permitted.
Therefore, OSFI concluded that trading in PSC derivatives fell within the ambit of the business of banking so long as it met the following conditions:
- A transaction must provide risk management services, a financial service, to a counterparty or to manage an FRFI's risk; and
- FRFIs may only take title to the commodity for the purpose of facilitating the transaction and not for the purpose of proprietary trading.
Additionally, OSFI required FRFIs that wished to engage in PSC derivatives-trading to put in place risk management policies to mitigate the risks associated with taking transitory title to commodities in the course of trading PSC derivatives.
Recent Case of Importance
The decision of the New South Wales Supreme Court in Enron Australia v. TXU Electricity [2003] NSWSC 1169 (Enron) confirms the enforceability of the "flawed asset" provisions of the 1992 Agreement. Enron Australia and TXU Electricity ("TXU") entered into various electricity-swap contracts governed by the 1992 Agreement. Under the 1992 Agreement, Enron Australia 's bankruptcy proceedings constituted an event of default and, at the time of the event of default, TXU owed A$3.3 million to Enron Australia under the electricity contracts then outstanding. TXU, as the non-defaulting party, had the right but not the obligation, under the 1992 Agreement, to designate an early termination date in respect of all of the out standing transactions. TXU, in order to avoid payment of its obligations to Enron Australia, chose not to designate an early termination date and relied upon the "flawed asset" provision in section 2(a)(iii) of the 1992 Agreement to avoid making any ongoing payments. This provision states that each obligation to make payment is subject to the condition precedent that no event of default has occurred with respect to the other party.
The court ruled that the combined effect of the event of default by Enron Australia and the flawed asset provision was to leave the 1992 Agreement in place at TXU's discretion and allow TXU to suspend ongoing payments until the event of default had ceased. Since Enron Australia 's insolvency could not be remedied, TXU was able to avoid its obligations to Enron Australia.
The decision in Enron is of interest to market participants for two reasons. Firstly, the decision clarifies that the flawed asset provisions of the 1992 Agreement are enforceable against the creditors of a bankrupt entity. Secondly, it demonstrates how the provisions of the 1992 Agreement can be used by a non-defaulting party to avoid or delay payment to a defaulting party. This has attracted and will continue to attract the attention of financial institution regulators, who will need to examine the decision to determine whether it will have any impact on capital netting of derivatives by financial institutions.