Frequently Asked Questions – Structured Notes Distributed Under the Shelf Prospectus System
This article was originally published in the Investment Funds Practitioner in September 2016.
In January 2015, CSA staff published CSA Staff Notice 44-305 – 2015 Update – Structured Notes Distributed Under the Shelf Prospectus System (the Notice) to provide further guidance regarding disclosure that issuers should consider in offering documents for structured notes. Since that time, we have received several questions with respect to the Notice to which we wish to respond as well as discuss some other issues. Our responses to these questions are set out in the attached Appendix.
Frequently Asked Questions and Other Issues Concerning Structured Notes
Q: Can I use the term "estimated value" of the note as opposed to the "estimated fair value"?
A: We received some questions regarding whether issuers may refer to the "estimated value" of a note as opposed to the term "estimated fair value" which we used in the Notice. Our primary objective in the Notice was to encourage issuers to be more transparent regarding the estimated value of the notes which they internally prepared and the potential profit to be made on a note, but not mandate specifically how the estimates should be calculated or to impose specific fair value accounting concepts. We believe this approach to be consistent with the approach taken in the U.S. by the Securities and Exchange Commission (SEC). We leave it to issuers to decide which term they are more comfortable using when disclosing their estimates.
Q: What discount rate should I use when estimating the value of a zero coupon bond?
A: We received questions regarding whether there was a staff view on which discount rate issuers should use for the valuation of the zero coupon bond that issuers partially hedge their exposure under the notes with. As discussed above, staff did not express a view in the Notice regarding specifically how estimates should be prepared. As such, issuers should continue to use the reasonably selected discount rate they have been using. We expect, however, that issuers will disclose what discount rate they have used and why.
Q: Can I include contingent costs in my estimate of a note's value?
A: It is our understanding that industry practice is not to include contingent costs in the estimate of a note's value. The estimate is generally based upon the valuation of the note's bond and derivative components. If an issuer does choose to include contingent costs, we expect it to disclose what contingent costs are included and why those costs are included in the calculation.
Q: Can I disclose a straight-line depreciation of the difference between the note's issue price and its estimated value or fair value?
A: It is our understanding that industry practice is not to disclose a straight line depreciation of the difference between the issue price of the notes and their estimated fair value. Also, in our view, this information may be of limited assistance and cannot fairly be compared against annual management fees investors must pay in connection with other investment products such as mutual funds.
Q: Where on the cover page should I disclose the note's estimated value or estimated fair value?
A: We encourage issuers to include the disclosure on the first page of the pricing supplement in a prominent location or, if formatting is an issue, in the introductory paragraph that immediately follows the description of the notes offered.
Q: How should I disclose the estimated value or fair value for Delta-1 notes?
A: In instances where banks offer notes that are linked to a particular strategy, usually a quantitative model, and that have no derivative component that either boosts the return, calls the note or provides some downside protection, there may not be an embedded profit in their offering price. As such, the fair value estimate is typically the offering price minus the dealer costs. In instances where banks are offering such notes, we ask for additional disclosure to be included in the paragraph on the cover page that discloses the fair value estimate. We have requested that the additional disclosure be bolded and state that the estimated value or fair value does not include the other fees (i.e. management fee, withholding taxes, etc.) that will be charged to the notional portfolio over the term of the notes and reference the fees and expenses section in the pricing supplement.
Q: What disclosure is expected to explain why the estimated value may be different than the price at which an investor can sell the note in the secondary market?
A: As noted in section 1.1 of the Notice, issuers are expected to include an explanation as to why the estimated value of the note and the initial secondary market price will differ (the Delta). In order to satisfy this disclosure expectation, the disclosure should focus on the Delta immediately once the note is issued rather than the Delta once time elapses and market forces affect the note's price.
Q: Should I disclose the note's estimated value or fair value in the note's marketing documents?
A: Staff note that the marketing documents that are typically used to sell notes often do not include disclosure of the estimated value or fair value of the notes. We encourage issuers to include the disclosure of the estimated value or fair value and a brief explanation of its meaning in marketing materials going forward.