Report of the Task Force on Debt-Like Derivatives
Report of the Task Force on Debt-Like Derivatives
NOTICE OF THE REPORT ON THE TASK FORCE ON DEBT-LIKE DERIVATIVES
In 1995, the Ontario Securities Commission (the "Commission") constituted the Task Force on Debt-Like Derivatives (the "Task Force"), with members drawn from the securities industry, the legal community, the Commission and Commission staff. The mandate of the Task Force was to review the application of the existing securities regulatory regime in Ontario to the distribution of debt-like derivative securities and make recommendations as to the regulation of debt-like derivatives at the retail level. In January 1999, the Task Force delivered its report (the "Report") to the Commission. The Report is being released today and a copy is published in this Bulletin.
The Report is in its final form and it is not proposed that the Task Force be reconvened. The Commission would like to take this opportunity to thank the members of the Task Force for the considerable time and effort they spent on this project. To assist the Commission in its consideration of the recommendations contained in the Report, interested parties are invited to make written submissions with respect to the proposals set out in the Report. Submissions received by April 30, 1999 will be considered.
Submissions should be sent in duplicate to:
Daniel P. Iggers, Secretary
Ontario Securities Commission
20 Queen Street West
Suite 800, Box 55
Toronto, Ontario M5H 3S8
Copies of the Report are available from:
Corporate Relations Branch
Ontario Securities Commission
20 Queen Street West, Suite 800
P.O. Box 55
Tel: (416) 593-3699
From our website at: www.osc.gov.on.ca
Questions may be referred to:
Susan Wolburgh Jenah
Manager, Corporate Finance
REPORT OF THE
TASK FORCE ON DEBT-LIKE DERIVATIVES
January 5, 1999
The Ontario Securities Commission (the "Commission") constituted the Task Force on Debt-Like Derivatives (the "Task Force") in 1995 with members drawn from the securities industry, the legal community, the Commission and Commission staff. The mandate of the Task Force was to review the application of the existing securities regulatory regime in Ontario to the distribution of debt-like derivative securities and make recommendations to the Commission and the Canadian Securities Administrators (the "CSA") as to the regulation of debt-like derivatives at the retail level.(1)
The mandate of the Task Force was not to rethink existing statutory prospectus exemptions that have been used in recent years to distribute certain debt-like derivative securities in Ontario. Consequently, the Task Force attempted to evaluate whether the use of existing exemptions by issuers of debt-like derivative securities has resulted in a lack of legal and regulatory protections for retail investors in Ontario, or has otherwise prejudiced Ontario's capital markets. The recommendations of the Task Force to the Commission and the CSA are set out in this Report.
The members of the Task Force are:
Stephen R. Ashbourne - Blake, Cassels & Graydon
Kirby C. Gavelin - RBC Dominion Securities Inc.
John A. Geller - Ontario Securities Commission
Philip J. Henderson - Stikeman, Elliott
Tanis J. MacLaren - Ontario Securities Commission
Paul M. Moore - Tory Tory DesLauriers & Binnington
Margo L. Paul - Ontario Securities Commission
Robert P. Wildeboer - Wildeboer Rand Thompson Apps & Dellelce
Susan Wolburgh Jenah - Ontario Securities Commission
The Committee would also like to acknowledge the assistance of David D. Valentine of Blake, Cassels & Graydon.
Since the early 1980s, derivative products have changed the landscape of financial markets throughout the world and have become an important instrument of modern financial management. The application of the Securities Act (Ontario)(2)
(the "Act") to swaps and other over-the-counter derivatives has been the subject of considerable study by Commission staff in recent years, culminating in proposed Ontario Securities Commission Rule 91-504, Over-the-Counter Derivatives, published by the Commission in November 1996.(3)
Throughout the past few years, the capital markets in Canada have witnessed the development and distribution of many other forms of derivative instruments that are, in some cases, conventional securities with embedded derivatives and, in other cases, derivative instruments that possess many of the features of securities but may technically not be securities. In Ontario, as in many other jurisdictions, the history of the regulation of derivative instruments has been an exercise in attempting to fit derivatives within pre-existing regulatory structures which were designed with the regulation of non-derivative securities in mind.
During the course of its meetings, the Task Force reviewed the various types of debt-like derivative instruments that have been offered for sale at the retail level in Ontario to date as well as many of the disclosure documents that have been used in connection with the distribution of those derivative instruments. The Task Force considered, among other financial instruments which have been distributed in the Ontario capital markets, index and commodity warrants, index and commodity linked notes, equity and equity index linked deposits, mortgage backed securities, co-ownership certificates, government and corporate strip bonds, real return bonds and government issued warrants. The Task Force also considered carefully the statutory exemptions currently available for the distribution of certain derivative instruments, the regulatory initiatives of the Commission to date in this area and the powers of the Commission in respect of derivatives under the Securities Amendment Act, 1994 ("Bill 190").
Based on its review of these matters, the Task Force has recommended in this Report the adoption of an alternative disclosure regime to be made available to qualified issuers of qualified debt-like derivative instruments. It is important to note that the recommended alternative disclosure regime does not create additional prospectus and registration exemptions for any kind of issue but, rather, involves the imposition of additional regulatory requirements that do not presently exist; it removes existing exemptions for certain debt-like derivative securities which do not qualify to use the proposed alternative disclosure regime.
The Task Force anticipates that its recommendations are a further step in the ongoing review by the Commission and the CSA of the regulation of derivatives generally.
Existing Statutory Exemptions
Many of the debt-like derivative instruments which have been offered for sale on a retail basis in Ontario have been offered in reliance on the registration and prospectus exemptions contained in paragraphs 1 and 2 of section 35(2) and section 73(1)(a) of the Act, respectively, or pursuant to discretionary relief from the Commission in cases of uncertainty. The Task Force recognizes that debt-like derivatives might also be offered in reliance on the registration and prospectus exemptions contained in paragraph 4 of section 35(2) and section 73(1)(a) of the Act, respectively.(4)
Paragraphs 1, 2 and 4 of section 35(2) and section 73(1)(a) of the Act exempt from the registration and prospectus requirements of the Act the following kinds of "securities":
1. Bonds, debentures or other evidences of indebtedness,
(a) of or guaranteed by the Government of Canada or any province or territory of Canada or by the Government of the United Kingdom or any foreign country or any political division thereof;
(b) of any municipal corporation in Canada, including debentures issued for public, separate, secondary or vocational school purposes, or guaranteed by any municipal corporation in Canada, or secured by or payable out of rates or taxes levied under the law of any province or territory of Canada on property in such province or territory and collectable by or through the municipality in which such property is situated;
(c) of or guaranteed by a bank listed in Schedule I or II to the Bank Act (Canada), a trust corporation or loan corporation registered under the Loan and Trust Corporations Act (Ontario) or an insurance company licensed under the Insurance Act (Ontario);
(c.1) issued by a credit union, to which the Credit Unions and Caisses Populaires Act, 1994 (Ontario) applies, to its members, a league or the deposit insurer;
(c.2) issued by a league, to which the Credit Unions and Caisses Populaires Act, 1994 (Ontario) applies, to its members, the members of its member credit unions or the deposit insurer;
(d) of or guaranteed by the International Bank for Reconstruction and Development established by the Agreement for an International Bank for Reconstruction and Development approved by the Bretton Woods Agreement Act (Canada), if the bonds, debentures or evidences of indebtedness are payable in the currency of Canada or the United States of America;
(d.1) of or guaranteed by the International Finance Corporation established by the Articles of Agreement approved by the Bretton Woods and Related Agreements Act (Canada),if the bonds, debentures or evidences of indebtedness are payable in the currency of Canada or the United States of America and if, with respect to such securities, such documents, certificates, reports, releases, statements, agreements or other information as may be required by the Commission are filed; or
(e) of or guaranteed by the Asian Development Bank or the Inter-American Development Bank, if the bonds, debentures or evidences of indebtedness are payable in the currency of Canada or the United States of America and if, with respect to such securities, such documents, certificates, reports, releases, statements, agreements or other information as may be required by the Commission are filed;
2. Certificates or receipts issued by a trust corporation registered under the Loan and Trust Corporations Act (Ontario) or by a credit union or league within the meaning of the Credit Unions and Caisses Populaires Act, 1994 (Ontario) for money received for guaranteed investment.
4. Negotiable promissory notes and commercial paper maturing not more than one year from the date of issue, provided that each such note or commercial paper traded to an individual has a denomination or principal amount of not less than $50,000.
Section 22(1) of the regulation under the Act (the "Regulation")(5)
removes the exemption referred to in clause 1(c) above in respect of bonds, debentures or other evidences of indebtedness that are subordinate in right of payment to deposits held by the issuer or guarantor of such bonds, debentures or other evidences of indebtedness.
The Task Force recognized the regulatory concern that these statutory exemptions for evidences of indebtedness reflect the intent of the Ontario legislature at a time prior to the existence of debt-like derivative instruments in the Ontario capital markets or elsewhere. The Task Force also recognized that some debt-like derivative instruments may be more complex than many conventional evidences of indebtedness. However, the Task Force rejects the notion that lack of complexity underlies these statutory exemptions and has concluded that mere complexity should not necessarily trigger a prospectus requirement in the case where an evidence of indebtedness is otherwise an exempt security. The Task Force has concluded that, where adequate disclosure is provided to investors about the product in question, there is no convincing reason why a debt-like derivative instrument should not benefit from the statutory exemptions to the same extent as more conventional evidences of indebtedness.
It was not the mandate of the Task Force to question generally the continued appropriateness of these statutory exemptions. The Task Force has accepted for purposes of this Report that certain types of securities issued or guaranteed by certain entities, as well as negotiable promissory notes and commercial paper, qualify for statutory exemptions and has not attempted to address the broader legislative policy question of whether statutory exemptions for evidences of indebtedness of these kinds of entities, and negotiable promissory notes and commercial paper, continue to be appropriate today.
Definition of "Security"
Many other debt-like derivative instruments have been offered for sale on a retail basis in Ontario without compliance with the registration and prospectus or any other requirements of the Act on the basis that they do not constitute securities within the meaning of the Act.
The term "security" is defined in section 1(1) of the Act in a non-exhaustive manner. The definition includes "any document, instrument or writing commonly known as a security" (clause (a)) and, subject to certain specific exceptions, "any bond, debenture, note or other evidence of indebtedness" (clause (e)). The following financial instruments are specifically excluded from the definition of "security" in clause (e) of section 1(1):
- a contract of insurance issued by an insurance company licensed under the Insurance Act (Ontario); and
- an evidence of deposit issued by a bank listed in Schedule I or II to the Bank Act (Canada), by a credit union or league to which the Credit Unions and Caisses Populaires Act, 1994 (Ontario) applies or by a loan corporation or trust corporation registered under the Loan and Trust Corporations Act (Ontario).
By virtue of the definition of the term "security" in section 1(1) of the Act, a number of financial institutions have issued deposits or deposit like instruments to retail customers in recent years, in circumstances where the interest (and, in some cases, repayment of part of the principal) has been linked to the performance of an equity index or other underlying interest throughout the term of the instrument. These issues have been completely outside the scope of the prospectus and registration requirements of the Act. The Task Force believes that retail investors in Ontario should reasonably expect a level playing field and the same minimum standard of disclosure in connection with debt-like derivative instruments sold to them whether or not the instrument is properly characterized as a security, as a deposit or as an insurance contract.
Bill 190 has given the Commission the power to make rules regulating or varying the Act in respect of derivatives. Consequently, deposit instruments and insurance contracts, to the extent that they are defined to be derivatives, would come within the regulatory purview of the Commission. The Task Force has concluded that deposit instruments and insurance contracts, to the extent that they constitute debt-like derivatives and are marketed to retail investors, should be subject to minimum disclosure requirements. The Commission has recently defined the term "derivative" in Ontario Securities Commission Rule 14-501, Definitions.(6) A "derivative" is defined as an instrument, agreement or security, the market price, value or payment obligations of which is derived from, referenced to or based on an underlying interest (a defined term)(7)
, other than a contract as defined for purposes of the Commodity Futures Act (Ontario).
Regulatory Initiatives to Date
(a) Debt-Like Derivative Securities Notice. In July 1991, the Commission formalized its earlier views on debt-like derivatives when it issued a staff notice respecting "Debt-Like Derivative Securities" which purported to limit the availability of the exempt securities exemption.(8)
Prior to the Notice, a number of debt-like derivative securities were distributed in reliance on this exemption or pursuant to discretionary relief from the Commission. These distributions involved the issuance by a Canadian government agency (for example, Export Development Corporation), a bank (including Schedule II banks), a loan or trust company or an insurance company of a note or similar obligation, the coupon of which was calculated by reference to a bench-mark such as the S&P 500 index.(9)
The Debt-Like Derivative Securities Notice stated that, in the view of the Commission, due to the complexity and nature of certain debt-like securities it was not appropriate for issuers to rely upon the exempt securities exemption without prior approval of the Director, Corporate Finance, of the Commission. The Notice went on to state that where a material or detachable component of a debt-like security is linked to an index or some other commodity, a prospectus will normally be required. The Commission effectively treated such instruments as comprising two separate securities -- a zero coupon note and an embedded index option. The Notice identified as "debt-like securities" those instruments having one or more of the following features:
(i) principal is repaid; however, in lieu of some or all interest, there is a payment based on a formula linked to an index or some other commodity;
(ii) traditional interest is paid; however, in lieu of repayment of some or all principal, there is a payment based on a formula linked to an index or some other commodity; or
(iii) an above-market rate of interest is paid or the purchase price is at a discount to the face value of the security, in return for a possible reduction in the rate of interest or the return of principal based on the movement in the price or level of an index or some other commodity.
The legal effect of the Debt-Like Derivative Securities Notice was unclear. Nevertheless, most debt-like derivatives that were offered in the retail market between 1991 and 1996 were offered on the basis that the particular product was not a security, by way of prospectus or through discretionary relief granted by the Commission. The Debt-Like Derivative Securities Notice was withdrawn by Commission staff, and replaced by a new Staff Notice, in June 1996.(10)
Commission staff still encourages issuers to confer with them prior to any proposed reliance on existing statutory exemptions for the distribution of debt-like derivatives.
(b) Draft National Policy No.46 ("NP 46"). In the late 1980s and early 1990s several public issues of derivative securities in the form of put and call warrants on stock indices such as the Nikkei 225 Index were undertaken and listed on stock exchanges in Canada. The regulatory response to these public issues was the publication of draft NP 46 in 1992.(11)
Draft NP 46 stated, in its preamble, that the securities regulatory authorities recognized that a significant portion of traditional prospectus disclosure was not necessary in relation to these types of products. Some commentators have argued, however, that the uncertainty with respect to, and complexity of, the alternative disclosure regime which it prescribed had the effect of rapidly cooling the public market for derivative securities in Canada. Certain of the disclosure requirements of NP 46 may continue to have merit in the context of public offerings of derivative warrants, but they have not been incorporated in the Task Force's recommendations on qualified debt-like derivatives.
There appears to have been a recent resurgence in activity by issuers of derivative warrants in the public market in Canada based on a perceived change in the regulatory approach to derivative warrants since the publication of draft NP 46 in 1992. The recent experience of issuers of these warrants has been that provincial securities commissions have been receptive to the special issues arising on derivative offerings and very timely in prospectus review and clearance.
The Task Force's recommendations do not propose that the alternative disclosure regime be made available for derivative warrants. The Task Force believes that derivative warrants are, in many instances, the economic equivalent of principal exposed debt-like derivatives, which are not intended to benefit from the proposed alternative disclosure regime.
(c) Proposed Rule 91-504, Over-the-counter Derivatives. The Commission published in November 1996 a Notice of a Proposed Rule and a Proposed Policy under the Act relating to over-the-counter derivatives, which was amended to reflect comments received and republished in December 1998.(12)
The Commission has characterized the proposed Rule as an attempt to remove the uncertainty surrounding the application of Ontario securities laws to trades in over-the-counter derivatives and to provide appropriate investor protection to unsophisticated persons using over-the-counter derivatives, rather than as an attempt to regulate the over-the-counter derivatives market. The proposed Rule is an amendment and reformulation of the earlier draft Ruling and draft Policy Statement published by the Commission in January 1994 (the "1994 Proposals").(13)
The 1994 Proposals were based on the Commission's view that certain over-the-counter derivatives constitute trades in securities. The Commission has since been given statutory authority to make rules regulating or varying the Act in respect of "derivatives". The proposed Rule deals with over-the-counter derivatives (whether or not they technically constitute securities) but respects what has been market practice in Ontario to date in that most types of over-the-counter derivatives will not be subject to any Ontario securities laws.
The Task Force intends that the alternative disclosure regime for qualified debt-like derivatives will complement the proposed Rule on over-the-counter derivatives but operate independently from it. It is anticipated that a particular derivative instrument which is governed by the proposed Rule would not also be subject to the proposed regime for debt-like derivatives. A particular derivative instrument may be subject to, and qualify for exemptive relief under, either or both regimes depending on its particular characteristics.
The Case for an Alternative Disclosure Regime
The Task Force believes that the regulation of derivative instruments in Ontario, and elsewhere, has been a rather awkward exercise in which regulators have attempted to fit derivatives within pre-existing regulatory structures which were designed with the regulation of non-derivative securities in mind. While the emergence of derivative instruments in the Ontario capital markets during the 1980s gave rise to what has sometimes been described as a "merit-based" approach to regulation, it appears trite today to say that derivative instruments have become an important component of the capital markets. Regulators appear to accept that a "disclosure-based" regulatory approach is no less suitable for derivative instruments than for more conventional securities. The Task Force proposes a disclosure based regulatory regime for debt-like derivative instruments.
The notion of disclosure based regulation, however, should not conceptually and automatically give rise to a prospectus requirement. While some debt-like derivative instruments may be more complex than many conventional evidences of indebtedness, the Task Force is of the view that mere complexity should not necessarily trigger a prospectus requirement where an evidence of indebtedness is otherwise an exempt security.
The remedies available under Ontario securities law against issuers and others involved in a distribution of securities pursuant to a prospectus do not easily apply to debt-like derivatives which are otherwise exempt securities. The statutory rights of withdrawal and the statutory rights of action for damages or rescission for misrepresentation available to purchasers in the context of a prospectus offering were developed in the context of conventional securities offerings where the security in question is not simply a financial instrument but has intrinsic value derived from the business and affairs of the issuer. Debt-like derivatives, on the other hand, are generally extremely time sensitive and fluctuate in value based on factors which are external to the issuer. Accordingly, a right of withdrawal would provide to purchasers of debt-like derivatives a free and inappropriate option to walk away from an investment in a financial instrument if the market moves adversely.(14)
The Task Force recommends that purchasers of qualified debt-like derivatives not be granted any rights akin to the statutory rights of withdrawal available in the context of a prospectus offering.
The Task Force also recommends that purchasers of qualified debt-like derivatives under the proposed alternative disclosure regime be granted a limited right of action for damages or rescission against a qualified issuer (which the Task Force has called a "term sheet disclosure right") as a consequence of the required term sheet containing an untrue statement of a material fact. In this regard, it is important to note that the disclosure required to be included in the term sheet given to prospective investors is limited, essentially, to a description of the economic terms of, and risk factors specific to, the particular qualified debt-like derivative being offered. A term sheet does not necessarily have to include disclosure about the business and affairs of the qualified issuer.
The Task Force's recommendations apply only to qualified debt-like derivatives; that is, debt-like derivative instruments which are otherwise outside the scope of the Act or exempt evidences of indebtedness within the meaning of the existing statutory exemptions. The recommendations do not attempt to expand the existing statutory exemptions in any way, but impose basic disclosure requirements on qualified issuers of debt-like derivatives relying on these exemptions.
The recommendations establish that debt-like derivatives are qualified debt-like derivatives only where the principal at risk must be repaid in full pursuant to its terms within a specified period of time.(15)
Consequently, derivative warrant products do not constitute qualified debt-like derivatives. However, qualified debt-like derivatives can include conduit or pass-through products (e.g. mortgage backed securities) as well as covenant-based products (e.g.. equity linked deposits) provided they satisfy the basic requirement of the exemption that the product constitutes an evidence of indebtedness of or guaranteed by a prescribed entity or a negotiable promissory note or commercial paper.
The Task Force has not adopted the notion that an expanded shelf prospectus regime for qualified debt-like derivatives is the appropriate solution for the regulation of all debt-like derivative products. The Task Force believes that, on a balance of competing interests, the additional discipline of prospectus liability (whether through a shelf prospectus or otherwise) is unnecessary in the context of qualified debt-like derivatives and that, although the shelf prospectus regime provides some flexibility to issuers in accessing the market on a timely basis, there is insufficient reason to impose a prospectus requirement on qualified debt-like derivatives in the first instance.
The Task Force's recommendations do not affect other statutory prospectus and registration exemptions which may be available to issuers of debt-like derivative instruments nor do they affect the availability of exemptions granted in proposed Rule 91-504, Over-the-Counter Derivatives.
Recommendations of the Task Force
The Task Force recommends the adoption by the Commission of a new Rule respecting "qualified debt-like derivatives". For illustrative purposes, a draft Rule (Schedule 1) and a draft Companion Policy (Schedule 2) accompany this Report.
(a) Alternative Disclosure Regime
The draft Rule imposes the prospectus and dealer registration requirements of the Act on debt-like derivatives that are not securities to the same extent as if they were securities of the type listed in paragraph 1, 2 or 4 of subsection 35(2) of the Act and removes the exemptions contained in paragraph 73(1)(a) of the Act corresponding to the exemptions contained in paragraphs 1, 2 or 4 of subsection 35(2) of the Act in the case of distributions of such debt-like derivatives.
The draft Rule then provides an exemption from sections 25 and 53 of the Act for distributions of "qualified debt-like derivatives" made in accordance with the alternative disclosure regime of the draft Rule.
(b) Qualified Debt-like Derivatives
The definition of "qualified debt-like derivative" contained in the draft Rule restricts the availability of the alternative disclosure regime to debt-like derivatives issued or guaranteed by one or more qualified issuers in circumstances where the initial purchase price of the debt-like derivative is not at risk, all amounts payable pursuant to the debt-like derivative are due not later than ten (10) years after issuance and the amounts payable under the debt-like derivative are derived from or based on one or more permitted underlying interests. The payout within ten (10) years requirement is designed to prevent qualified debt-like derivatives from effectively exposing principal to risk by simply delaying its repayment; the Task Force felt that this approach avoids any "materiality" debate as to permitted principal at risk.
The definition of "permitted underlying interest" attempts to exclude underlying interests which are not widely known or are potentially subject to manipulation by the issuer or others.
(c) Disclosure Documents
The additional disclosure requirements which the Task Force has recommended in the draft Rule include an obligation to deliver to prospective purchasers a generic risk disclosure statement concerning debt-like derivatives and, prior to the investment decision, a term sheet describing the economic terms of, and risks specific to, the qualified debt-like derivative. The generic risk disclosure statement need only be delivered once.
The draft Rule prescribes certain content requirements for a term sheet, but it is not intended that a term sheet must include disclosure other than the economic terms of, and risk factors specific to, the particular qualified debt-like derivative.(16)
The draft Rule also requires a certificate in the term sheet, signed by the qualified issuer. The certificate is a statement that the term sheet contains the information required by the Rule and does not contain an untrue statement of a material fact. The contents of any other marketing materials made available to prospective purchasers in connection with the distribution of the qualified debt-like derivative must also be covered by the certification.
The draft Rule requires that all term sheets be filed with the Commission, but there is no requirement for review or other clearance by the Commission. Commission staff nevertheless reserves the right to review, comment on and take any appropriate action respecting term sheet disclosure on a case-by-case and after-the-fact basis.
(d) Registration Requirements
There was some debate among Task Force members as to who should be permitted to sell qualified debt-like derivatives in the retail marketplace: all representatives of full service dealers (investment dealers, brokers or securities dealers), only options or futures qualified representatives of full service dealers or some wider group of sellers. Task Force members agreed that individuals selling such instruments should be knowledgeable about their features, but this observation did not lead to the conclusion that such instruments should only be sold by representatives of full service dealers. The Task Force is not recommending at this time any specific or additional training course requirements for individuals selling such instruments, but welcomes comments from industry participants on whether the development of appropriate training course requirements is feasible or warranted in the context of qualified debt-like derivatives.
The Task Force recommends that the sale of qualified debt-like derivatives be subject to the same registration regime that otherwise is applicable to more conventional evidences of indebtedness issued by the entities listed in section 35(2)1 and 2 of the Act or commercial paper referred to in section 35(2)4 of the Act.(17)
If a similar approach to the draft Rule is adopted in other provinces of Canada, in provinces without a universal registration regime no person or company would need to be registered to trade in qualified debt-like derivatives.
Areas for Further Consideration
The Task Force considered various alternatives in addition to those incorporated in its recommendations. Some of theses alternatives may be worthy of further consideration.
For example, it may also be appropriate to consider whether non-qualified issuers of debt-like derivatives should be able to avail themselves of an expanded shelf prospectus system and whether discretionary relief may be available from the Commission for non-qualified issuers so that they can use, in appropriate circumstances, the alternative disclosure regime embodied in the draft Rule. Also, some commentators might argue that the alternative disclosure regime adopted in the draft Rule should be available to qualified issuers of commodity and index warrants or principal-at-risk debt-like derivatives.
The Task Force has made no recommendations with respect to these matters at this time but believes that they do warrant further consideration.
* * * * *
This Report is respectfully submitted.
January 5, 1999.
ONTARIO SECURITIES COMMISSION
PART DEFINITIONS(19) AND APPLICATION
1.1 Definitions - In this Rule
"approved rating" means a rating from an approved rating organization that falls within one of the following generic rating categories of the approved rating organization or a rating category that replaces a category listed below:
Approved Rating Organization
A-1+, A-1, A-l (Low) or A-2
Dominion Bond Rating Service Limited
R-1 or R-2
Moody's Investors Service, Inc.
Prime-1, Prime-2 or Prime-3
Standard & Poor's Corporation
A-1+, A-1, A-2
"approved rating organization" means each of CBRS Inc., Dominion Bond Rating Service Limited, Moody's Investors Service, Inc. and Standard & Poor's Corporation and any of their successors;
"approved rating asset-backed commercial paper" means a negotiable promissory note or commercial paper referred to in paragraph 35(2)4 of the Act that
(a) is issued by a special purpose entity whose assets are comprised primarily of receivables or other financial assets the cashflows from which are designated as the source for payment of outstanding obligations of the entity, and
(b) at the time of distribution, has received an approved rating from at least one approved rating organization and has not received a rating lower than an approved rating from any approved rating organization and in respect of which no approved rating organization has indicated an intention to provide a rating, whether on a provisional or final basis, that is lower than an approved rating;(20)
"cash equivalent" means
(a) cash, or
(b) a conventional debt instrument that has a remaining term to maturity of 365 days or less and that is issued, or fully and unconditionally guaranteed as to principal and interest, by
(i) the Government of Canada or the government of a jurisdiction,
(ii) the Government of the United States of America, the government of one of the states of the United States of America, the government of another sovereign state, if, in each case, the conventional debt instrument has an approved rating, or
(iii) a Canadian financial institution(21) or a financial institution that is not incorporated or organized under the laws of Canada or of a jurisdiction if evidences of indebtedness of that issuer or guarantor that are rated as short term debt by an approved rating organization have an approved rating;(22)
"conventional debt instrument" means indebtedness of an obligor under which
(a) the obligor covenants to pay the holder a fixed and specified principal amount,
(b) the amounts payable are either fixed and specified or determined based on one or more financial references, interests or variables commonly used in commercial arrangements to ascribe value to the time value of a money investment, or are incidental amounts payable upon a default by the obligor, and
(c) there is no limitation on the recourse available against the obligor for amounts payable;(23)
(a) insurance, other than "life insurance" as defined in the Insurance Act,(26)
(b) "disability insurance" as defined in the Insurance Act,
(c) a fixed life annuity,(27)
(d) dividends paid or payable from, or a return of capital under, a related participating account,(28) or
(e) a contract requiring the insurer to pay one or more net(29) amounts, each of which is
(A) fixed and specified in the contract,
(B) a return of premiums, or
(C) an amount determined based on one or more financial references, interests or variables commonly used in commercial arrangements to ascribe value to the time value of a money investment, and
(ii) to be paid at a time that is
(A) fixed and specified in the contract,
(B) contingent upon the happening of one or more events determined by reference to an interest that is an insurable interest(30) of the insured, or
(C) determined by the holder in the holder's sole discretion;(31)
(a) a bond, debenture or other evidence of indebtedness referred to in paragraph 35(2)1 of the Act, other than a bond, debenture or other evidence of indebtedness referred to in subsection 22(1) of the Regulation,
(b) a certificate or receipt referred to in paragraph 35(2)2 of the Act,
(c) a negotiable promissory note or commercial paper referred to in paragraph 35(2)4 of the Act, unless traded to an individual in a denomination or principal amount of less than $50,000;(34)
(d) an evidence of deposit referred to in clause (e) of the definition of "security" in subsection 1(1) of the Act, or
(e) a contract of insurance referred to in clause (e) of the definition of "security" in subsection 1(1) of the Act;
"permitted underlying interest" means(35), in relation to a debt-like derivative
(a) an underlying interest listed in Appendix A, or
(b) an underlying interest the price, value or payment obligations of which, on the date of distribution of the debt-like derivative
(i) can be calculated or otherwise determined in an objective manner based on a methodology that is transparent to prospective investors,
(ii) is publicly reported not less than twice weekly, and
(iii) cannot be controlled or influenced materially by or on behalf of the issuer or a guarantor of the issuer's obligations or by an affiliate of the issuer or a guarantor(36)
"qualified debt-like derivative" means a debt-like derivative
(a) the underlying interest or interests of which are permitted underlying interests,
(b) under which the minimum aggregate amount of money and the principal amounts of other cash equivalents payable or deliverable equals or exceeds the aggregate purchase price paid for the debt-like derivative, excluding any underwriter commissions, taxes or other transaction costs,(37) and
(c) under which all cash equivalents are payable or deliverable at a time specified in the instrument or at a time determined by the holder, provided that such time occurs not later than 10 years after the issue date of the debt-like derivative or, in the case of a contract of insurance, upon the occurrence of the insurable event;(38)
"related document" means, in relation to a debt-like derivative, any document that describes the business and affairs of the issuer of the debt-like derivative or the economic terms of and risks associated with the debt-like derivative, and has been prepared primarily for delivery to and review by prospective purchasers of the debt-like derivative so as to assist those prospective purchasers to make an investment decision in respect of the debt-like derivative in a distribution to which Part 3 applies, other than
(a) a term sheet,
(b) a document setting out current information about the issuer of the debt-like derivative for the benefit of prospective purchasers familiar with the issuer through prior investment or business contacts,
(c) an annual report, interim report, information circular, take-over bid circular, issuer bid circular, prospectus or other such document the content of which is prescribed by statute or regulation; or
(d) an independent research report;(39)
"risk disclosure statement" means a statement substantially in the form of Appendix B;
"term sheet" means the written statement prepared in relation to a distribution of qualified debt-like derivatives under Part 3, giving the information and containing the legends required by Appendix C; and
"term sheet disclosure right" means, in relation to a qualified debt-like derivative, a contractual right described in Appendix C under "Description of Term Sheet Disclosure Right".
1.2 Application of Rule - This Rule does not apply to
(a) a conventional debt instrument;
(b) a conventional insurance contract;
(c) a security of a mutual fund or a non-redeemable investment fund;
(d) approved rating asset-backed commercial paper;
(e) an "OTC derivative" as defined in Rule 91-504 Over-the-Counter Derivatives;
(f) a "recognized option" as defined in Rule 91-502 Recognized Options; and
(g) a "strip bond" as defined in Rule 91-501 Strip Bonds.(40)
PART 2 APPLICATION OF THE ACT(41)
2.1 Application of the Registration Requirements of the Act to Certain Debt-Like Derivatives - Section 25 of the Act applies to a trade in a debt-like derivative listed in paragraphs (d) or (e) of the definition of "debt-like derivative" as if the debt-like derivative were a security referred to in paragraph 35(2)1 of the Act issued by the same financial institution.
2.2 Application of the Prospectus Requirements of the Act to Certain Debt-Like Derivatives - Section 53 of the Act applies to a distribution of a debt-like derivative listed in paragraphs (d) or (e) of the definition of "debt-like derivative" as if the debt-like derivative were a security referred to in paragraph 35(2)1 of the Act issued by the same financial institution.
2.3 References to Securities - In applying section 25 and section 53 of the Act to a debt-like derivative listed in paragraphs (d) or (e) of the definition of "debt-like derivative", each reference in Ontario securities law to a "security" shall be read to be a reference to the debt-like derivative.
2.4 Removal of Exemptions - The exemptions contained in paragraph 73(1)(a) of the Act corresponding to the exemptions contained in paragraphs 35(2)1, 2 and 4 of the Act are not available for the distribution of a debt-like derivative.
2.5 Exemption from Registration and Prospectus Requirements - Despite section 2.3 section 53 of the Act does not apply to a distribution of a qualified debt-like derivative made in accordance with Part 3.
PART 3 EXEMPT DISTRIBUTIONS OF QUALIFIED DEBT-LIKE DERIVATIVES(42)
3.1 Term Sheet Required
(1) An issuer who proposes to rely upon section 2.5 for a distribution of a qualified debt-like derivative shall prepare, in plain language, a term sheet that contains the information and legends required by Appendix C.
(2) An issuer who has prepared a term sheet under subsection (1) and is using the term sheet for the distribution of a qualified debt-like derivative shall prepare an amended term sheet updating or correcting the term sheet if it contains a statement that constitutes an untrue statement of material fact.
3.2 Certification - A term sheet and each amended term sheet shall contain a certificate in the following form signed by the issuer and any guarantor of the issuer's obligations under the qualified debt-like derivative:
"This term sheet,[ as amended,] together with any related document, includes the information required by Ontario Securities Commission Rule 91-505 and does not contain an untrue statement of a material fact."
3.3 Term Sheet Disclosure Right - A term sheet and any amended term sheet shall confer a term sheet disclosure right in favour of the purchaser against the issuer and any guarantor of the issuer's obligations under a qualified debt-like derivative.
3.4 Delivery of Term Sheet and Risk Disclosure Statement
(1) Subject to subsection (5), a dealer who receives an order or subscription for a qualified debt-like derivative shall deliver to the purchaser a risk disclosure statement under subsection (2) and a term sheet for the qualified debt-like derivative under subsection (3).
(2) A risk disclosure statement shall be delivered to a purchaser before entering into an agreement of purchase and sale for the qualified debt-like derivative, except if the dealer has previously done so.
(3) A term sheet for a qualified debt-like derivative shall be delivered to a purchaser promptly after receiving a request for a term sheet from the purchaser or, if not previously delivered to the purchaser, at the time required for delivery of the written confirmation of the trade in the qualified debt-like derivative contemplated by section 3.7.
(4) If a term sheet or a related document is delivered by a dealer to a purchaser before the completion of a purchase and sale of a qualified debt-like derivative, the dealer shall deliver any amended term sheet and any amended related document to the purchaser before completing the purchase and sale.
(5) Subsections (1) to (4) do not apply to a dealer acting solely as agent of the purchaser with respect to the trade in the qualified debt-like derivative if the dealer has not received and has no agreement to receive compensation from or on behalf of the vendor with respect to the purchase and sale.
3.5 Filing of Term Sheet - An issuer who distributes or proposes to distribute qualified debt-like derivatives in reliance upon section 2.5 shall file a copy of the term sheet and any related document and each amended term sheet and any amended related document not later than the second business day after the document or documents is, or are, first delivered to a purchaser.
3.6 Limitation of Liability - In no case shall the amount recoverable under the term sheet disclosure right exceed the price at which the relevant qualified debt-like derivative was sold.(43)
3.7 Confirmation of Trade - An issuer who distributes qualified debt-like derivatives in reliance upon section 2.5 shall promptly send by prepaid mail or deliver to the purchaser of the qualified debt-like derivative a written confirmation of the transaction, setting forth;
(1) the quantity and description of the security;
(2) the consideration;
(3) the commission, if any, charged in respect of the trade; and
(4) the name of the salesperson, if any, in the transaction.
PART 4 EXEMPTION
4.1 Exemption - The Director may grant an exemption to this Rule, in whole or in part, subject to such conditions or restrictions as may be imposed in the exemption.
PERMITTED UNDERLYING INTERESTS(44)
1. ScotiaMcLeod Universe Bond Index.
2. TSE 100 Total Return Index.
3. TSE 35 Index.
4. 91 Day Canada T-Bill Rate.
5. TSE 300 Total Return Index.
6. Morgan Stanley Emerging Markets Free Index ($Cdn).
7. Morgan Stanley Europe Index.
8. Morgan Stanley Japan Index.
9. Morgan Stanley World Index.
10. Salomon Brothers World Bond Index.
11. Scotia McLeod Conventional Mortgage Index.
12. Nesbitt Burns Small Cap Index.
13. S&P 500 Total Return Index ($Cdn).
14. Dow Jones Industrial Average.
15. NASDAQ Composite Index.
16. FT-SE 100 Price Index.
17. HANG SENG Price Index.
18. NIKKEI 225 Price Index.
19. Morgan Stanley EAFE Index.
[None of the securities regulators who regulate debt-like derivatives have expressed an opinion about the merits of the debt-like derivatives described generally below or otherwise. It is an offence to say that they have.]
RISK DISCLOSURE STATEMENT FOR DEBT-LIKE DERIVATIVES(45)
General If you have been given this risk statement, it means that you are considering purchasing, or may have agreed to purchase, a debt-like derivative.
With respect to any proposed investment in a debt-like derivative, you may also ask for a term sheet that describes the most important information about that debt-like derivative.
You should read both this document and the term sheet to ensure that you understand what you are buying and what the risks are that are associated with what you are buying.
Debt-like derivatives are not suitable for many investors.
You should carefully consider whether they are appropriate for you in light of your experience, investment objectives and your ability to bear risk.
Amount of Return on Your Investment
When you buy a debt-like derivative, you are buying an instrument that will give you a return that is based in some way on some external financial indicator. This external financial indicator is called an "underlying interest". For instance, you might be buying an instrument that will pay you a return based on how well a certain stock market does in the period in which you hold the instrument; in that case, the stock market index is called the "underlying interest" of the instrument.
Your principal investment should not be at risk for an investment for which this statement is given to you. You should made sure, before you buy the instrument, that you are entitled to get back at least the amount that you will pay for the instrument.
Many types of underlying interests can be used for debt-like derivatives. For example, the return on a debt-like derivative can be based on of the following underlying interests:
a currency exchange rate
the price of a commodity (such as gold or oil)
the level of an interest rate
the price of some securities, or the level of a particular stock exchange.
These underlying interests can go up or down while you hold a debt-like derivative, and it is impossible to predict whether they will go up or down, or how much they will go up or down. Whether they go up or down depends on a lot of factors over which you and the institution that sold you the debt-like derivative have no control. Also, how the underlying interest may have gone up or down in the past does not mean that it will do the same in the future.
If the underlying interest on which the return of your debt-like derivative is based goes down while you hold the debt-like derivative, your return on the derivative could be zero. This means that you would get the amount of your original investment back, but with no return or interest. If this happens, you will have a lower return from the debt-like derivative than you would have had with an ordinary guaranteed investment certificate (GIC). This is because with a GIC, you would have been guaranteed some particular return.
Also, the amount of your return on your debt-like derivative may be different than the amount, or percentage amount, that the underlying interest goes up or down. For instance, for an instrument that is based on a stock exchange index, you might get a return of 20% if the index goes up 30%. Or, your instrument might pay a zero percent return if the index does not go up at least 5%.
You should make sure that you understand how the return on your debt-like derivative will be calculated.
You may not be able to cash in your debt-like derivative with the institution from whom you bought it until it matures or until particular dates. You should make sure you understand how your instrument works in this regard.
Also, there may be no secondary market for your debt-like derivative. This means that there may be no one to sell it to if the institution that you bought it from will not let you cash it in.
In addition, if there is a secondary market for your debt-like derivative, the price of the derivative on that market may be volatile, and you may not be able to get as good a price for your derivative as you think would be appropriate.
Commissions and Other Charges
The term sheet will include an explanation of all commissions and fees in connection with the sale of the related debt-like derivatives. These charges will affect your net profit (if any) or increase your loss.
Legal and Accounting Issues
You should consider the legal and accounting implications of purchasing, holding and selling debt-like derivatives and consult such advisers as may be appropriate to assist you to understand the risks involved.
Debt-like derivatives are complex and so it may be difficult to monitor their value.
Before purchasing a debt-like derivative you should understand the income tax implications of doing so. Different debt-like derivatives have different income tax implications.
The income tax implications of holding debt-like derivatives are dependant upon the nature of your business activities and of the instrument in question. You should, therefore, consult your tax adviser to understand the relevant income tax considerations.
Term Sheet for [description of debt-like derivatives]
You should consult a financial or legal adviser to find out more about the risks and investment considerations relating to a purchase of these instruments. Purchasing these instruments may be inappropriate for some investors.
Issuer: [the name and registered office address of the issuer].
Guarantor: [the name and registered office address of any guarantor of the issuer's obligations under the debt-like derivative].
Debt-Like Derivative: [the title of the debt-like derivative and the class and series of which such debt-like derivatives may form part].
Denominations: [the denominations of such debt-like derivatives].
Terms: [describe the economic terms of the debt-like derivative including terms such as
the price at which the debt-like derivative is sold
the extent to which the return on investment will be determined with reference to an underlying interest
the date or dates on which amounts will be payable or conventional debt instruments will be deliverable
any provisions for early redemption, retraction or exercise
the formula or basis for calculating return, including a description of any multiplier or other leveraging factor
a brief description of the underlying interest, including where the underlying interest are publicly reported or made available and whether performance by the issuer will be subject to, or limited by, extraordinary events]
and provide that information which is necessary to enable prospective purchasers to calculate the return under the debt-like derivative including the change in the level of the underlying interest at which the investors would commence to receive a return on their investment.
Obligations [Not]Insured: [indicate whether and to what extent the obligations of the issuer or guarantor under the qualified debt-like derivative are insured under a deposit insurance program or similar arrangement].
Specific Risk Factors: briefly describe any material risks to prospective investors which are specific to the debt-like derivatives to be issued and which are not adequately described in the Risk Disclosure Statement.
Description of Term Sheet
Disclosure Right: If this term sheet [amended term sheet] [and any related document] contains a statement of material fact which is untrue at the time of purchase of these instruments and the purchaser had no knowledge of the inaccuracy, the purchaser will be deemed to have relied upon the untrue statement in making the purchase decision and will have the following rights against the issuer and any guarantor:
the purchaser may claim damages equal to the lesser of (1) the decrease in the value of the debt-like derivatives resulting from the inaccuracy and (2) the purchase price paid for the debt-like derivative
the purchaser will be entitled to exercise this right by delivering notice of exercise to the issuer [and any guarantor] at [their] registered offices (the address[es] of which [are] set out above) not later than 180 days after payment of the purchase price is made.
Granting of Term Sheet
Disclosure Right State that the contractual rights described under "Description of Term Sheet Disclosure Right", above, are hereby conferred upon the initial purchaser of the debt-like derivatives described in this term sheet.
Certificate of Issuer
[and Guarantor] Provide the following certificate:
This term sheet, as amended, together with any related document, includes the information required by Ontario Securities Commission Rule 91-505 and does not contain an untrue statement of a material fact.
COMPANION POLICY *
PART 1 PURPOSE
1.1 Purpose - The purpose of this Policy is to state the views of the Ontario Securities Commission on various matters relating to Rule * Debt-like Derivatives (the "Rule"), including
(a) a discussion of the general approach taken by the Commission in, and the general regulatory purpose for, the Rule;
(b) the interpretation of various terms used in the Rule; and
(c) information that the Commission believes will assist market participants in understanding the operation of the Rule.
PART 2 GENERAL DISCUSSION OF THE RULE
2.1 Introduction and Purpose
(1) The Rule has been adopted following the recommendations of the Report (the "Report")(46) of the Task Force (the "Task Force") on Debt-like Derivatives, which was submitted to the Commission in January 1999.
(2) As stated in the Report, the mandate of the Task Force was to review the application of existing securities law in Ontario to the distribution of debt-like derivative securities and make recommendations to the Commission and the Canadian Securities Administrators ("CSA") as to the regulation of debt-like securities at the retail level.
(3) The Task Force was formed in response to the development of the sale at a retail level of debt-like derivatives that, for various reasons, were either not securities under the Securities Act (the "Act"), or were capable of being issued in reliance on existing prospectus or registration exemptions provided by the Act. Section 2.2 of this Policy contains a discussion of the legal basis on which these instruments were issued.
(4) The Task Force was of the view that investors purchasing these products should be provided with some minimal disclosure concerning the structuring and risk of those products, and the Rule was designed to ensure that disclosure was provided. The Rule generally was prepared in a manner consistent with the Task Force report, and reference should be made to that report for additional discussion concerning some of the policy rationale that informed the development of the Rule.
2.2 Type of Instruments to Which the Rule Applies
(1) The Rule applies, subject to certain exclusions, to any product that is a "debt-like derivative", as defined in the Rule. A debt-like derivative is defined as a "derivative" that falls into certain categories of instruments.
(2) A derivative is an instrument that provides payments or returns based on some underlying interest, such as a stock exchange index or some other financial reference. The term "derivative" is defined in Rule 14-501 Definitions as "an instrument, agreement or security, the market price, value or payment obligations of which is derived from or based on an underlying interest, other than a contract as defined for the purposes of the Commodity Futures Act". The term "derivative" can cover a wide range of products, some of which raise investor protection concerns because of the risks and complexities associated with the products.
(3) The Rule does not purport to apply to all derivatives, but only to those that fall into the following two primary categories:
(a) a debt security that is otherwise exempted from the registration and prospectus requirements of the Act under paragraph 35(2)1, 2 or 4 of the Act and the corresponding exemptions under paragraph 73(1)(a) of the Act; or
(b) a deposit instrument or contract of insurance that is otherwise excluded from the application of the Act by clause (e) of the definition of "security" contained in subsection 1(1) of the Act.
(4) The products described in subsection (3), absent the Rule, may be issued outside the prospectus and, except for universal registration, the registration requirements of the Act.
(5) The exemptions referred to in paragraph 3(a) cover "bonds, debentures or other evidences of indebtedness" issued by government and financial institutions referred to in those exemptions, certificates or receipts issued by certain trust companies or credit unions and negotiable promissory notes or commercial paper. The Commission is of the view that those exemptions were intended to be available only to straight forward debt obligations of the institutions listed. The types of debt instruments sold by these issuers have evolved over the years and the Commission is of the view that, with respect to debt instruments that are debt-like derivatives, certain risk and other disclosure is required for investor protection.
(6) Paragraph 3(b) refers to products that are excluded from the Act on the basis that they are either evidences of deposits of financial institutions or contracts of insurance. These products have traditionally been regarded as being outside the realm of securities law, being either banking or insurance products.
(7) One of the driving forces behind the Rule was the widespread use of the exemptions referred to in paragraph 3(a) by a number of Canadian financial institutions to issue debt-like derivatives without a prospectus. The Commission and the Task Force have also noted that Canadian financial institutions and insurance companies have distributed to retail investors derivative products that were, in form, structured as evidences of deposit or insurance contracts, but that raised investor protection concerns.
(8) The Rule recognizes that a level playing field and the same minimum standards of disclosure should apply uniformly to debt-like derivatives distributed in Ontario, whether or not the instrument is properly characterized as a security, as a deposit, as a contract of insurance or otherwise.(47) Therefore, the Rule has been drafted to include debt-like derivatives that legally take different forms.
2.3 Overview of Operation of Rule
(1) Part 2 of the Rule contains the technical provisions that require debt-like derivatives to be sold only in compliance with the prospectus and registration provisions of the Act, or under the alternative disclosure regime established by the Rule.
(2) Section 2.1 of the Rule provides that the registration requirements of the Act apply to trades in debt-like derivatives that are listed in paragraphs (d) and (e) of the definition of "debt-like derivative" in the Rule (i.e. debt-like derivatives that are evidences of deposit or insurance contracts) as if those products were securities listed in paragraph 35(2)1 of the Act.
(3) Section 2.2 of the Rule applies the prospectus requirements of the Act to the products to which section 2.1 of the Rule pertains. Therefore, absent the relief provided by section 2.5 of the Rule or other relief, those products can be sold only by means of a prospectus.
(4) Section 2.3 of the Rule provides that the prospectus and registration provisions of Ontario securities law should be read to include the products to which section 2.1 of the Rule applies.
(5) Section 2.4 of the Rule removes the prospectus exemption from the products listed in paragraphs (a), (b) and (c) of the definition of "debt-like derivative" in the Rule - i.e. the "debt" products listed in those sections.
(6) The overall effect of sections 2.1 through 2.4 of the Rule is to bring all of the products listed in the definition of "debt-like derivative" within the prospectus and registration provisions of the Act.
(7) In Ontario, the universal registration regime takes away the registration exemption for sales of securities listed in subsection 35(2) by market intermediaries. Therefore, absent other exemptions, any market intermediary trading in debt-like derivatives will be required to be registered as a full service dealer (investment dealer, broker or securities dealer) or as a limited market dealer. Where these products are being sold by a financial intermediary (as defined in section 204(1) of the Regulation), Rule 32-502 gives back the registration exemption for these trades.
(8) Section 2.5 then provides that a debt-like derivative that is a "qualified debt-like derivative" may be sold without a prospectus if the alternative disclosure regime provided by the Rule is used. The alternative disclosure regime permits distributions using a simple term sheet, which describes, among other things, the economic terms and risks of the debt-like derivatives, and a generic form of "risk disclosure statement".
(9) A debt-like derivative that is not a "qualified debt-like derivative" cannot be distributed under the alternative disclosure regime provided by the Rule, and must therefore, absent other relief, be distributed only under an exemption from the prospectus provisions provided by the Act, or under a prospectus.
PART 3 NON-APPLICATION OF THE RULE
3.1 General - Section 1.2 of the Rule excludes certain instruments from the application of the Rule even though they might be debt-like derivatives. These are excluded primarily because they are already governed by a legal regime other than the Rule that provides appropriate investor protection or because the policy concerns on which the Rule is based are not applicable. Some of the excluded instruments, and a brief discussion of the rationale for the exclusion, are described in this Part.
3.2 A "Conventional Debt Instrument"
(1) Given the breadth of the definition of "underlying interest" under Rule 14-501, the term "debt-like derivative" would apply to virtually all debt instruments, including conventional indebtedness under which interest is payable based on a variable interest rate commonly used in commercial lending arrangements. The Commission does not intend that the Rule interfere with normal commercial lending transactions, and the exclusion of conventional debt instruments from the Rule is intended to accomplish this.
(2) The definition of "conventional debt instrument" includes three components. First, the instrument must provides for payment of a fixed and specified principal amount. There must be current indebtedness under the instrument for it to be a conventional debt instrument. It is not sufficient for the instrument to provide for contingent future payments. Second, the amounts payable under the instrument must be either fixed and specified (e.g., repayment of a fixed principal amount) or determined based on one or more financial references, interests or variables commonly used in commercial arrangements. Finally, the instrument must contain a general, unrestricted covenant by the obligor to make payment of amounts owing under the instrument. These components are designed to reflect the common indicia of conventional debt.
3.3 A "Conventional Insurance Contract" - As with conventional debt instruments, a wide variety of conventional financial contracts, including basic contracts of insurance without any significant derivative component, will nevertheless be covered by the broad definition of "debt-like derivative". The definition of a "conventional insurance contract" is designed to exclude those contracts as the Commission has no interest in bringing ordinary insurance contracts into the Rule.
3.4 "Approved Rating Asset-Backed Commercial Paper"
(1) The Commission recognizes that there is in Canada a large asset-backed commercial paper market, consisting of asset-back securities that have been issued by special purpose issuers in reliance upon the exemption contained in paragraph 35(2)4 of the Act. Asset-backed securities are serviced primarily by the cashflows of a pool of liquidating assets such as accounts receivable, instalment sales contracts, leases or other assets which by their terms convert into cash within a specified period of time. These securities are generally rated "investment grade" by one or more approved rating organizations.
(2) Because asset-backed securities frequently limit an investor's right to be paid to the proceeds of a specified group of financial assets, the securities may limit available recourse against the issuer for amounts payable. The Commission does not intend this Rule to interfere with that market, and so has explicitly excluded "approved rating asset-backed securities" from the application of the Rule.
3.5 Other Instruments - Section 1.2 of the Rule also provides that the Rule does not apply to an "OTC derivative" within the meaning of proposed Rule 91-504 Over-the-Counter Derivatives, a "recognized option" within the meaning of Rule 91-502 Recognized Options and a "strip bond" within the meaning of Rule 91-501 Strip Bonds. The distribution of each of these instruments is governed by the regime established by the indicated rule, and is therefore not subject to the Rule.
3.6 Warrants - The Commission also notes that the Rule does not apply to derivative warrants of the type often sold by way of prospectus. These products do not fit into the definition of "debt-like derivative" contained in the Rule, and it is therefore unnecessary to formally exclude them from the operation of the Rule in section 2.5 of the Rule.
PART 4 AVAILABILITY OF THE ALTERNATIVE DISCLOSURE REGIME OF THE RULE
4.1 Qualified Debt-Like Derivatives
(1) The alternative disclosure regime provided by Part 3 of the Rule is available to a "qualified debt-like derivative". The definition of "qualified debt-like derivative" requires that a debt-like derivative meet each of the following four criteria:
1. Payments under a qualified debt-like derivative may be made in cash or in various types of short-term debt. In effect, this limitation precludes reliance on the alternative disclosure regime if the instrument converts or is exchangeable into a debt-like derivative.
2. Payments under a qualified debt-like derivatives must be based on one or more "permitted underlying interests". This concept excludes underlying interests that are not widely known or are potentially subject to manipulation by the issuer or others.
3. The minimum aggregate cash equivalents payable or deliverable must equal or exceed the aggregate purchase price of the instrument. This ensures that the instrument will be "principal protected". The alternative disclosure regime is not considered appropriate for a financial product in which an investor may lose some or all of his or her initial investment.
4. All cash equivalents must be payable or deliverable at a specified time or as determined by the holder, in each case, not later than 10 years after the issue date of the debt-like derivative or, in the case of a contract of insurance, upon the occurrence of an insurable event. This provision requires the return of the investor's principal before the effects of the time value of money and inflation reduce the value of that principal unduly.
4.2 Permitted Underlying Interests - One of the key concepts in the definition of "qualified debt-like derivative" is that of a "permitted underlying interest". The Commission is of the view that only debt-like derivatives that have underlying interests that are widely known and not subject to manipulation by an issuer of a debt-like derivative or others should be permitted to use the alterative disclosure regime provided by the Rule. The distribution of debt-like derivatives with non-permitted underlying interests should appropriately be generally the subject of review by the Commission. The Commission will entertain applications for the distribution of debt-like derivatives as qualified debt-like derivatives using underlying interests that are not permitted underlying interests under the Rule, but does not expect to grant relief in this area except in extraordinary circumstances.
PART 5 DISTRIBUTIONS UNDER THE RULE
5.1 Term Sheet Requirement
(1) The Commission is of the view that term-sheet level disclosure of the particular attributes of a qualified debt-like derivative product, when coupled with the provision of a risk disclosure statement, are adequate disclosure to investors. In reaching this view, the Commission has balanced the need for investor protection with a desire to permit these products to be distributed in an efficient and economical manner.
(2) The Commission is satisfied as to the adequacy of a term sheet because the term sheet will describe all important economic terms of the debt-like derivative, will provide a right of damages for misrepresentation in the term sheet and in any marketing material provided to an investor in connection with the investment decision. The Commission notes that the issuer-specific disclosure typically contained in a prospectus will generally be irrelevant in many distributions of debt-like derivatives.
(3) The Commission expects that term sheets will be prepared in a clear, concise manner that will be capable of being read and easily understood by investors. The Commission urges the use of a plain language approach to the drafting of the term sheet, and the use of presentation techniques that assist in readability and comprehension of the document. For instance, the use of tables and charts to illustrate the returns of the debt-like derivative under various scenarios is encouraged.
(4) The form of term sheet mandated by the Rule and contained in Appendix C of the Rule requires disclosure of specific risk factors not adequately described in the Risk Disclosure Statement. The Commission expects that issuers will use their provision to highlight, among other things, particular risks associated with the manner in which return is calculated on the applicable product. For instance, if a given stock market index that is the underlying interest for the product must appreciate by 5% before the investor realizes any return, then that fact should be highlighted.
5.2 Requirement to Amend a Term Sheet - Issuers are reminded that an issuer who has prepared a term sheet and is using it to distribute qualified debt-like derivatives is required by subsection 3.4(4) of the Rule to prepare an amended term sheet updating or correcting the term sheet if it contains a statement that constitutes an untrue statement of material fact.
5.3 Term Sheet Disclosure Right
(1) The Rule requires that purchasers of qualified debt-like derivatives under the alternative disclosure regime be granted a limited right of action for damages against the issuer and any guarantor if the term sheet or any related document contains an untrue statement of a material fact. This right is referred to in the Rule as a "term sheet disclosure right".
(2) The term sheet disclosure right generally parallels the "contractual right of action" defined in Rule 14-501 Definitions, except that:
(a) there is no concept of omitted information. The standard of disclosure relates only to untrue statements of material facts. There is no reference to an omission to state a material fact that is required to be stated or that is necessary to make a statement not misleading in the light of the circumstances in which it was made" therefore does not apply; and
(b) the remedy for misrepresentation consists only of a right to damages, not rescission.
5.4 Filing of Term Sheet - The Rule requires that a copy of the term sheet and each amended term sheet and any related document or amended related document be filed with the Commission not later than the second business day after such document is first delivered to a purchaser. The documents need not be cleared by Commission staff before use. Commission staff may from time to time select term sheets for review and may discuss with the relevant issuer any concerns on the sufficiency of disclosure contained in the document.
3.See Notice of Proposed Rule and Proposed Policy under the Securities Act, Over-the-counter Derivatives, November 1, 1996, published in (1996) 19 OSCB 5954 and republished, with amendments, December 18, 1998 (1998) 21 OSCB 7755.
4. It was evident to the Task Force that different issuers are taking different approaches (and significant uncertainty exists) concerning the application of existing statutory exemptions and the policy arguments underlying applications for relief.
7. An "underlying interest", in respect of a derivative, is defined as a security, commodity, financial instrument, currency, interest rate, foreign exchange rate, economic indicator, index, basket, agreement or benchmark or any other financial reference, interest or variable, and, if applicable, the relationship between any of them, from, to or on which the market price, value or any payment obligation of the derivative is derived, referenced or based.
12. See Notice of Proposed Rule and Proposed Policy under the Securities Act, Over-the-Counter Derivatives, November 1, 1996, published in (1996) 19 OSCB 5954 and republished, with amendments, December 18, 1998 (1998) 21 OSCB 7755.
14. For this reason, derivative warrant offerings by prospectus in Ontario have often been structured to minimize the statutory rights of withdrawal issue by providing that the strike price is set only upon or after the expiry of such rights.
15. The Task Force considered but rejected the inclusion of a materiality concept in assessing how much principal may be at risk while remaining a qualified debt-like derivative, largely because of the practical difficulties in applying such an approach. The valuation of the principal-at-risk component of a debt-like derivative is by definition a subjective exercise and materiality approaches, such as the substantial component and material component principles suggested in draft NP 46 and the 20% test included in the definition of "debt-like security" inNational Policy No. 39 (Mutual Funds), have in practice proven to create significant uncertainty in their application.
16.The Task Force also concluded that, where appropriate, disclosure as to whether and to what extent the obligations of the issuer or guarantor under the qualified debt-like derivative are insured under a deposit insurance scheme or similar arrangement should be included in the term sheet.
17. In Ontario, only entities registered as full service dealers and limited market dealers may sell the full range of securities listed in section 35(2)1, 2 and 4. Financial institutions ("FIs"), either registered as financial intermediary dealers or exempt from registration under section 209(10) of the Regulation, are able to sell all of these instruments other than evidences of indebtedness guaranteed by the FI and issued by an entity other than an affiliate of the FI. At the present time, Rule 32-502 of the Commission allows FIs to sell any securities for which there was a registration exemption prior to the introduction of universal registration in 1987. However, the sale of securities by an FI may be subject to constraints in the financial institution legislation under which the FI carries on business. (For example, the securities activities of federal financial institutions ("FFIs") are presently limited by the Securities Dealing Regulations enacted in 1992, which would not permit FFIs to sell FI guaranteed debt of non-affiliates. This prohibition is mirrored in section 209(1) of the Regulation). An FI can, however, sell non-affiliate guaranteed debt in the FI's branches through its affiliated mutual fund dealer if the mutual fund dealer is also registered as a limited market dealer.
18. This draft Rule (the "Rule") is based on the report and recommendations of the Debt-Like Derivatives Task Force formed by the Ontario Securities Commission to review the regulation of debt-like derivatives in Ontario. The Rule should be read in conjunction with the draft Companion Policy (the "Policy") that is being published concurrently with the Rule. The Policy contains discussion of the general purpose for the Rule, provides an overview of the operation of the Rule and discusses a number of particular issues relating to the Rule.
Paragraph 143(1)35 of the Act gives the Commission the power to make rules regulating or varying the Act in respect of "derivatives". Subsection 1(1.1) of the Act provides that this term is to be defined in the regulations or the rules made pursuant to the Act. The term "derivative" is defined in Rule 14-501 Definitions as "an instrument, agreement or security, the market price, value or payment obligations of which is derived from or based on an underlying interest, other than a contract as defined for the purposes of the Commodity Futures Act". The term "underlying interest" is defined in Rule 14-501 Definitions as "for a derivative, the security, commodity, financial instrument, currency, interest rate, foreign exchanges rate, economic indicator, index, basket, agreement or benchmark, and, if applicable, the relationship between any of the foregoing, from or on which the market price, value or payment obligations of the derivative are derived or based."
19. A general definition rule has been adopted as Rule 14-501 Definitions. It contains definitions of certain terms used in more than one rule. Rule 14-501 also provides, among other things, that terms used in a rule and defined in section 1 of the Securities Act or subsection 1(2) of the Regulation will have the respective meanings given to them in the Securities Act or regulation, as appropriate.
20. Approved rating asset-backed commercial paper is one of the types of instruments to which this Rule does not apply by virtue of section 1.2. The rationale for this exclusion is discussed in section 3.4 of the Policy.
21. The term "Canadian financial institution" is defined in National Instrument 14-101. The definition is "a bank, loan corporation, trust company, insurance company, treasury branch, credit union or caisse populaire that, in each case, is authorized to carry on business in Canada or a jurisdiction, or the Confédération des caisses populaires et d'économie Desjardins du Québec".
22. This definition is used in the definition of "qualified debt-like derivatives" in order to permit the obligations under a qualified debt-like derivative to be payable in either cash or "cash equivalents". This is proposed on the basis that no additional investor protection issues arise if obligations under a debt-like derivative are paid in the straight forward instruments included under the definition of "cash equivalents" than would arise if those obligations were paid in cash.
23. A conventional debt instrument is one of the types of instruments to which this Rule does not apply by virtue of section 1.2. The rationale for this exclusion is discussed in section 3.2 of the Policy.
24. A conventional insurance contract is one of the types of instruments to which this Rule does not apply by virtue of section 1.2. The rationale for this exclusion is discussed in section 3.3 of the Policy. Issues relating to the inclusions and exclusions from the definition of conventional insurance contract are contained in footnotes to this definition.
25. The term "variable insurance contract" is defined in subsection 1(2) of the Regulation. These contracts have not been included in the definition of conventional insurance contract because, for the purposes of this draft Rule, some variable insurance contracts could have the character of a debt-like derivative. The Commission specifically seeks comment on which variable insurance contracts should appropriately be included in the definition of "conventional insurance contract" in this Rule and thereby excluded from the application of this Rule. These contracts are generally exempted from the prospectus requirements of the Act under Section 14(a) of the Regulation, and are subject to disclosure standards established by Canadian Life and Health Insurance Association Inc. ("CLHIA") under recently promulgated Guidelines approved by the Canadian Council of Insurance Regulators.
26. The definition of "conventional insurance contract" excludes benefits under all insurance other than under "life insurance". The term "life insurance" is defined in the Insurance Act. Accordingly, property and casualty insurance will not be subject to the Rule. In addition, since the definition of "life insurance" includes "disability insurance", this class of insurance has also been specifically excluded.
The term "life insurance" is broadly defined in the Insurance Act and includes financial products which should be subject to the Rule.
28. Some contracts of insurance provide for benefits that are derived from related participating accounts. Other contracts are drafted to provide that policyholders may share in profits earned by the insurer and receive returns of "capital" contributed to the insurer. These benefits may vary depending on, for example, the overall profitability of the insurer, the performance of underlying account investments, management and administrative charges deducted by the plan administrator and other variable factors relating to the business of the insurer or underlying account investments.
29. The reference to net amount is to ensure that deductions from amounts payable not be structured on a variable basis so that the amount payable to an investor is in fact linked to an external financial reference, interest or variable.
30. The term "insurable interest" is recognized at common law to be an interest that can be insured without offending public policy (e.g., wagering). It is used here to ensure that the underlying interest is susceptible of being the subject of an insurance contract in the first instance.
31. These benefits are limited to amounts payable that are either fixed and specified in the contract, a return of premiums, or an amount determined based on one or more financial references, interests or variables commonly used in commercial arrangements to ascribe value to the time value of a money investment. The concept of including variables commonly used in commercial arrangements is analogous to the approach used in the definition of "conventional debt instrument" and is designed to attempt to exclude from the operation of the Rule insurance contracts that do not have the characteristics of "debt-like derivatives". Accordingly, where a contract of insurance provides for an escalator clause or other provision that provides for payment based on inflation (e.g., the consumer price index), these features will not "taint" an otherwise excluded contract of insurance.
Some contracts of insurance combine two or more types of benefits from among those described in the definition. A single contract that provides for such benefits will be a conventional insurance contract, so long as all of the indicia of paragraph (e) of the definition are satisfied.
32. The term "derivative" is defined in Rule 14-501. The definition is "an instrument, agreement or security, the market price, value or payment obligations of which is derived from or based on an underlying interest, other than a contract as defined for the purposes of the Commodity Futures Act".
33. Clauses (a), (b) and (c) narrow the category of entities and instruments subject to this Rule to those that currently fall within the exemptions under paragraphs 35(2)1, 2 and 4 of the Act. Clauses (d) and (e) extends the Rule to apply to deposits and insurance contracts. This Rule is designed to deal with instruments that could otherwise be sold under the exemptions referred to in paragraphs (a), (b) and (c) of this definition, and the instruments referred to in paragraphs (d) and (e) that could be sold completely outside the Act as non-securities.
34. The reference to trades to an individual in a denomination of less than $50,000 is designed to parallel the language of paragraph 35(2)4 of the Act. Commercial paper traded to an individual in a denomination of less than $50,000 cannot be sold under the exemption in that paragraph, and it is therefore unnecessary to be included within the scope of this Rule.
35. The term "underlying interest" is defined in Rule 14-501 as "for a derivative, the security, commodity, financial instrument, currency, interest rate, foreign exchanges rate, economic indicator, index, basket, agreement or benchmark, and, if applicable, the relationship between any of the foregoing, from or on which the market price, value or payment obligations of the derivative are derived or based."
36. The concept of "permitted underlying interest" is to exclude underlying interests that are not widely known or are potentially subject to manipulation by an issuer of a debt-like derivative or others. This definition recognizes, in Appendix A, a number of financial indices and reference points that are widely known; the definition also permits other underlying interests if they meet the criteria in paragraph (b) of the definition.
37. The Rule does not include a materiality concept in assessing the variable or "at-risk" component of a qualified debt-like derivative. Such standards are difficult to apply in practice, largely because of the qualitative judgements inherent in valuing the variable component as a percentage of the overall value of the instrument.
38. A "qualified debt-like derivative" is an instrument that is permitted to be distributed under the alternative disclosure system proposed by this Rule. See section 4.1 of the Policy for a discussion of this definition.