Canadian Regulators Issue Revised Derivatives Dealer and Adviser Business Conduct Rule Proposal
June 28, 2018
On June 14, 2018, the Canadian Securities Administrators (CSA) published for comment a revised version of Proposed National Instrument 93-101 – Derivatives: Business Conduct (Business Conduct Rule). The Business Conduct Rule would impose a range of requirements on Canadian and foreign persons engaged in the business of trading over-the-counter derivatives (derivatives) (Derivatives Dealers) or advising in connection with transacting in derivatives (Derivatives Advisers) in any Canadian province or territory (jurisdictions). The new version of the Business Conduct Rule is closely based on the original version published for comment in April 2017, though some notable changes have been made as discussed below.
Obligations under the Business Conduct Rule will apply to all Derivatives Dealers and Derivatives Advisers (Derivatives Firms) engaged in derivatives trading or advising business in a jurisdiction, even if the Derivatives Firm is not required to register as a derivatives dealer or adviser in the jurisdiction. This approach is intended to subject all Derivatives Firms to certain core business conduct standards in order to protect investors and derivatives counterparties, reduce risk, improve transparency and accountability, and promote responsible business conduct in derivatives markets. Substituted compliance exemptions from particular business conduct requirements are proposed to be included in the final version of the rule for Canadian banks and certain other regulated domestic and foreign financial institutions and dealers.
The Business Conduct Rule will operate alongside a proposed registration regime for Derivatives Firms, Proposed National Instrument 93-102 – Derivatives: Registration (Registration Rule), which was published for comment in April 2018. For more information, please see our April 2018 Blakes Bulletin: Canadian Derivatives: Registration Regime for Dealers and Advisers Gets Momentum. Registration obligations include formal registration obligations including for certain officers of the Derivatives Firm, annual fees, proficiency requirements for registered individual representatives, capital requirements and ongoing regulatory reporting obligations.
The comment periods for both the Business Conduct Rule and the Registration Rule end on September 17, 2018.
WHO IS SUBJECT TO THE BUSINESS CONDUCT RULE?
Obligations under the Business Conduct Rule only apply to market participants that are “engaging in the business of trading derivatives as principal or agent” or are “engaging in the business of advising others as to transacting in derivatives” in a jurisdiction. This same “business trigger” is also used to determine if registration requirements apply under the Registration Rule.
The Business Conduct Rule Companion Policy provides a non-exhaustive list of factors to be considered under the business trigger test, including whether an entity:
- Acts as a market maker by routinely quoting prices for derivatives
- Regularly trades or advises in any way that produces, or is intended to produce, profits
- Provides services facilitating or relating to the intermediation of transactions between third parties
- Carries on derivatives transaction activity with the intention of being compensated
- Directly or indirectly solicits derivatives transactions
- Engages in activities similar to a derivatives adviser or derivatives dealer
- Provides derivatives clearing services
The test applies on a jurisdiction-by-jurisdiction basis to all derivatives activities carried on in the relevant jurisdiction. A company that carries on dealing or advising as a business with counterparties and clients (Derivatives Parties) located in a jurisdiction will be subject to the Business Conduct Rule even if the company does not have any place of business, staff or other presence in Canada or the particular jurisdiction.
What Is the Scope of the Business Conduct Requirements?
The scope of business conduct requirements applicable to a Derivatives Firm’s dealings with a particular Derivatives Party will depend on whether the Derivatives Party is an “eligible derivatives party” (EDP). Subject to applicable exemptions, a core set of requirements will apply when transacting with or advising any Derivatives Party, and an additional set of requirements will apply to Derivatives Firms when dealing with Derivatives Parties that do not qualify as EDPs (non-EDPs).
The proposed classes of EDPs are the same as set out in the proposed Registration Rule, with one minor distinction that might be eliminated in the final versions of these rules. EDPs include:
- Canadian financial institutions, derivatives dealers and advisers registered in any Canadian jurisdiction, securities investment dealers and securities advisers registered in any Canadian jurisdiction, foreign entities analogous to such types of entities and regulated pension funds
- Companies that have (i) net assets of at least C$25-million or (ii) of at least C$10-million if they are “commercial hedgers” (i.e., enter into derivatives to hedge business risks) (Specified Commercial Hedgers) and that have, in each case, made specified representations concerning their knowledge and experience to evaluate certain derivatives information
- Individuals who own financial assets with a net realizable value of at least C$5-million and who have made such specified representations concerning their knowledge and experience
- Entities (other than individuals) if their derivatives transactions are guaranteed by an EDP that is not an individual or Specified Commercial Hedger
The Business Conduct Rule also provides that a commercial hedger that does not meet the C$10-million net asset test (Small Commercial Hedger) will be an EDP if its derivatives transactions are guaranteed by an EDP that is a Specified Commercial Hedger. This may be a correction to the Registration Rule, which instead provided that a Small Commercial Hedger will be an EDP if its derivatives transactions are guaranteed by an EDP that is an individual.
It is also noteworthy that the new version of the Business Conduct Rule reversed the original 2017 proposal that managed accounts may not be treated as EDPs by a Derivatives Adviser. Under the new proposal, all Derivatives Firms may treat the managed account of an EDP as an EDP.
What Business Conduct Requirements Apply When Dealing with Derivatives Parties?
Subject to applicable exemptions discussed below, the following core set of requirements are proposed to apply when transacting with, or advising, any Derivatives Party (including when dealing with EDPs):
- Fair dealing obligations
- General Know-Your-Client requirements
- An obligation to deliver written confirmations of transactions
- Obligations to segregate collateral and other assets received from Derivatives Parties
- Maintenance of policies, controls and supervision in connection with compliance with derivatives laws, risk management and individual competence and integrity requirements
- Senior derivatives manager supervisory and compliance reporting requirements
- Obligations to self-report to regulators material non-compliance with the Business Conduct Rule or laws related to trading and advising in derivatives, which creates a risk of material harm to any Canadian Derivatives Party or to capital markets or which is part of a pattern of non-compliance
- Conflict of interest management and disclosure obligations
- Documentation and record-keeping requirements
Are There Additional Requirements When Dealing With Non-EDPs?
Subject to applicable exemptions discussed below, an additional set of business conduct requirements are proposed to apply to Derivatives Firms when dealing with non-EDPs or with any individual or Specified Commercial Hedger who has not waived such requirements, including:
- Specific Know-Your-Client requirements in respect of the Derivatives Party’s needs, objectives, financial circumstances and risk tolerance
- Product suitability obligations
- Permitted referral arrangements and related disclosure obligations
- Complaint handling requirements
- Prohibition of coercive tied selling
- Disclosure obligations in respect of account terms, fees and charges, conflicts of interest, third-party compensation, the firm’s method of holding collateral and related risks, how performance benchmarks might be used to assess transaction performance, and disclosure describing certain other obligations imposed on the Derivatives Firm by the Business Conduct Rule
- Pre-trade disclosures regarding proposed transaction types, transaction risks, pricing and the most recent valuation of the transaction, and delivery of a standard statement regarding leverage and the use of borrowed money to finance derivatives transactions
- Quarterly account statement delivery obligations as well as daily valuation reporting by Derivatives Dealers and monthly valuation reporting by Derivatives Advisers
- Requirements in respect of the holding, use and investment of initial margin
- Derivatives Firms not headquartered in Canada must provide Derivatives Parties with standard disclosure regarding difficulties in enforcing legal rights against the Derivatives Firm due to the location of its head office and principal place of business, and must also identify agents for service of process in applicable Canadian jurisdictions.
What Are the Pricing Implications for Derivatives?
The original version of the Business Conduct Rule proposed a specific business conduct obligation to provide non-EDP counterparties with derivatives prices that are “fair and reasonable taking into consideration all relevant factors” and to establish procedures to obtain “the most advantageous terms reasonably available” when acting as agent for non-EDP clients. These specific obligations have been removed from the Business Conduct Rule, but have been replaced with a statement in the Companion Policy that the fair dealing obligation that is owed to Derivatives Parties (including EDPs) is understood to include an obligation to determine prices for derivatives “in a fair and equitable manner”. The Companion Policy goes on to state that if essentially the same derivative is transacted with different derivatives parties, then there should be a rational basis for any discrepancy in price, such as the level of counterparty risk, the derivatives party’s trading activity and relationship pricing. Furthermore, “lack of sophistication, knowledge or understanding about a derivatives product should never be a factor in providing less advantageous pricing.”
ARE THERE EXEMPTIONS?
Substituted Compliance Exemptions for Canadian Regulated Entities
Under the proposal, Canadian financial institutions (including Canadian banks, trust companies, insurance companies and credit unions) and Canadian securities dealers that are registered as investment dealers will be exempted from certain requirements applicable to Derivatives Dealers on a substituted compliance basis. The scope of the exemptions and the relevant corresponding requirements have not been described in the new version of the Business Conduct Rule, so it remains to be seen whether these exemptions will successfully eliminate or reduce the potential overlap and inconsistency with existing business requirements that already apply to these types of regulated institutions.
The Business Conduct Rule also includes a specific exemption for Canadian financial institutions and registered securities dealers from the general Know-Your-Client requirements.
Foreign Derivatives Firms Dealing only with EDPs
Under the proposal, a Derivatives Dealer will be exempt from some of the business conduct requirements if: its head office or principal place of business is outside of Canada in a qualifying foreign jurisdiction; it is authorized to engage in the business of dealing in derivatives in a qualifying foreign jurisdiction; and all Canadian counterparties that it solicits or transacts derivatives with are EDPs. The current version of the Business Conduct Rule does not yet include the list of relevant foreign jurisdictions that qualify under this exemption or the list of business conduct requirements that will continue to apply to exempted foreign Derivatives Dealers.
This exemption is analogous to the international dealer exemption from securities dealer registration requirements. As with the international securities dealer exemption, in order to benefit from the foreign derivatives dealer exemption, the foreign Derivatives Dealer must: provide specified disclosures to its counterparties; file a submission to jurisdiction and appointment of agent for service with regulators in the relevant jurisdictions; undertake to make books and records available to these regulators upon request; and satisfy annual notification and fee payment requirements (if the foreign Derivatives Dealer is not paying derivatives dealer registration fees). In addition, an obligation has been added to report to regulators in applicable jurisdictions any material non-compliance with derivatives laws of the relevant foreign jurisdiction if such non-compliance creates a risk of material harm to any Canadian Derivatives Parties or to capital markets or is part of a pattern of non-compliance.
The Business Conduct Rule also provides a foreign derivatives adviser exemption that is comparable to the international adviser exemption from the securities adviser registration requirements. A Derivatives Adviser whose head office or principal place of business is in a qualifying foreign jurisdiction and that is authorized to conduct the relevant derivatives advisory activities in a qualifying foreign jurisdiction will be exempted from some of the business conduct requirements if the Derivatives Adviser’s only clients in the relevant Canadian jurisdictions are EDPs. As with the foreign derivatives dealer exemption, the list of relevant foreign jurisdictions that qualify under this exemption and the list of business conduct requirements that will continue to apply to exempted foreign Derivatives Advisers has not been included in the current version of the Business Conduct Rule. The steps required to be taken in order to rely on this exemption are similar to those applicable under the foreign derivatives dealer exemption described above.
Activities conducted with affiliates that are not investment funds may be ignored for the purposes of the tests for qualification for these foreign derivatives dealer and adviser exemptions.
An end-user exemption is provided in the Business Conduct Rule, which exempts qualifying end-users from all requirements of the Business Conduct Rule. A person qualifies for the end-user exemption if it is not a registered securities or derivatives firm in any Canadian jurisdiction or in the jurisdiction of its head office or principal place of business, and it does not:
- Solicit, or otherwise transact in a derivative with, for, or on behalf of, a person that is not an EDP
- Advise non-EDPs in respect of derivatives transactions other than by providing general advice in accordance with certain specified requirements
- Regularly make, or offer to make, a market in a derivative
- Regularly facilitate or otherwise intermediate transactions in derivatives for another person
- Facilitate the clearing of derivative transactions
Activities conducted with affiliates that are not investment funds may be ignored for the purposes of determining if this end-user exemption is available.
DELAYED IMPLEMENTATION AND LEGACY TRANSACTIONS
The Business Conduct Rule includes a provision indicating that the rule will come into force one year after the date of publication of the final rule. Furthermore, a transition provision has been proposed for transactions entered into prior to its coming into force (Legacy Transactions), which will permit Derivatives Dealers to rely on current counterparty classification and exemption categories until the rule comes into force. Specifically, the Business Conduct Rule will not apply to Legacy Transactions entered into with permitted clients (as defined under the securities registration rule) and Derivatives Parties for which dealer registration exemptions are currently available under the Quebec Derivatives Act or provincial blanket order exemptions except that the fair dealing obligation would apply from the day the rule comes into force (which could presumably apply, for example, in respect of unwinds of Legacy Transactions). Daily, monthly and quarterly reporting obligations would also apply in respect of such Legacy Transactions if the Derivatives Party is not also an EDP for which the standard exemption from these requirements applies.
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