Federal Budget To Allow Derivatives And Securities Financing Counterparties To Realize On Collateral
The derivatives industry is welcoming the announcement in the March 17 federal Budget that Canada’s insolvency legislation will be amended to allow counterparties to derivatives and securities financing transactions to realize on their collateral in a timely manner. In his speech, Finance Minister Jim Flaherty noted that similar changes in the U.S. and E.U. have reduced risk for market participants in those jurisdictions and expressed the Government of Canada’s desire to effect the reform to enhance the competitiveness of Canadian banks when new Basel II capital requirement rules come into force in November 2007.
The announcement was followed up by Bill C-52, the Budget Implementation Act, 2007, which received first reading on March 29. Part 9 of the Bill provides for amendments to the eligible financial contract provisions in the Bankruptcy and Insolvency Act, Companies’ Creditors Arrangement Act, the Winding-up and Restructuring Act, the Canada Deposit Insurance Corporation Act and the Payment Clearing and Settlement Act. Each of these Acts would be amended to provide specific protection against stays with respect to any actions to deal with or realize on financial collateral for obligations under eligible financial contracts. Financial collateral includes cash, cash equivalents, securities, securities accounts, futures and other similar items provided as collateral under a security agreement or a title transfer credit support agreement. As amended by the Bill, the Acts would further clarify that a court cannot make an order in an insolvency proceeding subordinating a security interest against financial collateral for an eligible financial contracts. For example, a DIP financing could not take priority over such a security interest. The Acts would also exempt such transfers of financial collateral from the presumption that a preference is created where the effect of a transfer is to prefer a creditor.
In addition to the protections for collateral arrangements, the Bill proposes a change to the definition of "eligible financial contract" in each of the insolvency statutes. It was a major disappointment for the derivatives industry in 2005 when the Bill C-55 amendments did not modify the list of EFCs to include such now-standard contracts as equity derivatives, credit derivatives and weather derivatives, or such emerging classes as derivatives in freight, economic statistics and emissions allowances. Bill C-52 proposes that the definition of EFCs be moved to the Regulations to each of the Acts. Although there is no indication as yet what the new definition will be, moving it to the Regulations (changes to which do not require legislation) signals the Government’s intention to make the definition easier to amend as market developments require. The current definition remains in this Bill so that there will be an effective definition pending the passage of the regulations.
The Bill will also fix the netting problem created by the CCAA amendments in Bill C-55. That legislation had proposed the creation of an automatic stay on the termination, acceleration or forfeiture of a term of any agreement by reason only of the commencement of a CCAA proceeding. In addition, a second proposed provision would have permitted the court to make any order it considered appropriate. The drafting oversight is to be remedied in the new legislation.
With a minority government, there is no certainty that Bill C-52 will pass. Let’s hope it does. A copy of the Bill can be found at the Parliament of Canada website (search for "LEGISinfo" using any search engine and click on "House of Commons – Government Bills"). As noted above, the relevant part is Part 9. Look for our more detailed review of these provisions of the Bill in the coming weeks.
Budget Announcements Positive For Structured Finance
The federal budget contains a number of other announcements of interest to the structured finance community.
Canadian withholding tax on interest
Canadian and U.S. representatives have been involved in sporadic negotiations with respect to the Canada-U.S. tax treaty over a number of years. Reports of progress (or, more often, the lack thereof) have been made by Department of Finance officials on numerous occasions, with the ultimate result that no one in the tax community has been holding their breath in anticipation of the changes being made anytime soon. The Government took the opportunity presented by this Budget to announce that agreement in principle has been reached between the negotiators on the major elements of an updated treaty, and that formal negotiations are expected to conclude "in the very near future". The Budget does acknowledge in a footnote that treaty changes, even when finally agreed between the Canadian and U.S. negotiators, still have to be accepted by their respective Governments and then legislatively endorsed. Still, while there is no guarantee that this saga is necessarily over, one hopes that this announcement signals that the end is near.
The Budget describes in some detail one important aspect of the proposed changes to the Canada-U.S. tax treaty, and some even farther-reaching legislative proposals dependent on its implementation. The proposed treaty change is the elimination of the withholding tax on interest paid on cross-border financing. The Canada-U.S. tax treaty currently limits the rate of withholding tax on interest payments made by a Canadian resident to a U.S. resident to 10%. These measures will facilitate a Canadian resident’s access to foreign debt financing without the structural limitations currently imposed by the so-called "5/25 exemption" contained in subparagraph 212(1)(b)(vii) of the Income Tax Act. Surprisingly, the proposed change to the Canada-U.S. tax treaty will eliminate withholding tax on interest paid on both arm’s length and non-arm’s length debt, with the elimination applying in the first calendar year after entry into force of the treaty changes in respect of interest on arm’s length debt, and the elimination being phased in over three years (i.e., 7%, 4% and 0%) in the case of interest on non-arm’s length debt.
The Budget also announces a proposal to legislatively eliminate Canadian withholding tax on interest on all arm’s length debt from foreign residents, regardless of their country of residence. The exemption would be conditional on the implementation of the changes to the Canada-U.S. tax treaty described above and is proposed to be effective once the Canada-U.S. tax treaty exemption comes into effect.
Apart from increasing access to foreign short-term debt markets by Canadian residents, the elimination of Canadian withholding tax will reduce the need for many existing financing structures designed to avoid the imposition of the tax.
Extension of treaty benefits to US LLCs
Less highlighted in the Budget is the similarly important announcement that the agreement in principle on the Canada- U.S. tax treaty changes will include the extension of treaty benefits to U.S. limited liability companies ("LLCs"). The oft-repeated administrative position of the Canada Revenue Agency that LLCs are generally not entitled to the benefits of the current Canada-U.S. tax treaty has been a source of concern for U.S. investors investing in Canada for many years.
Federal support for modernization of securities transfer legislation
The Minister of Finance also announced federal support for the modernization of securities transfer legislation. As discussed under "New and Proposed Legislation", below, a number of Canada’s provinces have moved to adopt modern Securities Transfer Acts based on Article 8 of the U.S. UCC. So far, Ontario, Alberta, British Columbia and Saskatchewan have passed or introduced legislation. The Budget speech announced that the federal Department of Finance will shortly issue a consultation paper requesting comments from the public on harmonizing securities transfer provisions in federal statutes with the new provincial regimes.
New Developments
Securities Transfer Act (Ontario and Alberta)
The Ontario and Alberta Securities Transfer Act (STA) came into effect on January 1, 2007. The STA creates a comprehensive system of rules dealing with the transfer and holding of securities and interests in securities. Modeled on Article 8 of the U.S. Uniform Commercial Code and adopting the conflict of laws rules proposed by the Hague Securities Convention (the PRIMA approach), the STA essentially brings Ontario and Alberta into line with the highest international commercial standards. British Columbia’s STA received Royal Assent on March 29, 2007 (although it is not yet proclaimed in force) and Saskatchewan has also introduced similar legislation. Other Canadian provinces are likely to follow suit shortly. In addition, as noted above, it was announced in the March 17, 2007 federal Budget that the federal government intends to make its laws STA-friendly.
This development is welcome news for Canada’s financial markets. Existing laws governing the transfer and pledging of securities largely presuppose paper-based trading of securities by the direct holder, and do not reflect the modern-day reality of an intermediated securities holding system. Previous attempts at updating the system have resulted in a patchwork of confusing laws. By consolidating current securities transfer laws and providing comprehensive rules for attaining clear title to directly held securities and securities in the indirect holding system, the STA supports international securities transfer and holding practices which will lead to increased market stability. Secured parties in collateral arrangements with respect to securities will now be able to perfect by "control" by having securities transferred to an account with their own securities intermediary or entering into a control agreement with an intermediary.
The Canadian ISDA Collateral opinion has been updated to reflect these significant changes. More information on the STA is available at www.stikeman.com or from any member of our Structured Finance Group.
Commodity Futures Act (Ontario)
On March 28, 2007, the Government of Ontario tabled the final report of the Commodity Futures Act Advisory Committee. Consisting of leading practitioners, lawyers and regulators – including Stikeman Elliott’s Margaret Grottenthaler – the Committee was tasked with making recommendations for a reformed Commodity Futures Act (CFA). Introduced three decades ago in an industry dominated by agricultural and other physical commodities, Ontario’s CFA requires numerous changes if it is to respond effectively to technological innovation, globalization and particularly to the rising importance of numerous new non-traditional derivative products.
The Report, developed through extensive consultations with futures markets participants and regulators, makes a number of recommendations. Among the most significant are that Ontario adopt a thoroughly modernized statute based on a "core principles" approach compatible with the U.S. Commodity Futures Modernization Act of 2000 and that there be a role for securities regulation of OTC derivative transactions involving retail investors. The Committee’s recommendations will now proceed to a Committee of the Legislature for review, including public hearings, at the conclusion of which it is anticipated that legislation amending the CFA will be introduced.
Details of the report are available at the Ontario Ministry of Government Services website. A pdf version is available at: http://www.gov.on.ca/MGS/graphics/121810.pdf
Derivatives Act (Quebec)
In May 2006, Quebec’s Autorité des marchés financiers (AMF) published a major concept paper on the regulation of derivatives in Quebec. Like Ontario’s Commodity Futures Act report, the Quebec paper recommends a "core principles" approach, but there are a number of points of discrepancy with the recommendations of the Ontario Advisory Committee, particularly as regards the regulation of OTC derivatives. In the coming months, the AMF expects to publish a draft Derivatives Act for the regulation of both OTC and exchange-traded derivatives in Quebec. In February 2007, the AMF published its response to the thirteen letters of commentary which it had received on its paper. While assuring its commentators that it wished the new Quebec derivatives law to "harmonize" with legislation in other provinces, the AMF reiterated its preference for a special derivatives law founded on broad "core principles" with carve-outs for products and contracts that should clearly not be regulated as derivatives. In the AMF’s view, given the Montreal Exchange’s specialization in derivatives since 1999, "the AMF must develop an innovative regulatory framework from which other provinces can take inspiration." [author’s translation]
Canadian securities regulators notice on principal protected notes
On July 7, 2006, the Canadian Securities Regulators (CSA) released CSA Notice 46-303 – Principal Protected Notes, detailing their concerns about the distribution and sale of this type of investment, and mapping out the CSA’s proposed approach. PPNs are investment products that consist of two parts: a guaranteed return of principal and a non-guaranteed potential to earn returns based on the performance of an underlying investment.
The Notice points out that not only has there been an explosion in the number and availability of these types of products on offer to retail investors in recent years, but that they are also becoming increasingly sophisticated and complex in their structure. Because many PPN products are marketed without a prospectus (either under a prospectus exemption for guaranteed debt or because they are structured to fall outside the scope of provincial securities legislation), the CSA is concerned that retail investors are not being adequately informed about the nature of and risk in investing in this type of product, and the associated fees. There is also great sensitivity to the fact that the underlying investment of a PPN might be an alternative asset class such as a hedge fund, fund of funds or managed futures which would otherwise not be available to retail investors without a prospectus.
The CSA believes that retail investors often receive inadequate disclosure about how PPNs are structured and how they work. In particular, disclosure documents often lack sufficient detail about the underlying investment, the participants, and applicable fees, and often contain poor or overly-promotional presentation of performance returns. There are also concerns that Know Your Client (KYC) obligations are not being observed. In addition, the CSA proposes to monitor the structuring and marketing of PPNs generally, and to consult with industry and stakeholders about how the existing prospectus and registration exemptions are being interpreted in the PPN investment context. Whether new regulatory guidance is necessary will depend on the outcome of this consultation process.
In the interim, the CSA recommends that issuers intending to distribute and sell PPNs take steps to ensure that disclosure documentation is sufficiently clear, comprehensive, and balanced to enable potential investors and their advisors to make an informed decision or recommendation. They also suggest that investors should be alerted to the applicable fees and risks associated with investing in PPNs, and to the fact that exiting the PPN early could result in a penalty. Further, the CSA is of the view that sellers of PPNs should ensure that, if required, they are properly registered to do so, are appropriately qualified and trained to sell the product, and have a sound understanding of the PPN. In light of CSA Notice 46-303, it would certainly make sense for registered dealers to review their internal policies to ensure that the PPNs they recommend to clients are suitable.
In Staff Notice 81-316 (January 12, 2007), the CSA states that its consultations on PPNs are continuing.
For further information please contact Stikeman Elliott at www.stikeman.com.
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