Securities Law & Instruments


Headnote

Application for relief from dealer registration and prospectus requirements that may be applicable to certain trades in over-the-counter (OTC) derivatives with “permitted counterparties” – permitted counterparties will consist exclusively of persons or companies who are “permitted clients” as defined in Section 1.1 of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations – relief sought in Ontario as interim response to current regulatory uncertainty associated with OTC derivatives in Ontario – relief granted subject to certain terms and conditions, including sunset provision of up to four years.

Applicable Legislative Provisions

Securities Act, R.S.O. 1990, c. S.5, as am., ss. 25(1), 53(1), 74.
National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations, s. 1.1 (“permitted client”).

October 17, 2017

IN THE MATTER OF
THE SECURITIES ACT,
R.S.O. 1990, Chapter S.5
(the OSA)

AND

IN THE MATTER OF
EOX HOLDINGS LLC

RULING & EXEMPTION
(Section 74(1) of the OSA)

Background

Upon the application (the Application) of EOX Holdings LLC (the Applicant) to the Ontario Securities Commission (the Commission or OSC) for an order, pursuant to subsection 74(1) of the OSA, that the dealer registration requirement under subsection 25(1) of the OSA and the prospectus requirement under subsection 53(1) of the OSA that may otherwise be applicable to a trade in or distribution of an OTC Derivative (as defined below) made by either:

(i)            the Applicant to a “Permitted Counterparty” (as defined below), or

(ii)           by a Permitted Counterparty to the Applicant,

shall not apply to the Applicant or the Permitted Counterparty, as the case may be (the Requested Relief), subject to certain terms and conditions.

                AND WHEREAS for the purpose of this ruling and exemption:

(i)            “CFTC” means the U.S. Commodity Futures Trading Commission.

“Clearing Corporation” means an association or organization through which Options or futures contracts are cleared and settled.

“ECP” means an eligible contract participant as that term is defined in the U.S. Commodity Exchange Act.

“FINRA” means the Financial Industry Regulatory Authority in the U.S.

“Forward Contract” means an agreement, not entered into or traded on or through an organized market, stock exchange or futures exchange and cleared by a Clearing Corporation, to do one or more of the following on terms or at a price established by or determinable by reference to the agreement and at or by a time established by or determinable by reference to the agreement:

(a)           make or take delivery of the Underlying Interest of the agreement; or

(b)           settle in cash instead of delivery.

“NFA” means the National Futures Association in the U.S.

“Option” means an agreement that provides the holder with the right, but not the obligation, to do one or more of the following on terms or at a price determinable by reference to the agreement at or by a time established by the agreement:

(a)           receive an amount of cash determinable by reference to a specified quantity of the Underlying Interest of the Option.

(b)           purchase a specified quantity of the Underlying Interest of the Option.

(c)           sell a specified quantity of the Underlying Interest of the Option.

“OTC Derivative” means one or more of, or any combination of, an Option, a Forward Contract, or any instrument of a type commonly considered to be a derivative, in which:

(a)           the agreement relating to, and the material economic terms of, the Option, Forward Contract, swap or other instrument have been customized to the purposes of the parties to the agreement and the agreement is not part of a fungible class of agreements that are standardized as to their material economic terms;

(b)           the creditworthiness of a party having an obligation under the agreement would be a material consideration in entering into or determining the terms of the agreement; and

(c)           the agreement is not entered into or traded on or through an organized market, stock exchange or futures exchange.

“Permitted Counterparty” means a person or company that is a “permitted client”, as that term is defined in section 1.1 [Definition of terms used throughout this Instrument] of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103).

“SEC” means the United States Securities and Exchange Commission.

“Underlying Interest” means, for a derivative, the currency, foreign exchange rate, security, economic indicator, index, basket, benchmark or other variable, or another derivative, and, if applicable, any relationship between, or combination of, any of the foregoing, from or on which the market price, value or payment obligations of the derivative are derived or based.

(ii)           terms used in the Decision that are defined in the OSA, and not otherwise defined in the Decision, shall have the same meaning as in the OSA, unless the context otherwise requires;

                AND UPON considering the Application and the recommendation of staff of the Commission;

                AND UPON the Applicant having represented to the Commission as follows:

1.             The Applicant is a limited liability company formed under the laws of the State of Delaware. Its head office is located in Houston, Texas, U.S.

2.             The Applicant is a wholly-owned direct subsidiary of OTC Global Holdings LP (OTC Global), one of the largest independent institutional brokers of commodities in the U.S., covering physical and financial commodity instruments.

3.             The Applicant is based in Houston, Texas, and operates as an inter-dealer broker in both exchange-traded and over-the-counter (OTC) energy commodities.

4.             In order to provide these services, the Applicant is an approved member of and is regulated by the NFA (NFA ID number: 0409750) and is registered as an “introducing broker” with the CFTC. The Applicant is not a broker-dealer registered with the SEC, is not a member of FINRA and does not conduct a securities business in the U.S.

5.             The Applicant is not registered in any capacity under the OSA. The Applicant does not rely on any exemption from registration in Canada.

6.             The Applicant is not a member of any exchange, but it is considered to be a “broker participant” by and has entered into a broker clearing agreement with each of the following U.S. exchanges: CME (Nymex), ICE Futures U.S., NFX (Nasdaq energy futures exchange), and the Nodal exchange.

7.             The Applicant is not in default of securities, commodity futures or derivatives legislation in any jurisdiction of Canada, other than in respect of the subject matter to which this Ruling relates.

8.             The Applicant is in compliance in all material respects with U.S. securities, commodity futures and derivatives laws.

9.             The principal business of the Applicant is providing:

(a)           brokerage services for over-the-counter and futures transactions in energy commodities to various financial institutions and utilities; and

(b)           in relation to customers who are deemed “US Persons”, as defined under applicable U.S. law, introducing services for ECPs.

10.          The Applicant will not maintain an office, sales force or physical place of business in Ontario.

11.          The Applicant qualifies as a “permitted client” as that term is defined in section 1.1 of NI 31-103.

12.          As the Applicant is not currently registered in any capacity with the SEC, it is unable to rely on the international dealer registration exemption available in section 8.18 of NI 31-103 in Ontario.

Proposed Conduct of OTC Derivative transactions

13.          The Applicant proposes to enter into bilateral OTC Derivative transactions with counterparties located in Ontario that consist exclusively of persons or companies that are Permitted Counterparties. The Applicant understands that the Permitted Counterparties would be entering into the OTC Derivative transactions for hedging or investment purposes. The Underlying Interest of the OTC Derivatives that are entered into between the Applicant and a Permitted Counterparty will consist of: a currency; a foreign exchange rate; a security; an economic indicator; an index; a basket; a benchmark; another variable; another OTC Derivative; or some relationship between, or combination of, one or more of the foregoing.

14.          The Applicant will not offer or provide credit or margin to any of their Permitted Counterparties for the purposes of an OTC Derivative transaction.

15.          The Applicant seeks the Requested Relief as an interim, harmonized solution to the uncertainty and fragmentation that currently characterizes the regulation of OTC Derivatives across Canada, pending the development of a uniform framework for the regulation of OTC Derivative transactions in all provinces and territories of Canada.

Regulatory uncertainty with the Regulation of OTC Derivative transactions in Canada

16.          There has generally been a considerable amount of uncertainty respecting the regulation of OTC Derivative transactions as “securities” in the provinces and territories of Canada other than Quebec (the Relevant Jurisdictions).

17.          In each of British Columbia, Prince Edward Island, the Yukon, the Northwest Territories and Nunavut, OTC Derivative transactions are regulated as securities on the basis that the definition of the term “security” in the securities legislation of each of these jurisdictions includes an express reference to a “futures contract” or a “derivative”.

18.          In Alberta, the term “security” no longer includes an express reference to a “futures contract”. Following the introduction, effective October 31, 2014, of a new framework and terminology for the regulation of derivatives, Alberta securities legislation now includes a definition of “derivatives”.

19.          In each of Manitoba, Ontario, New Brunswick, Newfoundland and Labrador, Nova Scotia and Saskatchewan, it is not certain whether, or in what circumstances, OTC Derivative transactions are “securities” because the definition of the term “security” in the securities legislation of each of these jurisdictions makes no express reference to a “futures contract” or a “derivative”.

20.          In October 2009, staff of the OSC published OSC Staff Notice 91-702 Offerings of Contracts for Difference and Foreign Exchange Contracts to Investors in Ontario (OSC Notice 91-702). OSC Notice 91-702 states that OSC staff take the view that contracts for differences, foreign exchange contracts and similar OTC Derivative products, when offered to investors in Ontario, engage the purposes of the Securities Act (Ontario) (the Ontario Act) and constitute “investment contracts” and “securities” for the purposes of Ontario securities law. However, OSC Notice 91-702 also states that it is not intended to address direct or intermediated trading between institutions. OSC Notice 91-702 does not provide any additional guidance on the extent to which OTC Derivative transactions between the Applicant and a Permitted Counterparty may be subject to Ontario securities law.

21.          In Quebec, OTC Derivative transactions are subject to the Derivatives Act (Quebec), which sets out a comprehensive scheme for the regulation of derivative transactions that is distinct from Quebec's securities regulatory requirements.

22.          In each of British Columbia, Alberta, Manitoba, New Brunswick and Nova Scotia and Saskatchewan (the Blanket Order Jurisdictions) and Quebec (collectively, the OTC Exemption Jurisdictions), OTC Derivative transactions are generally not subject to securities or derivative regulatory requirements, pursuant to applicable exemptions (the OTC Derivative Exemptions), when they are negotiated, bi-lateral contracts that are entered into between sophisticated non-retail parties, referred to as “Qualified Parties” in the Blanket Order Jurisdictions and “accredited counterparties” in Quebec.

23.          The corresponding OTC Derivative Exemptions are as follows:

Province

OTC Derivatives Exemption

British Columbia

Blanket Order 91-501 Over-the-Counter Derivatives

Alberta

ASC Blanket Order 91-506 Over-the-Counter Trades in Derivatives

Saskatchewan

General Order 91-907 Over-the-Counter Derivatives

Manitoba

Blanket Order 91-501 Over-the-Counter Trades in Derivatives

Quebec

Section 7 of the Derivatives Act (Quebec)

New Brunswick

Local Rule 91-501 Derivatives

Nova Scotia

NSSC Blanket Order 91-501 Over-the-Counter Trades in Derivatives


24.          Before March 27, 2010, section 3.3 [Accredited investor] of National Instrument 45-106 Prospectus and Registration Exemptions (NI 45-106) provided an exemption from the dealer registration requirement for certain trades made to “accredited investors”, which may have been relied upon by persons or companies entering into OTC Derivative transactions considered to be securities. However, in Ontario and Newfoundland and Labrador this exemption was not available to most “market intermediaries” due to section 3.0 [Removal of exemptions -- market intermediaries].

The Evolving Regulation of OTC Derivative Transactions as Derivatives

25.          Each of the OTC Exemption Jurisdictions has sought to address the regulatory uncertainty associated with the regulation of OTC Derivative transactions as securities by regulating them as derivatives rather than securities, whether directly through the adoption of a distinct regulatory framework for derivatives in Quebec, or indirectly through amendments to the definition of the term “security” in the securities legislation of the other OTC Exemption Jurisdictions and the granting of the OTC Derivative Exemptions.

26.          Between 1994 and 2000, the OSC sought to achieve a similar objective by introducing proposed OSC Rule 91-504 Over-the-Counter Derivatives (the Proposed OSC Rule) for the purpose of establishing a uniform, clearly defined regulatory framework for the conduct of OTC Derivative transactions in Ontario, but the Proposed OSC Rule was returned to the OSC for further consideration by Ontario's Minister of Finance in November, 2000.

27.          The Final Report of the Ontario Commodity Futures Act Advisory Committee published in January, 2007 concluded that OTC Derivative contracts are not suited to being regulated in accordance with traditional securities regulatory requirements and should therefore be excluded from the scope of securities legislation, because they are used for commercial-risk management purposes and not for investment or capital-raising purposes.

28.          Ontario has now established a framework for regulating the trading of derivatives in Ontario (the Ontario Derivatives Framework) through amendments to the Ontario Act that were made by the Helping Ontario Families and Managing Responsibly Act, 2010 (Ontario).

29.          The amendments to the Ontario Act establishing the Ontario Derivatives Framework will not become effective until the date on which they are proclaimed in force. These amendments are not expected to be proclaimed in force until an ongoing public consultation on the regulation of OTC Derivatives has been completed.

30.          On August 25, 2015, the jurisdictions participating in the development of the Cooperative Capital Markets Regulatory System (Cooperative System) published for comment the revised consultation draft provincial/territorial Capital Markets Act (CMA) and draft initial regulations under the provincial/territorial legislation.

31.          Part 4 [Over-the-Counter Derivatives] of Capital Markets Regulatory Authority (CMRA) Regulation 91-501 Derivatives and Strip Bonds contains registration and prospectus exemptions for trades in OTC Derivatives where each party to the trade is a “qualified party” (as defined in CMRA Regulation 91-501) or “permitted client” (as defined in NI 31-103), each acting as principal.

Rationale for Requested Relief

32.          The Requested Relief would substantially address, for the Applicant and its Permitted Counterparties, the regulatory uncertainty that is currently associated with the regulation of OTC Derivative transactions, by permitting these parties to enter into OTC Derivative transactions in reliance upon exemptions from the dealer registration and prospectus requirements of the securities legislation in Ontario.

Books and Records

33.          The Applicant will become a “market participant” as a consequence of this decision. For the purposes of the Ontario Act, and as a market participant, the Applicant is required by subsection 19(1) of the Ontario Act to: (i) keep such books, records and other documents as are necessary for the proper recording of its business transactions and financial affairs, and the transactions that it executes on behalf of others; and (ii) keep such books, records and documents as may otherwise be required under Ontario securities law.

34.          For the purposes of its compliance with subsection 19(1) of the Ontario Act, the books and records that the Applicant will keep will include books and records that:

(a)           demonstrate the extent of the Applicant's compliance with applicable requirements of securities legislation;

(b)           demonstrate compliance with the policies and procedures of the Applicant for establishing a system of controls and supervision sufficient to provide reasonable assurance that the Applicant, and each individual acting on its behalf, complies with securities legislation;

(c)           identify all OTC Derivative transactions conducted on behalf of the Applicant and each of its clients, including the name and address of all parties to the transaction and its terms; and

(d)           set out for each OTC Derivative transaction entered into by the Applicant, information corresponding to that which would be required to be included in an exempt distribution report for the transaction, if the transaction were entered into by the Applicant in reliance upon the “accredited investor” prospectus exemption in section 2.3 [Accredited investor] of NI 45-106.

                AND UPON the Commission being satisfied that it would not be prejudicial to the public interest to grant the order requested:

                IT IS ORDERED, pursuant to 74(1) of the OSA, that the Requested Relief is granted, provided that:

(a)           the counterparty to any OTC Derivative transaction that is entered into by the Applicant is a Permitted Counterparty;

(b)           in the case of any trade made by the Applicant to a Permitted Counterparty, the Applicant does not offer or provide any credit or margin to the Permitted Counterparty; and

(c)           the Requested Relief shall terminate on the date that is the earlier of:

(i)            the date that is four years after the date of this decision; and

(ii)           the coming into force in Ontario of legislation or a rule that specifically governs dealer, adviser or other registration requirements applicable to market participants in connection with OTC Derivative transactions.

“Janet Leiper”
Commissioner
Ontario Securities Commission
“Frances Kordyback”
Commissioner
Ontario Securities Commission