Commission Approval of Rule (effective May 1, 1998): OSC Rule - 91-501 91-501CP - Strip Bonds

 

NOTICE OF ONTARIO SECURITIES COMMISSION RULE 91-501
AND COMPANION POLICY 91-501CP UNDER THE SECURITIES ACT
AND RESCISSION OF OSC POLICY 1.6
STRIP BONDS

 

Notice of Rule and Companion Policy and Rescission of Policy

The Commission has, under section 143 of the Securities Act (the "Act"), made Rule 91-501 Strip Bonds (the "Rule").

The Rule and the material required by the Act to be delivered to the Minister of Finance were delivered on December 24, 1997. If the Minister does not approvethe Rule, reject the Rule or return it to the Commission for further consideration by March 9, 1998, or if the Minister approves the Rule, the Rule will come intoforce, pursuant to section 6.1 of the Rule, on May 1, 1998.

The Commission has, under section 143.8 of the Act, adopted Companion Policy 91-501CP Strip Bonds (the "Policy"). The Policy will come into force on thedate that the Rule comes into force.

The Rule is derived from the Blanket Ruling In the Matter of Zero Coupon Strip Bonds (1984), 7 OSCB 4085 (the "Blanket Ruling") and Ontario SecuritiesCommission Policy 1.6 ("Policy 1.6"). The Blanket Ruling became a deemed rule of the same name, which was revoked on March 1, 1997 and replaced by aRule of the same name (the "Replacement Rule"), notice of which was provided on March 7, 1997 in (1997) 20 OSCB 1220. The Replacement Rule expires onthe earlier of the date on which the Rule comes into force and July 1, 1998.

The Commission has also rescinded Policy 1.6, effective on the date that the Rule comes into force.

As indicated in a Commission staff notice dated June, 1996 entitled "Debt-Like Derivative Securities", published in the OSC Bulletin at (1996) 19 OSCB 3427,the Commission has formed a Task Force, consisting of an industry representative, legal practitioners, a member of the Commission and Commission staff, toreview the regulation of debt- like derivatives in Ontario. The subject matter of the Rule will also be considered by the Task Force.

Substance and Purpose of Rule

Strip bonds are instruments that arise from the physical separation of individual interest coupons from an underlying bond. The individual coupons and the bonditself (called a bond "residue" when the interest coupons have been removed) may be sold separately. The instruments being sold represent a promise to pay afixed sum of money at a future date with no provision for interest and are sold at a significant discounts to their face value.

The purpose of the Rule is to regulate the sale of strip bonds in Ontario and ensure that purchasers of strip bonds are provided with an information statement thatdescribes the material attributes of strip bonds.

The Commission outlined the regulatory history of the Blanket Ruling and Policy 1.6 in the Notice dated June 21, 1996 that accompanied the publication of theRule and Policy for comment at (1996), 19 OSCB 3467 (the "June 1996 Notice"). Reference should be made to that Notice for information concerning thebackground to the Rule and Policy and for information concerning how the Rule has altered the terms of the Blanket Ruling and Policy 1.6.

Purpose of Policy

The Policy states the Commission's interpretation of certain provisions of the Rule and brings certain matters to the attention of participants in the strip bondmarket.

Summary of Rule

Strip Bonds

A "strip bond" is defined in the Rule to include an interest in an amount of principal or interest payable under an underlying bond, or in a pool of amounts ofprincipal or interest payable under one or more underlying bonds, in each case in which the sole entitlement of the holder of the interest is to receive, at a specificfuture date, a sum certain in money that is fixed at the date of issue of the interest. An "underlying bond" is a bond, debenture or other evidence of indebtednessof or guaranteed by the Government of Canada or any province or territory of Canada or by the Government of any foreign country or any political division of aforeign country.

Interests in pools of strip bonds have been included in paragraph (a) of the definition. An interest in a pool, in this context, would include an interest in stripbonds held through deposit receipts that represent a non-traceable interest in underlying physical coupons or bonds. The effect of including these pool interestsin the Rule is to permit a depository to hold physical coupons or bonds en bloc, and to issue deposit receipts in various principal amounts that do not necessarilycorrespond to the specific coupons or bonds. Interests in pools can appropriately be treated as strip bonds as long as it is clear that holding an interest in a poolstill represents a right to receive a sum certain in money at a specific future date rather than amounts determined on the basis of the performance of a portfolio ofsecurities.

The concept of "strip bond package" has been included as paragraph (b) of the definition of "strip bond". A strip bond package is a security that consists of twoor more of the interests described in paragraph (a) of the definition and that is not an underlying bond. Strip bond packages differ in some respects from stripbonds. For instance, the current Investment Dealers Association of Canada ("IDA") information statement discloses that the payment characteristics of stripbond packages may more closely resemble conventional debt than strip bonds. In contrast to strip bonds, the income stream received on a strip bond packageprior to maturity or the final payment may be reinvested at the then- prevailing interest rates. Therefore, the market price of a strip bond package may not be asvolatile as the market price of a strip bond with the same credit risk and term to maturity or final payment date. However, it may be more volatile than themarket price of a conventional interest-bearing debt security with the same credit risk and term to maturity. Also, strip bond packages are treated differently fortax purposes than strip bonds. The inclusion of strip bond packages in the definition of "strip bond" means that strip bond information statements must providedisclosure on strip bond packages as well as on ordinary strip bonds.

Strip Bond Information Statement

The document required to be provided to specified purchasers of strip bonds is a strip bond information statement. The Rule provides that such a statement isacceptable for use under the Rule so long as it has been accepted by the Director, it includes the information required to be included, and does not, in a materialrespect, contain any information that is misleading or untrue or omit to include any information that is necessary to make information in the strip bondinformation statement not misleading in the light of the circumstances in which it is made. The Rule also provides that the Director may revoke any acceptancepreviously given for a strip bond information statement if the statement does not satisfy disclosure requirements of the Rule.

The Rule provides that a strip bond information statement must clearly describe

(a) the nature of strip bonds, the rights of a holder of strip bonds, and how strip bonds differ from conventional interest-bearing debt securities;

(b) the fluctuations, and volatility of fluctuations, in the market price and value of strip bonds resulting from fluctuations in prevailing interest rates;

(c) the effect on the volatility of fluctuations referred to in paragraph (b) associated with the time to maturity of strip bonds;

(d) the secondary market for strip bonds and underlying bonds;

(e) custodial arrangements for strip bonds and underlying bonds;

(f) the Canadian federal income tax consequences of buying, selling and holding strip bonds; and

(g) the existence of dealer mark-ups or commissions on the purchase and sale of strip bonds and the impact, illustrated in tabular form, of different mark-ups orcommissions on the yield to maturity of a strip bond, and shall include a statement inviting the prospective purchaser or seller of a strip bond to compare the yieldto maturity of the strip bond, calculated after giving effect to any applicable dealer mark-up or commission, against the similarly calculated yield to maturity of aconventional interest- bearing debt security, and to inquire about the dealer's bid and ask prices for the subject strip bond.

Since the definition of strip bonds includes interests in pools and strip bond packages, the strip bond information statement must provide disclosure for thoseinstruments as well as ordinary strip bonds.

Under the Rule, a strip bond information statement ceases to be a strip bond information statement for the purposes of the Rule if it is does not satisfy theinformation requirements in the definition, even if the Director has not taken the formal step of revoking a previous acceptance.

Existing information statements in use, such as the IDA information statement on strip bonds and strip bond packages dated January 1995, will have to beamended to accommodate the new disclosure requirements. A revised statement will have to be prepared and submitted to the Director for review in order toensure that the statement can be accepted when the Rule becomes effective.

Removal of Registration and Prospectus Exemptions

The Rule provides that the registration exemption for government securities contained in subparagraph 1(a) of subsection 35(2) of the Act, and the relatedprospectus exemption under subsection 73(1) of the Act, do not apply to trades in strip bonds. This is designed to ensure that market participants cannot sellstrip bonds under those exemptions without compliance with the Rule.

The Rule would prevent registrants and other market intermediaries who are not qualified market intermediaries from selling strip bonds under the Rule eventhough they may have been able to sell them under Policy 1.6, the Blanket Ruling and its successor instruments.

Registration Exemption

The Rule provides registration exemptions for trades of strip bonds in three situations.

First, a registration exemption is provided for trades of strip bonds by non-market intermediaries; this exemption ensures that persons who are not in the businessof trading in securities may trade in strip bonds without compliance with the Rule on the same basis as they could trade in other exempt securities under the Act.

Second, a registration exemption is provided for trades of strip bonds by a "qualified market intermediary" to a person or company that is not a specifiedpurchaser. A qualified market intermediary is defined in the Rule to be a market intermediary that, in effect, is permitted to trade in government securities; theeffect of this exemption, therefore, is to make available a registration exemption for strip bonds to those persons or companies who are permitted to trade ingovernment securities.

The Commission notes that the term "qualified market intermediaries" includes both those market intermediaries that are permitted to trade in governmentsecurities pursuant to their registration, or pursuant to an exemption from registration that has not been made unavailable to the intermediary by universalregistration (i.e, subsection 206(1) of the Regulation (the "Regulation") under the Act). The latter circumstance would include financial intermediaries, referredto in subsection 204(1) of the Regulation, for whom the relevant aspects of universal registration are not applicable by virtue of either, or both of, subsection209(10) of the Regulation and Rule 32-502 Registration Exemption for Certain Trades by Financial Institutions.1 The effect of the Rule is to establish a regimefor strip bonds that is consistent with the universal registration regime of Ontario securities law.

Third, a registration exemption is provided for trades of strip bonds by a qualified market intermediary to a person or company that is a specified purchaser if thatpurchaser receives the strip bond information statement before the specified purchaser enters into an agreement of purchase and sale relating to the trade. Asdescribed in the June 1996 Notice, this represents, in part, a departure from the approach taken in the Blanket Ruling and Policy 1.6.

Specified Purchaser

A specified purchaser is defined as a purchaser to whom the then-current version of the strip bond information statement has not been delivered. This is designedto ensure that the then-current version of the strip bond information statement has been delivered to all purchasers of strip bonds purchasing from marketintermediaries before those purchasers enter into an agreement of purchase and sale for the strip bonds.

The Rule also provides that, for the purpose of the definition of "specified purchaser", a purchaser of a strip bond includes a beneficiary of a defined contributionpension plan for whose benefit a strip bond is purchased, and who made the investment decision to purchase the strip bond. The Rule also provides thatreferences in the Rule to "entering into an agreement of purchase and sale with a specified purchaser", or words to like effect, shall be read with reference to sucha beneficiary to refer to entering into an agreement of purchase and sale with the defined contribution pension plan of which the purchaser is a beneficiary.

Delivery Requirement for Registrants

The Rule provides that a registrant, before entering into an agreement of purchase and sale relating to a trade in a strip bond with a specified purchaser, shalldeliver a strip bond information statement to the specified purchaser.

This provision is designed to ensure that registrants cannot trade in strip bonds without delivering the strip bond information statement to specified purchasers inthe same manner as those who trade in strip bonds in reliance upon the exemption provided by the Rule. This provision is necessary because persons who areregistered generally to trade in securities would not have to rely upon the exemption to sell strip bonds. This provision ensures that all persons selling stripbonds, whether pursuant to a registration exemption, as described under "Registration Exemption", or pursuant to their registration must satisfy the same stripbond information statement delivery requirements.

Prospectus Exemption

The Rule provides relief from the prospectus requirements of the Act for trades in strip bonds if the trade is made under a registration exemption provided by theRule, by a qualified market intermediary to a person or company that is not a specified purchaser under the Rule or by a registrant in compliance with thedelivery obligations of the Rule.

Effective Date of Rule

Assuming ministerial approval of the Rule, the Rule will come into force on May 1, 1998 pursuant to section 6.1. This effective date is designed to providesufficient time between ministerial approval of the Rule and its effective date to permit market participants to prepare strip bond information statements that willsatisfy the requirements of the Rule. The Commission expects that staff will review any proposed strip bond information statements, and settle any commentswith market participants, before the Rule comes into effect, so that the Director may formally accept the proposed statements immediately after the Rule comesinto force on May 1, 1998.

Summary of Policy

Definition of Strip Bonds

The Policy clarifies the Commission's views on the interpretation of pools of strip bonds and strip bond packages.

Delivery Obligations

The Policy states that the delivery obligations concerning strip bond information statements imposed by the Rule may be satisfied in a number of ways, includingmass mailings to clients or the routine delivery of a statement by a registrant to new clients.

Strip Bond Information Statements

The Policy contains a reminder to participants in the strip bond market that the onus is on the person or company using a strip bond information statement toensure that it satisfies the information requirements of the definition in the Rule. The Companion Policy notes that the effect of this definition is that aninformation statement is not a strip bond information statement for the purposes of the Rule if it does not include information required to be included, or, in amaterial respect, contains any information that is misleading or untrue or omits to include any information in the strip bond information statement that isnecessary to make other information in the strip bond information statement not misleading in the light of the circumstances in which it is made, even if theDirector has accepted the strip bond information statement and has not taken the step of revoking his or her acceptance of the statement.

The Policy also confirms that a submission to the Director for acceptance of a proposed strip bond information statement is subject to the fee referred to insection 51 of Schedule 1 of the Regulation.

Summary of Written Comments Received by the Commission

Background

The proposed Rule (the "Draft Rule") and proposed Companion Policy (the "Draft Policy") concerning Strip Bonds were released for public comment in theOntario Securities Commission Bulletin on June 21, 1996 at (1996), 19 OSCB 3467. During the comment period on the proposed Rule and proposed Policy,which expired on September 23, 1996, the Commission received submissions from four commenters. A list of commenters is located in Appendix A to thisNotice.

The Commission has considered the comments received, and thanks all commenters for providing their comments on the Rule and Policy.

The following is a summary of the comments received, together with the Commission's responses and, where applicable, the changes adopted by theCommission. In addition to the comments discussed here, a number of technical drafting suggestions were made by some commenters; all of those commentswere considered, and some adopted by the Commission.

Discussion of Specific Comments about the Draft Rule and Draft Policy

Part 1 - Definitions

Section 1.1 - definition of "first-time purchaser"

One commenter suggested that a different term than "first-time purchaser" should be used to describe a person that has not received a strip bond informationstatement. The Commission agrees with this suggestion and has accordingly changed the term "first-time purchaser" to "specified purchaser" in the Rule.

One commenter expressed concern that the definition of "first-time purchaser" in the Draft Rule presumes that a dealer will know which purchasers have receiveda copy of the current strip bond information statement and that this will not be possible to do easily in most circumstances, since purchasers often transactbusiness with more than one intermediary.

The Commission believes that any difficulty in determining whether a strip bond purchaser is a first-time purchaser can be easily dealt with if the vendor assumesthat all purchasers are specified purchasers and so delivers a copy of the required strip bond information statements to them.

The commenter further contended that market intermediaries should be able to rely upon the information provided by a purchaser about his or her status as afirst-time purchaser, so that intermediaries would not be required to make further inquiries about the purchaser. The Commission is of the view that thissuggestion is inconsistent with the general scheme of the Act, in which vendors of securities are often required to deliver information documents to potentialpurchasers. The most familiar example is that of an issuer delivering a prospectus to a purchaser.

One commenter proposed that a strip bond information statement be "delivered" rather than "received"; this change would avoid requiring some form ofacknowledgement to ensure delivery took place.

The Commission agrees with this proposal, and accordingly has changed the definition of "specified purchaser" to make reference to a person to whom a stripbond information statement has not been delivered, rather than a person who has not received such a statement.

One commenter submitted that the strip bond information statement should be provided to all defined contribution pension plan members who make investmentdecisions resulting in the purchase of strip bonds for their benefit.

The Commission accepts this comment, and has added section 1.2 to include in the definition of purchaser a beneficiary of a defined contribution pension plan forwhose benefit a strip bond is purchased, and who made the investment decision to purchase the strip bond. Section 1.2 also provides that references in the Ruleto "entering into an agreement of purchase and sale with a specified purchaser", or words to like effect, shall be read with reference to such a beneficiary to referto entering into an agreement of purchase and sale with the defined contribution pension plan of which the purchaser is a beneficiary.

The effect of section 1.2 is to ensure that defined contribution pension plan members who make investment decisions to purchase strip bonds are treated aspurchasers under the Rule, even though those members likely will not directly enter into an agreement of purchase and sale for the strip bonds with the seller ofthe strip bonds. Under section 1.2, a seller of strip bonds must provide the pension plan member with a strip bond information statement if a copy of thatstatement has not been previously delivered to him or her (i.e., if that member is a "specified purchaser"), and that delivery must take place before the sellerenters into the agreement of purchase and sale in respect of that sale, even if the agreement of purchase and sale is with the pension plan rather than the pensionplan member.

Section 1.1 - definition of "strip bond information statement"

One commenter was of the opinion that paragraph (c) of the definition of "strip bond information statement" created uncertainty. Paragraph (c) states that thestrip bond information statement "does not, in a material respect, contain any information that is misleading or untrue or omit to include any information that isnecessary to make other information in the information statement not misleading in light of the circumstances in which it is made". The commenter suggestedthat if there were something unintentionally misleading, the liability should not operate to create the right to void the transaction, unlike the regime governingprospectuses. The commenter pointed out that there is no statutory liability for other documents of this nature; instead, the only recourse for misleadinginformation contained in these types of documents is through a right of action at common law.

The Commission is of the view that the obligation to ensure that a strip bond information statement is not misleading is fundamental to the operation of the Ruleand has not changed the Rule in response to this comment.

This commenter also proposed that the Commission seek an undertaking from the IDA to both advise of any problems with the documents and to confirm on anannual basis that the documents remain appropriate. The Commission believes that the Rule attaches significant importance to the accuracy of a strip bondinformation statement and does not believe that a formal step of this nature is necessary to ensure that only accurate strip bond information statements will beused in the market.

Section 1.1 - definition of "underlying bond"

One commenter suggested that the definition of "underlying bond" should track the language of section 35(2) of the Act. The Commission notes that the maindifference between the definition in the Act and the definition in the Draft Rule was the inclusion in the Act of bonds, debentures and evidences of indebtednessof "the Government of the United Kingdom". The Draft Rule includes a reference to a bond, debenture or other evidence of indebtedness...of any foreigncountry, which includes the Government of the United Kingdom. Therefore, the Commission has not made the suggested change.

Part 2 - Registration and Prospectus Exemptions

Section 2.1 - Removal of Exemptions

One commenter objected to the extension of the universal registration regime to strip bonds on the basis that "the universal registration regime is sufficientlyproblematic that we should not extend it further".

The Commission is of the view that it is appropriate that trades in strip bonds be treated in a consistent manner as trades in government securities, and so hasstructured the Rule to achieve this result. The Commission recognizes that "universal registration" does not apply to trades in strip bonds under the BlanketRuling and Policy 1.6. However, the extension of universal registration to trades in strip bonds is not expected to have a significant impact, since virtually allmarket participants engaged in selling strip bonds are also engaged in selling other products, in particular, government securities. As a result, the Commissionexpects that few market participants that now trade in strip bonds will be required to register under the Act in order to continue to do so.

Part 3 - Delivery Obligation

Section 3.1 - Delivery Obligation

Two commenters objected to the requirement that all registrants be required to deliver strip bond information statements to a "first-time purchaser" [now a"specified purchaser"] before the purchaser enters into an agreement of purchase and sale relating to the trade. They noted that the Blanket Ruling and Policy1.6 permit certain registrants to deliver the statement with the confirmation of a trade in strip bonds. The commenters stated the requirement was "anunnecessary and administrative exercise, in view of the professional obligations of the SRO registered Investment Advisor [i.e. representative] both to providepurchasers with relevant background information on the investment recommendations, develop a detailed understanding of the client's investment profile andensure the investment recommendation is suitable and in keeping with the client's investment objectives."

The two commenters proposed that the Rule should permit a continuation of the current regime in which vendors registered as investment dealers and brokerssend strip bond information statements to purchasers concurrently with the trade confirmation. One of the commenters argued that the requirement in the Rulerelating to the timing of delivery of strip bond information statements is unreasonable given that the underlying security is a government security.

As stated in the June 1996 Notice, the Commission is concerned that the existing approach may not provide first-time purchasers with meaningful disclosure atthe appropriate time of the investment decision. The Commission also does not anticipate that the requirement to deliver a strip bond information statementbefore an agreement of purchase and sale is entered into will create hardship to registrants. The Commission notes that registrants will be able to fulfil theirobligation in this respect through delivery of the strip bond information statements to new purchasers at the time a new account is opened, together with massmailings to existing purchasers. Therefore, no changes to the Rule have been made in this regard.

The Commission also notes that some of the administrative burden associated with the existing regime is eliminated in the Rule, as it is no longer necessary forregistrants to obtain an acknowledgment of receipt of the information statement from purchasers.

One of the commenters suggested that the obligation to deliver the information statement at an earlier time in the process than is required under the currentregime would prejudice purchasers who are situated outside main population centres or who do not have access to certain technology; such purchasers may beunable to complete transactions quickly. It was submitted that purchasers should be able to complete transactions in a timely fashion despite their technical orgeographic inability to receive a strip bond information statement.

The Commission does not anticipate that geographical or technological factors will cause significant difficulties for registrants to deliver strip bond informationstatements to purchasers. The Commission has confidence that registrants will easily be able to take appropriate steps to ensure strip bond informationstatements are delivered to purchasers so transactions may be entered into in a timely fashion.

One commenter observed the apparent anomaly of requiring disclosure in secondary market purchases such as strip bonds, but not elsewhere, such as speculativejunior resource stock.

The Commission takes the position that the absence of secondary disclosure requirements for other transactions does not mean that it is inappropriate to requirethis disclosure for strip bond purchases. Strip bonds are subject to greater sensitivity to changes in interest rates, special tax consequences and different custodialconsiderations. Investor confusion relating to these special attributes of these securities, compared to the attributes of government securities from which they arederived, more than justify secondary disclosure requirements.

Part 4 - Strip Bond Information Statement

Section 4.1 - Contents of Strip Bond Information Statement

One commenter observed that the requirement in the Draft Rule that a strip bond information statement "clearly" describe certain items was too stringent astandard and could create uncertainty. The Commission believes that disclosure in strip bond information statements, as in other disclosure documents, shouldbe clear, and has retained the wording.

The commenter also suggested that the definition of "strip bond" could result in section 4.1 being interpreted to require generic disclosure of all possible issuersof strip bonds and currencies. In particular, the commenter thought the required disclosure of secondary market or custodial arrangements might requiredisclosure of the particular government issuer and currency to which a particular transaction related. The Commission does not share this view of section 4.1.The requirements of section 4.1 are designed to permit generic disclosure in a manner consistent with the information statements that are currently in use. TheCommission is not aware of any problems of the nature raised by this commenter with the existing information statement that is widely used in connection withstrip bond transactions.

The commenter also proposed that section 4.1(f), which requires a strip bond information statement to describe the income tax consequences of buying, sellingand holding strip bonds, should specifically refer to Canadian federal income tax considerations. The Commission agrees with this proposal and has made thischange.

One commenter noted that the strip bond information statement required by the Rule differs from the information statement required by Policy 1.6 and currentlyin use in the market. The commenter was of the opinion that the existing information requirements are simple and straightforward, and have worked effectivelyto describe the nature of strip bonds to investors. The commenter questioned the need for any changes to the existing information requirements.

The Commission is of the view that the development and importance of the strip bond market has led to the need for specific disclosure on a number of matters,including the nature of strip bonds, the rights of holders of strip bonds, and the existence of dealer mark-ups or commissions on strip bond transactions. As aresult, the Commission has imposed new disclosure requirements in section 4.1. The Commission does not anticipate that the creation of a new strip bondinformation statement for use in the industry will impose undue hardship on registrants.

Text of Rule and Policy

The texts of the Rule and Policy follow.

Text of Rescission of Policy

The Rule will replace, in part, Policy 1.6. The Commission is rescinding Policy 1.6 effective on the date on which the Rule and Policy come into force. The textof the rescission is as follows:

"Ontario Securities Commission Policy 1.6 entitled "Strip Bonds" is rescinded effective the date that Rule 91-501 Strip Bonds comes into force."

DATED: January 2, 1998.

APPENDIX A

LIST OF COMMENTERS ON ONTARIO RULE AND ONTARIO COMPANION POLICY

i. Canadian Bankers Association

ii. Investment Dealers Association of Canada

iii. Pension Commission of Ontario

iv. Simon Romano