Proposed Federal Regulations For Principal Protected Notes

Originally published in Blakes Bulletin on Securities Regulations, December 2007

The federal Department of Finance recently published for comment proposed regulations (Regulations) on principal protected notes (PPNs) issued by federally-regulated deposit taking institutions. The Regulations are proposed to be brought into force on April 1, 2008, and are open for comment until December 24, 2007. They will replace the existing Index-linked Deposits Interest Disclosure Regulations for banks, co-operative credit associations and trust and loan companies, first introduced in 2002 and now seen as inadequate for the complex PPNs currently available in the market.

PPNs are defined as "a financial instrument that is issued by an institution to an investor and that (a) provides for a payment to be made by the institution that is determined in whole or in part, by reference to any index or reference, including (i) the market price of a security, commodity, investment fund or other financial instrument, and (ii) the exchange rate between any two currencies; and (b) provides that the principal amount that the institution is obligated to repay at the note’s maturity is equal to or more than the total paid by the investor for the note".

The Regulations specify the content, manner and timing of disclosure that institutions are required to provide at the point of sale; the information that must be made available, upon request, to investors to monitor their investment; and restrictions on advertising. They require such information to be provided at least two days before the PPN is purchased, unless a two-day rescission right is provided. The Regulations represent a mix of principle-based regulation and specific requirements, and are applicable to Schedule I, II and III banks, credit unions governed by the Cooperative Credit Associations Act and federally-regulated trust and loan companies (Institutions).

Under the Regulations, at least two days before entering into a contract for a PPN, the following information must be provided by the Institution to the investor, both in writing and orally by a person who is knowledgeable about the terms and conditions of the PPN (a Knowledgeable Person):

1. the term of the PPN, and how and when the principal is to be repaid and the interest, if any, is to be paid; any fees and their impact on the interest payable;
2. how interest is accrued, and any limitations in respect of the interest payable;
3. any risks associated with the PPN, including, if applicable, the risk that no interest may accrue;
4. the distinction between a PPN and a fixed-rate investment with respect to the levels of risk and return;
5. the circumstances in which a PPN could be an appropriate investment;
6. if the PPN is not eligible for deposit insurance coverage by the Canada Deposit Insurance Corporation, the fact that it is not eligible;
7. whether the PPN provides that it may be redeemed before its maturity and, if so, that redemption before maturity may result in the investor receiving less than the principal amount;
8. the terms and conditions of any secondary market offered by the Institution;
9. whether investors may cancel their purchase of the PPN and, if so, how the purchase may be cancelled;
10. whether the PPN provides that the Institution may amend the note and, if so, in what circumstances;
11. whether the manner in which the PPN is structured or administered may place the Institution in a conflict of interest;
12. any other information that could reasonably be expected to affect an investor’s decision to purchase the PPN; and
13. that the above information is available on request and on the Institution’s Web site and that specified information regarding
14. the current value of the note is available on request after the note is issued.

There are three exceptions to the above disclosure requirements. First, if the PPN contract is entered into by electronic means, then oral disclosure is not required provided the Institution discloses in writing the telephone number of a Knowledgeable Person. Second, an Institution that has made the applicable public commitment under the Financial Consumer Agency of Canada Act to provide investors with a two-day rescission right can make the disclosure at any time prior to entering the contract, rather than two days before. Third, the disclosure may be made at any time prior to the issuance of a PPN if the Institution and investor expressly consent to it and the contract is entered into with the investor in person.

There is no prescribed form that the disclosure must take but it must be made in language that is clear and simple and in a manner that is not misleading.

Disclosure After Issuance Of PPN

Upon request from an investor, an Institution must disclose without delay the net asset value of the investor’s PPN and how that value is related to the interest payable under the PPN; and the last available measure, before the day as of which the calculation is made, of the index or reference point on which the interest is determined and how that measure is related to the interest payable under the PPN.

In addition, an Institution must disclose an amendment to a PPN in writing to an investor prior to making any such amendment, or, if prior notice is not possible, then without delay after the amendment is made. An Institution must also disclose without delay any change to the determination of interest payable in relation to the relevant index or reference point and upon an early redemption must also disclose in writing to the investor the total amount of principal and interest payable under the PPN and the amount of any applicable penalty or fee.

The disclosure that an Institution must make after the issuance of a PPN may be made electronically.

Advertisements

In each advertisement that refers to features of a PPN or the interest payable, an Institution must disclose, in addition to how information about the PPN may be obtained:

1. the manner in which interest is to be accrued, and any limitations in respect of the interest payable;
2. if the advertisement gives an example of a situation in which interest would be payable, an example of another situation in which no interest would be payable;
3. if the advertisement gives an example of a situation in which interest would be payable that is in addition to any minimum interest that is guaranteed, an example of another situation in which only the minimum interest would be payable; and
4. if the notes are not eligible for deposit insurance coverage by the Canada Deposit Insurance Corporation, the fact that they are not eligible.
5. Also, an Institution shall only use market information in an advertisement in respect of a period in which the PPN, or type of PPN, was offered by the Institution.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.