MEMBER REGULATION. notice

Transcription

1 MEMBER REGULATION INVESTMENT DEALERS ASSOCIATION OF CANADA notice ASSOCIATION CANADIENNE DES COURTIERS EN VALEURS MOBILIÈRES Contact: R. Corner: (416) rcorner@ida.ca MR 027 May 29, 2000 ATTENTION: Ultimate Designated Persons Chief Financial Officers Panel Auditors Distribute internally to: Corporate Finance Credit Institutional Internal Audit Legal & Compliance Operations Registration Regulatory Accounting Research Retail Senior Management Trading desk Training Offsets involving Capital Shares, Convertible Securities and Warrants, Rights, Instalment Receipts and like instruments and Offsets involving Takeover or Reorganization Transactions We have recently been receiving a number of questions concerning the proper application of existing offset rules where the offset either involves: a long position in any one of capital shares, convertible securities, warrants, rights, instalment receipts and like instruments and a short position in the equivalent number of shares in the underlying security (referred to for the remainder of this Notice as convertible security offsets ); or a long position in the shares of a company being acquired (where there is a share purchase offset) and a short position in the equivalent number of shares of the acquiring company where the acquisition involves a share for share exchange (referred to for the remainder of this Notice as takeover situation offsets ); or a long position in the shares of a company in the process of reorganizing and a short position(s) in the equivalent number of shares of the resultant company(ies) after the plan or reorganization is executed (referred to for the remainder of the Notice as reorganization situation offsets The basic principle underlying all of the above offset strategies is that the long position held must be currently convertible/exchangeable into the short position held. If this is not the case for a particular proposed offset strategy, the reduced offset margin is either denied or an additional market risk premium is required to be added to the normal offset margin requirement. TORONTO Suite 1600, 121 King Street West, Toronto, Ontario, M5H 3T9 Telephone (416) Fax: (416) MONTRÉAL Suite 2802, 1 Place Ville Marie, Montréal, Québec, H3B 4R4 Téléphone: (514) Télécopieur: (514) HALIFAX Suite 1620, TD Centre, 1791 Barrington Street, Halifax, Nova Scotia, B3J 3K9 Telephone (902) Fax: (902) CALGARY Suite 2300, 355 Fourth Avenue S.W., Calgary, Alberta, T2P 0J1 Telephone: (403) Fax: (403) VANCOUVER Suite 1325, P.O. Box 11614, 650 West Georgia Street, Vancouver, B.C., V6B 4N9 Telephone: (604) Fax: (604)

2 May 29, MR This member regulation notice has been prepared to provide general guidance 1 to Member firms wishing to utilize the above offset strategies. As such is the case, the remainder of this notice details the factors that IDA staff consider in determining whether or not certain security positions qualify for reduced margin under the existing offset rules. CONVERTIBLE SECURITY OFFSETS (IDA Reg G, H, I and J) As previously stated, the basic principle underlying all of the above offset strategies is that the long position held must be currently convertible/exchangeable into the short position held. Capital Shares (IDA Reg G) General Rules In the case of capital shares, conversion privileges are usually set out in the security prospectus documents that permit the conversion of the capital share (accompanied by a cash payment) and the capital share and preferred share into the underlying common shares. As a result, there are specific rules set out in IDA Reg G that permit the following offsets be granted reduced margin: Long capital shares versus short common shares - since this offset is economically the same as holding a short position in a preferred share, the margin requirement is the normal margin requirement (credit requirement in the case of a customer account position) on the related preferred share plus any exchange penalty amount set out in the prospectus plus 5% of the market value of the common shares where the cash equivalent value of the common shares is received upon conversion. [Note: Certain capital shares have an annual conversion privilege whereby the holder of the capital share can covert into the common share at no penalty. Because this is an annual (rather than an ongoing) conversion privilege this lower margin requirement may only be permitted where a term borrow arrangement (a term arrangement to borrow the common stock) is in place to cover the period of time between the date for which margin is being calculated and the annual conversion privilege date] Long capital shares and long preferred shares versus short common shares - since the combination of a capital share and a preferred share is the same as a common share, the margin requirement is any exchange penalty amount set out in the prospectus plus 5% of the market value of the common shares where the cash equivalent value of the common shares is received upon conversion. [Note: Certain capital/preferred share combinations have an annual conversion privilege whereby the holder of the capital and preferred shares can covert into the common shares at no penalty. Because this is an annual (rather than an ongoing) conversion privilege this lower margin requirement may only be permitted where a term borrow arrangement (a term arrangement to borrow the common stock) is in place to cover the period of time between the date for which margin is being calculated and the annual conversion privilege date] How the General Rules Apply to Certain Splitshare Issues In general, the above-discussed general rules apply in the same fashion to all splitshare issuances. However, there are instances where capital and preferred shares (also referred to as dividend shares) have been issued: 1 The guidance set out in this Notice is not a substitute for the performance of proper due diligence. When determining the capital or margin requirement for any offset, Member firms have a duty to ensure that the economic substance of the offset strategy results in either the extinguishment or minimization of market risk. Normally, this involves consulting the relevant prospectus documents for the convertible/exchangeable instrument to determine the conversion/exchange features, the appropriate hedge ratios and any penalties associated with the conversion/exchange features.

3 May 29, MR on a basket of underlying securities (i.e., Can-Banc NT Corporation which has as an underlying basket the five major Canadian banks or Leed NT Corporation which has as an underlying basket three major Canadian banks and two Canadian Pipeline companies, Telco Split Corp. which has as an underlying basket six major Canadian telephone companies); on an individual underlying security issue (i.e., B Split Corp. which has the BCE issue as an underlying) on a portion of a company (i.e., TeleClone Inc. which has the BCE issue stripped of the investment in Nortel Networks [long BCE, short Nortel]) As a result, because the underlying interest for a particular capital share may be different, particular attention should be paid to the exact nature of the underlying before offset relief is granted. For example, Telco Split Corp., B Split Corp. and Teleclone Inc. all have the BCE issue as part of their portfolio of underlying securities. Since BCE is currently undergoing a reorganization with respect to its ownership interest in Nortel Networks, what constitutes a proper economic hedge for offsets involving any one of these capital shares may be unknown once the distribution of Nortel Network shares to BCE shareholders has taken place. As a result, it would be inappropriate to allow a reduction in the normal capital/margin requirement for any offset involving Telco Split Corp., B Split Corp. or Teleclone Inc. until their portfolio rebalancing efforts have been completed and the resultant makeup of the portfolio of underlying securities to these capital shares issues is known. Convertible Securities (IDA Reg H and J) General Rule The group of security types referred to as convertible securities includes convertible preferred shares, convertible/exchangeable debentures, subscription receipts, special warrants and any other security provided that it contains a feature that may be converted into a stated number another security at no additional cost to the beneficial owner. As a result, there are specific rules set out in IDA Reg H and J that permit that reduced margin be granted to an offset involving a long position in a convertible security and a short position in the underlying security, provided that conversion may be performed as at the date of the offset. The margin requirement on this offset would be the conversion loss (the excess of the market value of the convertible security over the market value of the underlying security). This is because there is no market risk associated with this offset strategy since the long position can be converted at any time to cover the short position. As a result, the only possibility of loss occurs where the market value of the long position is in excess of the market value of the short position. Convertible Securities with Issuer Cash Payment Feature In the case of some convertible securities, the issuer has the option when the conversion feature is exercised of paying either the stated number of underlying securities or the equivalent amount in cash. Most examples of this cash payment option occur with exchangeable debentures. In fact two IDA Compliance Interpretation Bulletins have been issued previously detailing the appropriate margin treatment for specific exchangeable debenture issues. The following summarizes the appropriate margin requirement for an offset involving a long position in such issues and a short position in the underlying security: If the cash payment value is greater than the current market value of the underlying securities, then 100% of the loss on conversion calculated as the excess of the market price of the convertible/exchangeable issue over the current market value of the short underlying securities, plus 5% of the market value of the underlying securities, if the position is in inventory, or 10% of the market value if the position is in a client account.

4 May 29, MR If the cash payment value is less than the current market value of the underlying securities, then 100% of the loss on conversion calculated as the excess of the market price of the convertible/exchangeable issue over the cash payment value of the short underlying securities, plus 5% of the market value of the underlying securities, if the position is in inventory, or 10% of the market value if the position is in a client account. The 5% or 10% penalty amount serves to protect against the intra-day market price risk to the firm should the issuer elect to provide any combination of cash payment instead of underlying securities at the date of conversion, thereby requiring the firm to go into the market to purchase the equivalent amount of underlying securities being hedged. Compound Convertible Securities In the case of some convertible securities, the issuer has the option when the conversion feature is exercised of paying out either a stated number of Stock A, an equivalent number of Stock B (where Stock A and Stock B are two different share issues) or an equivalent amount in cash. Because the security is convertible into more than one share issue, it is referred to as a compound convertible security. At present there is only one known compound convertible security issued by a Canadian issuer in existence, the Teck Corporation exchangeable debenture [maturity date March 31, 2004]. In the case of this issue, when the conversion feature is exercised, Teck Corporation has the option of paying out either: a stated number of Cominco common shares ( shares per $1,000 par); an equivalent number of Teck Corporation Class B subordinate voting shares (determined using 95% of the current market price for such shares); or an equivalent amount in cash. The following summarizes the appropriate margin requirement in this instance for an offset involving a long position in the Teck Corporation exchangeable debenture and a short position in Cominco common shares: 100% of the loss on conversion calculated as the excess of the market price of the Teck Corporation exchangeable debenture over the current market value of the short Cominco common shares, plus 5% of the market value of the Cominco common shares, if the position is in inventory, or 15% of the market value if the position is in a client account. The 5% or 15% penalty amount serves to protect against the intra-day market price risk to the firm should the issuer elect to payout Teck Corporation Class B subordinate voting shares, thereby requiring the firm to go into the market to sell the subordinate voting shares and buy the Cominco common shares to close out the offset strategy. The penalty amounts calculated are net of the increased value of Teck Corporation Class B subordinate voting shares that would be received and are calculated as follows: For Firms Penalty Amount = 5% [required to liquidate Teck Corporation Class B subordinate voting shares] + 5% [required to buy in Cominco common shares] - 5% [representing the excess value of Teck Corporation Class B subordinate received] = 5% voting shares that would be

5 May 29, MR For Clients Penalty Amount = 10% [required to liquidate Teck Corporation Class B subordinate voting shares] + 10% [required to buy in Cominco common shares] - 5% [representing the excess value of Teck Corporation Class B subordinate received] = 15% Convertible Securities that are not currently convertible voting shares that would be A large number of convertible securities are not convertible until some point in time in the future. As a result, no reduction in the normal margin required would be permitted under the current rules as the convertible security has to be currently convertible. The only exception granted under the rules is where a term borrowing arrangement has been put in place to cover the remaining period until the first date a conversion may take place. Related Bulletins/Notices Previously Issued IDA C-67 IDA C-95 TSE RN-035 Offset involving Horsham 3.25% exchangeable debentures and American Barrick Resources common shares Offset involving Horsham 3.00% exchangeable debentures and Barrick Gold Corporation common shares Offset involving Teck Corporation exchangeable debentures [maturity date September 30, 2021] and Inco common shares Warrants, rights, instalment receipts and other cash payment convertible securities (IDA Reg I and J) General Rule Warrants, rights, instalment receipts and like instruments (referred to as cash payment convertible securities ) are similar to the securities referred to as convertible securities above with the exception that to convert these securities into another a cash payment must be made. As a result, there are similar rules to those for convertible securities set out in IDA Reg I and J that permit that reduced margin be granted to an offset involving a long position in a cash payment convertible security and a short position in the underlying security. Because of the required cash payment to convert these instruments, there is a different requirement for firm and customer account offset positions. In the case of a firm account, the capital requirement would be the conversion loss (the excess of the sum of the market value of the cash payment convertible security plus the cash payment over the market value of the underlying security). In the case of a customer account, the margin requirement would be the amount of the cash payment plus any excess in the market value of the cash payment convertible security over the market value of the underlying security. TAKEOVER SITUATION OFFSETS On many occasions we receive requests to allow offsets that relate to takeover situation offsets. These are offsets involving a long position in the shares of a company being acquired (where there is a share purchase offset) and a short position in the equivalent number of shares of the acquiring company where the acquisition involves a share for share exchange. Under these situations, the logic of the offset is that once the takeover is complete, the holder of the offset positions will receive the shares of the acquiring company (as a result of the share for share exchange) and will use these shares to close out the short position put on in these same shares. Thus the offset only makes sense if the takeover is going ahead. As a result, no margin reductions may be taken for such offsets unless all requirements, regulatory, competition bureau or court approval or otherwise, have been met with respect to the proposed takeover bid.

6 May 29, MR REORGANIZATION SITUATION OFFSETS We also receive requests to allow offsets that relate to reorganization situation offsets. Examples of such reorganizations are situations whereby: 1. The issuer company decides to split the company into multiple companies and therefore intends to replace an existing issue with multiple issues (referred to in the remainder of this notice as company spin-off reorganizations ); or 2. The issuer company decides to issue a new class of convertible security with the objective of using the proceeds of this issuance to finance a possible company or asset acquisition (referred to in the remainder of this notice as acquisition financing reorganizations ); Company spin-off reorganizations These are offsets involving a long position in the shares of a company in the process of reorganizing and a short position(s) in the equivalent number of shares of the resultant company(ies) [generally trading on a when-issued basis]. Under these situations, the logic of the offset is that once the reorganization is complete, the holder of the offset positions will receive the shares of the reorganized company(ies) (as a result of the execution of the plan of arrangement) and will use these shares to close out the when issued short position(s) put on in these same shares to flatten the total position. Thus the offset only makes sense if the reorganization is going ahead. However, if the reorganization transaction does not go ahead, the when issued transactions will end up being cancelled. As a result, unless all requirements, regulatory, competition bureau or court approval or otherwise, have been met with respect to the proposed takeover bid, the margin requirement for the offset will be the normal margin required on the long position in the shares of the existing company. Acquisition financing reorganizations These are offsets involving a long position in the new convertible issuance (usually issued as either special warrants or subscription receipts) of a company issued for the purpose of financing a proposed acquisition and a short position in the equivalent number of shares of the underlying security. Generally, the underlying security is the existing common share issuance of the company. So, in many respects securities issued under acquisition financing reorganizations are very similar in nature to securities covered by the convertible security offset rules (as discussed in a previous section). The main difference is that in the case of these convertible issuances, the conversion features available to the holder of the issue may be different depending on whether or not the planned acquisition goes ahead. In most cases the following are features of such instruments: The proceeds of the special warrant or subscription receipt are held in escrow with an acceptable institution; Upon issuance, the holder of the special warrant or subscription receipt has the right to convert the security into a stated number of common shares; Should the proposed acquisition take place, the holder of the special warrant or subscription receipt retains the right to convert the security into a stated number of common shares; and Should the proposed acquisition not take place, the holder of the special warrant or subscription receipt will have the option of converting the security into a stated number of common shares (generally at a more generous rate than if the acquisition takes place) or receiving a cash refund for the purchase price of the security. Under these situations (and assuming the convertible issuance has the features described above), the logic of the offset is that once the planned acquisition takes place, the holder of the offset positions can convert the special warrant or subscription receipt into the common shares of the company and use these shares to close out the short position(s) put on in these same shares. Further, even if the acquisition is unsuccessful, the ability to convert to close out a short position is still available to the holder of the special warrant or

7 May 29, MR subscription receipt. As a result, the margin requirement for this offset would be the conversion loss (the excess of the market value of the special warrant or subscription receipt over the market value of the common stock (determined using the lowest possible conversion rate)). Related Bulletins/Notices Previously Issued TSE RN-044 IDA C-70 Margin requirements for William Resources subscription receipts Margin on special warrants