Distributors, lawyers and regulators were eager to express their concerns about the level of disclosure in structured notes issued in Canada to around 100 delegates attending the inaugural Structured Products conference in Toronto. But the good news is that Canadian issuers have taken the initiative to standardise disclosure documents. What's more, they have been joined by regulators the Canadian Securities Adminstrators (CSA) and the Ontario Securities Commission (OSC) in their efforts to offer greater transparency.
While the penetration of retail structured products in Canada is relatively low, there is a general expectation that the market will resume steady growth once some kind of clarity is reached and the bad publicity that ensued in the wake of the collapse of investment manager Portus in 2005 subsides.
Further guidance is expected after the CSA passes judgement on whether it will amend the definition of 'novel' derivatives, which it claims will improve disclosure.
Som Seif, president of Claymore Investments and keynote speaker, opened the conference citing the concerns over poor disclosure of the risks in principal-protected notes (PPNs).
Seif said that some PPN marketing documents fail to properly highlight the risks contained in these investments. "We see this every day," he said. "Some PPNs sold to investors do not match their needs."
Speaking as a member of a discussion panel that followed the opening speech, Seif also expressed concerns about financial advisers who, despite being unfamiliar with PPNs, were distributing them to investors without understanding the risk-return profiles.
Fellow panel member Tracy Ross, senior counsel at Royal Bank of Canada (RBC) in Toronto, said that Canadian banks had been working together to produce standard disclosure documents for options-based structured notes and constant proportion portfolio insurance (CPPI)-based structured notes. "But we were sidetracked by the notice issued by the CSA last year," she said. "We are now waiting for the publication of the results of the consultation."
The CSA, an umbrella organisation for Canada's provincial securities commissions, issued notice 46-303 last year to express its concerns about the distribution and marketing of PPNs.
And according to three members of the OSC, the regulator is working with the CSA to improve PPN disclosure following the industry comments it received on expanding the definition of what constitutes a'novel' product in respect of the proposed National Instrument 44-102 Shelf Distribution (NI 44-102).
The CSA has consulted the industry for its proposed amendments to National Instrument 41-101 General Prospectus Requirements (NI 41-101) as well as consequential amendments to other instruments and policies including NI 44-102, which covers the shelf prospectus system for the distribution of investment products. The consultation ended on March 31.
The rule requires issuers to pre-clear prospectus supplements that qualify the issuance of specified derivatives that have not been publicly offered to date in Canada, and these derivatives are defined as novel. The proposed amendments will require pre-clearance of more prospectus supplements related to specified derivatives, including linked notes.
To use the shelf prospectus system, issuers must file a short-form, base-shelf prospectus containing all information other than the terms of each particular offering to be made over the two-year period.
Jo-Anne Matear at the OSC said that there had been increased use of the shelf system since last spring. But now the OSC is concerned that the shelf prospectuses filed do not contain adequate disclosure about linked notes that will be offered.
As a result, Matear said the OSC is proposing to amend NI 41-102 to broaden the pre-clearance mechanism. "Expanding the definition of novel allows us to see iterations of products that issuers may not currently consider novel," said Matear. "And it increases our awareness of the use of the shelf system in the distribution of linked notes."
Members of the OSC speaking at the conference said that it is likely that the CSA will indicate its decision over the proposed amendments at the end of this year.
On the subject of the 46-303 notice issued by the CSA last year, the OSC's Erez Blumberger said that the organisation is concerned about promotional presentation of performance returns. Notice 46-303 covers the CSA's concerns over debt products issued by banks as deposits, which fall outside the scope of provincial securities legislation. This means these products are exempt from the prospectus and registration requirements.
Blumberger said that in some cases there is no disclosure on illiquidity and penalties for the premature sales of PPNs. Some prospectuses also contain incomprehensible descriptions of the structure being sold. "Some of the prospectuses we have come across are difficult to understand even for sophisticated investors," Blumberger said.
In a companion document published along with the Federal budget plan announced in March this year, the Canadian government stated its intention to release for comment principles-based regulations for banks that issue PPNs. The OSC said the new principles-based disclosure regime proposed by the Federal government coincides with the notice issued by the CSA last year on the disclosure of PPNs.
Penetration levels of structured products at the retail level in Canada is still relatively low compared to Europe, said Robert Benson, London-based managing director at Arete Consulting, a retail structured products database provider.
Benson believes that structured products in the country continue to suffer from the collapse of investment manager Portus in 2005. Further predictable obstacles include competition for capital from mutual funds and income trusts.
The Canadian market has grown in volume in the last 12 months, with an estimated C$9 billion ($8.5 billion) in gross sales this year compared to C$8.5 billion ($8 billion) in gross sales during the whole of 2006, according to structuredretailproducts.com. And this growth is likely to continue if issuers can introduce new investment ideas rather than focusing on innovations in payouts, said Benson.
However, not all distributors have recorded sales growth. Several speakers noted that the amount of capital raised by distributing principal-protected notes (PPNs) has fallen in Canada due to oversupply. "The sales figures for this year are totally different from last year," said Raj Lala, Toronto-based managing partner at Jovian Asset Management, the asset management arm of Jovian Capital. "Sales per note have decreased significantly. Many PPNs have not generated the performance that the advisers had hoped for."
Lala said it has been difficult to distribute structured notes issued by non-Canadian banks as dealers and advisers favour domestic issuers. Citing the Jovian Asset Management survey conducted in March this year, Lala said that 68% of investment dealers responding said they typically purchase notes issued by the big five Canadian banks: Royal Bank of Canada (RBC), Toronto-Dominion Bank, Bank of Montreal (BMO), Bank of Nova Scotia, and Canadian Imperial Bank of Commerce (CIBC).
While 50% of the respondents are satisfied with the flow of information they received since their purchase of PPNs, 55% said they are neutral to unhappy about the performance of their PPNs. About 75% of the respondents expected their PPN sales to either increase or stay the same over the next one to two years.
Lala added that advisers are also increasingly looking for alternative underlyings, such as soft commodities, although the appetite for hedge funds as underlyings is still low.
Other factors deterring investors from placing capital in structured products include the high level of fees and the low level of liquidity. According to Toronto-based Paul Taylor, senior vice-president and chief investment officer at BMO Harris Investment Management, the private banking arm of BMO, the minimum investment level is too high for tailor-made structured solutions. For example, in some cases, up to C$5 million (US$4.7 million) is required for one transaction.
Taylor said that the risk profile of the BMO's clients is conservative. "A typical BMO Harris investor is approximately 63 years of age and has C$1.8 million ($1.7 million) to C$2 million ($1.8 million) of investable assets," he said. BMO Harris has been offering structured products to investors for seven months, but so far only a handful of investors have allocated their assets in structured products.
Taylor added that although structured products are useful investment management tools, they will not fit every client's objectives. "We remain cautious when it comes to offering structured products," he added.