Clarification on Schedule 14 of Form 1 and the limited recourse call loan agreement

GN-FORM1-21-003
Type: Rules Notice> Guidance Note
Rule connection:
IIROC Rules
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Executive Summary

Effective Date: December 31, 2021

IIROC is publishing guidance to provide clarification on Schedule 14 of Form 1 Provider of capital concentration charge and on the execution of the limited recourse call loan agreement.

Table of contents
  1. Will this capital charge affect my firm?

The answer to this question depends on the capital base of your firm.  Where a  firm  has  no  equity  stakeholder (i.e., shareholder, partner, etc.) or equity stakeholder group with “capital provided” (as defined)  of $10 million or more, Schedule 14 need not be completed. Where a firm does have one or more of such stakeholders, a separate copy of Schedule 14 must be completed for each stakeholder.

  1. What is the purpose of this concentration test?

The purpose of this test is to act as an anti-avoidance rule. Without this concentration charge in place, it would remain possible for a Dealer Member (Dealer) to report as regulatory capital:

  • capital contributions received that are in turn redeposited back with its provider of capital;
  • capital contributions received that are in turn lent back to its provider of capital; or
  • capital contributions received that are in turn invested in securities issued by its provider of capital;

Since the economic effect of the above activities may be the same as having a standby subordinated loan in place an anti-avoidance rule was made necessary. The anti-avoidance rule developed is in the form of a concentration charge which limits the ability of a Dealer Member to enter into the above activities, and thus ensure that it is not engaging in significant “avoidance” transactions.

  1. How do I determine which counterparties are considered to be a “provider of capital” for the purposes of reporting on Schedule 14?

A “provider of capital” has been defined in the Notes and Instructions to new Schedule 14 to include “an individual or entity and its affiliates that provides capital to a Dealer Member”. Thus in the case of capital provided by an entity, the entity in combination with the entity’s affiliates is considered to be a single “provider of capital” and all transactions/balances the Dealer has with the entity and its affiliates are considered for inclusion on Schedule 14.

The Notes and Instructions also stipulate that a copy of Schedule 14 must be completed for each “provider of capital” that has provided capital in excess of $10 million. The $10 million threshold is used because where capital of less than $10 million has been provided, no capital charge could result based on the way the mechanics of the Provider of Capital Concentration Charge work.

  1. How do I determine which affiliates are included under the definition of “provider of capital”?

  1. Definition of “affiliates”

As stated previously, in the case of capital provided by an entity, the entity in combination with the entity’s affiliates is considered to be a single “provider of capital” and all transactions/balances the Dealer has with the entity and its affiliates are considered for inclusion on Schedule 14. However, the Notes and Instructions to Schedule 14 don’t explicitly set out a definition for “affiliates”. This is due to the fact that the Provider of Capital Concentration Charge is intended to act as an anti-avoidance rule. Therefore, it was determined that any attempt to circumvent any concentration charge by using a non-arms length affiliate to intermediate between the Dealer and it’s “provider of capital” should also be caught by this test. As a result, the inclusion of “affiliates” was loosely defined to ensure that all avoidance transactions would be caught.

  1. What “affiliates” are to be included?

Since there is no specific definition of “affiliates”, Dealers must use the general definition of the term as guidance. The definition set out in IIROC Rule 1200 states:

““affiliate” - where used to indicate a relationship between two corporations, means:

  1. one corporation is a subsidiary of the other corporation,
  2. both corporations are subsidiaries of the same corporation, or
  3. both corporations are controlled by the same person;”

where person is defined as:

“person” An individual, a partnership, a corporation, a government or any of its departments or agencies, a trustee, an incorporated or unincorporated organization, an incorporated or unincorporated syndicate or an individual’s heirs, executors, administrators or other legal representatives.”

As a result any corporation that is controlled either directly or indirectly by the same person should be considered an “affiliate” for the purposes of completing Schedule 14.

  1. What affiliate balances may be excluded?

Where an affiliate is also a SRO Dealer and is a signatory to an approved Cross- Guarantee Agreement involving your firm, transactions/balances may be excluded to the extent of the guarantee amount (which is based on the guarantee percentage set out in the Cross- Guarantee Agreement). This is because where capital is placed at risk between one SRO Dealer and another commonly controlled SRO Dealer the Cross-Guarantee Agreement provides for coverage of any intra-Dealer exposure in the event of an insolvency. As an example, refer to the following situation:

Dealer A has:

  • financial statement capital of $70 million;
  • risk adjusted capital of $50 million;
  • exposures with Dealer B of $20 million; and
  • is 80% owned by Provider of Capital A

Dealer B has:

  • financial statement capital of $300 million;
  • risk adjusted capital of $120 million;
  • exposures with Dealer A of $50 million; and
  • is 70% owned by Provider of Capital A

Therefore Member A is guaranteeing Member B up to a maximum of $40 million (80% x $50 million) and Member B is guaranteeing Member A up to $84 million (70% x $120 million). As a result, exposures to be reported would be:

For Dealer A

  • Exposure to Dealer B  is $20nmillion
  • Guarantee provided by Dealer B is $84 million
  • Exposure to Dealer B to be reported on Schedule 14 is Nil

For Dealer B

  • Exposure to Dealer A is $50 million
  • Guarantee provided by Dealer A is $40 million
  • Exposure to Dealer A to be reported on Schedule 14 is $10 bmillion
  1. On what basis are transactions/balances to be reported on Schedule 14? Trade date or settlement date?

In order to determine the appropriate basis of reporting transactions/balances on Schedule 14, the purpose of the provider of capital concentration charge was revisited. As stated previously, the intent of this charge is to act as an anti-avoidance rule. As such is the case, the intent of the rule is to try to limit a Dealer’s ability to repatriate capital back to its provider of capital by entering into “avoidance” transactions. If a Dealer were to enter into such transactions, it would only be effective on settlement date when the capital would actually be repatriated back to the provider of capital. Further, the use of the Limited Recourse Call Loan Agreement will only be available to reduce provider of capital exposures on a settlement date basis. As a result, it has been determined that Dealer’s should complete Schedule 14 on a settlement date basis.

  1. What transactions/balances are to be reported in Sections A and B of Schedule 14 and how are the exposures that relate to these transactions/balances to be calculated?

In order to ensure that a Dealer is not engaging in the above mentioned “avoidance” transactions, Sections A and B of Schedule 14 require a Dealer to report transactions that may relate to these activities in the following manner:

  1. Lines A1 and A2 - Cash deposits

The full amount of any cash deposits must be reported on Line A1 or A2 depending on the nature of the deposit. Bank overdrafts may be reported on Line A14 to the extent that the Dealer has the legal right to offset the overdraft against the amounts reported on Lines A1 or A2. Further, any overdraft amount reported on Line A14 must not exceed the amount of the cash deposits reported on Lines A1 or A2 (i.e., you cannot effectively report a net overdraft position).

  1. Line A3 - Loans Receivable Undersecured relative to Normal Commercial Terms

For each individual loan balance, the net loan exposure in excess of the exposure under normal commercial terms is to be reported. To determine this exposure, use the following formula:

Exposure =

(actual loan exposure - loan exposure under normal commercial terms)

=

(amount of loan receivable - market value of collateral received) - (normal over-collateralization percentage x amount of loan)

To determine what normal commercial terms would be for the loan, comparisons would be made to the terms negotiated with comparable arms length counterparties. Where the exposure calculated is negative (i.e., the Dealer has either received excess collateral or has a more favourable collateral level than normal) the amount to be reported on Line A3 is nil. Where the exposure calculated is positive and the related loan agreement allows for the legal offset of the receivable balance against other receivable/payable balances, the exposure net of any allowable offsets is to be reported on Line A3. Otherwise, if no offsets are permitted, the amount of the exposure calculated above is to be reported on Line A3.

  1. Line A4 - Loans Receivable Secured by Provider of Capital Issued Securities

As with undersecured balances above, for each individual loan balance, the net loan exposure in excess of the exposure under normal commercial terms is to be reported. Again, the following formula would be used to determine this exposure:

Exposure =

(actual loan exposure - loan exposure under normal commercial terms)

=

(amount of loan receivable - market value of collateral received) - (normal over-collateralization percentage x amount of loan)

In the case where the loan is either secured or partially secured by provider of capital issued securities, these securities are given no value in the determination of the amount of any exposure. As before, to determine what normal commercial terms would be for the loan, comparisons would be made to the terms negotiated with comparable arms length counterparties. Where the exposure calculated is negative (i.e., the Dealer has either received excess collateral or has a more favourable collateral level than normal) the amount to be reported on Line A4 is nil. Where the exposure calculated is positive and the related loan agreement allows for the legal offset of the receivable balance against other receivable/payable balances, the exposure net of any allowable offsets is to be reported on Line A4. Otherwise, if no offsets are permitted, the amount of the exposure calculated above is to be reported Line A4.

  1. Line A5, A6 and A7 - Security Borrowing and Resale Agreements

Similar to the logic set out for Lines A3 and Lines A4 for each individual security borrowing/resale balance, the net exposure in excess of the exposure under normal commercial terms is to be reported.

  1. Lines A8, A9 and A10 - Commissions, Fees, Interest, Dividends and Other Amounts Receivable from Provider of Capital

Similar to the logic set out for Lines A3 and Lines A4 for each individual security borrowing/resale balance, the net exposure in excess of the exposure under normal commercial terms is to be reported.

  1. Line A11 – Over-collateralized Loans Payable

For each individual loan balance, the net loan exposure in excess of the exposure under normal commercial terms is to be reported. To determine this exposure, use the following formula:

Exposure =

(actual loan exposure - loan exposure under normal commercial terms)

=

(market value of collateral provided - amount of loan payable) - (normal over-collateralization percentage x amount of loan)

To determine what normal commercial terms would be for the loan, comparisons would be made to the terms negotiated with comparable arms length counterparties. Where the exposure calculated is negative (i.e., the Dealer has either provided insufficient collateral or has a more favourable collateral level than normal) the amount to be reported on Line A11 is nil. Where the exposure calculated is positive and the related loan agreement allows for the legal offset of the receivable balance against other receivable/payable balances, the exposure net of any allowable offsets is to be reported on Line A11. Otherwise, if no offsets are permitted, the amount of the exposure calculated above is to be reported on Line A11.

  1. Line A12 and A13 - Security Lending and Repurchase Agreements

Similar to the logic set out for Line A11 for each individual security lending/repurchase balance, the net exposure in excess of the exposure under normal commercial terms is to be reported.

  1. Line A14 – Bank overdrafts

Report any overdraft balances on Line A14 to the extent that they can be legally offset against any cash balances reported on either Line A1 or A2. As a result, any overdraft amount reported on Line A14 must not exceed the amount of the cash deposits reported on Lines A1 or A2 (i.e., you cannot effectively report a net overdraft position).

  1. Line B1 - Invested in Securities Issued by Provider of Capital

Report as exposure amount for each security:

Exposure =  (market value of security - normal margin - security concentration charge)

To the extent that security positions represent a valid offset strategy, these positions may either be excluded from inclusion on Line B1 or deducted on Line B3. “Valid offset” strategies are those involving security positions of the same issuer. Examples of these strategies include:

  • Long convertible security versus short underlying security;
  • Long security versus long put option contract;
  • Long security versus short call option contract;
  • Long security versus long put and short call option contracts;
  • Long convertible security versus short call option contract; and
  • Long debt security versus short debt security of same issuer within same maturity band

Please note that the above list is not exhaustive and therefore other valid offset strategies may be acceptable for the purposes of reducing exposures to security positions issued by the provider of capital.

  1. Line B2 – Securities financed by Limited Recourse Call Loan Agreement

Where a Limited Recourse Call Loan Agreement is put in place by the Dealer, the value of the securities (reported as part of the balances reported on Line B1) covered by the agreement (as set out in Schedule 1 to the agreement or a related referenced schedule) may be reported on Line B2. See discussion later on in this notice relating to the acceptable form of Limited Recourse Call Loan Agreement that must be executed by Dealers to take advantage of this line deduction.

  1. Line B3 – Securities sold short that are acceptable for offset purposes

As stated for Line B1, where “valid offset” strategies are in place, the related positions may either be excluded from inclusion on Line B1 or deducted on Line B3. If the position is to be deducted on Line B3, the value of the related long position reported as part of Line B1 should be reported on Line B3 to ensure that between Lines B1 and B3 the long position is properly excluded.

  1. How can a Dealer minimize the exposures that are to be reported on Schedule 14?

  1. Ensure proper calculation of exposure amounts

Section 6 of this notice details how exposure amounts are to be calculated. For financing transactions, whether or not a transaction is either overcollateralized or undersecured in relation to normal commercial terms is key to determining whether or not an exposure need be reported. As such is the case, the Dealer must keep adequate documentation to support the collateralization percentages it considers to be normal commercial terms for the various transactions it enters into with its provider of capital.

  1. Ensure “valid offset” security positions are excluded from consideration

Section 6.9 of this notice indicates that security positions that represent “valid offset” positions may be excluded from being reported on Schedule 14. The positions that constitute “valid offset” positions have been specifically limited to offsets currently permitted under IIROC requirements where the offset strategy involves only securities of the same issuer. Examples of “valid offset” positions have already been provided in Section 6.9.

  1. Ensure security positions for which there is a drawn new issue letter in force are excluded from consideration

Where a Dealer has a new issue letter in place with respect to provider of capital issued securities, these securities may be excluded from inclusion on Line B1 where financing available under the new issue letter agreement has been drawn down, subject to meeting other conditions. This exclusion is permitted since when the new issue letter is drawn:

  • The Dealer has transferred risk with respect to the provider of capital issued securities to the issuer of the new issue letter;
  • Any remaining risk relating to the underwriting will already be provided by the Dealer through its providing of margin on the underwriting commitment; and
  • The Dealer’s use of bank letters is currently limited by the existing “Margin for Concentration in Underwriting Commitments” as set out in Schedule 2A of Form 1
  1. Use Limited Recourse Call Loan Agreement to reduce exposure reported in Section B of Schedule 14

The Limited Recourse Call Loan Agreement in legal effect is very similar to the proposed Standard Form New Issue Letter (SFNIL). However, this agreement may be used to finance other inventory positions and assist a Dealer in limiting the credit exposure it has with it’s provider of capital. The limited recourse provisions contained in the agreement are only to apply in the event of a Dealer default. Situations where the Dealer is either risk adjusted capital deficient or a repayment under the Limited Recourse Call Loan Agreement will cause the Dealer to become risk adjusted capital deficient are considered to be events of default.

  1. Consider use of a cross product netting agreement to reduce exposures reported in sections A and B of Schedule 14

The most complete approach for a Dealer to minimize its exposures to its provider of capital would be through the execution of a cross product netting agreement. This agreement would permit the legal netting of all transactions/balances between a Dealer and its provider of capital. As a result, any exposure reported on Schedule 14 would be one net exposure balance.

  1. Applicable Rules and Schedules

IIROC Rules and schedules this Guidance Note relates to:

  • Schedule 14, Form 1.
  1. Previous Guidance Notes

This Guidance Note replaces:

  • MR0006 – Elimination of Standby Subordinated Debt for Regulatory Capital Purposed and Adoption of Provider of Capital Concentration
  • MR0024 -  Elimination of Standby Subordinated Debt for Regulatory Capital Purposes and Adoption of Provider of Capital Concentration
  1. Related documents

This Guidance Note was published under Notice 21-0190 - IIROC Rules, Form 1 and Guidance.