sbg regulatory
SBG Commentaries No. 4 - March 2010
This commentary is of interest to all IIROC members, whether or not they sell non-arm's length products.
IIROC requests comments on draft notice regarding non-arm's length products

On February 5, 2010 IIROC published for comment a draft notice entitled "Requirements and Best Practices for distribution of non-arm's length investment products." Comments are due by May 6, 2010.

Comments can be sent in writing or by fax or e-mail to:

Mr. Louis Piergeti

Vice-President, Financial and Business Conduct Compliance

Investment Industry Regulatory Organization of Canada

121 King Street West, Suite 1600

Toronto ON M5H 3T9

Fax: 416-364-4878



The following aspects of the draft notice warrants careful consideration and possibly comment by all IIROC members:

1.   The notice seeks to establish enforceable rules without going through the rule-making process.

In our Commentary No. 1 in November, 2009 we described how a previous IIROC draft notice on know-your-client and suitability guidelines had the effect of establishing prescriptive rules without going through the normal rule-making process.

The draft notice on non-arm's length products goes even further in that direction, and we believe that it should therefore be of concern to all IIROC members, whether or not they deal in non-arm's length products.

While the notice expresses reasonable concerns about the conflicts of interest that can arise when a dealer sells non-arm's length products, it states that IIROC has concluded that existing rules are sufficient to deal with those conflicts. However, it then establishes a reporting and approval regime that exists nowhere in the IIROC rules, Provincial securities acts and regulations or any other rules.  This is a requirement, i.e. a new rule, presented as a statement of "IIROC's expectations."

Specifics of the new requirements are given under the heading "Notice to IIROC" on Page 10:

Prior to the commencement of the distribution by a Dealer Member of a non-arms length investment product in respect of which this Notice applies, which is not either:

(i)            distributed pursuant to a prospectus for which a receipt is required pursuant to provincial securities legislation; or

(ii)           eligible for margin pursuant to IIROC Dealer Member Rules;

the Dealer Member shall provide written notice to IIROC of its intention to commence the distribution unless IIROC has specifically approved the product for distribution without notice. At present, securities issued by a federally regulated or provincially regulated financial institution distributed pursuant to an exemption under securities legislation has (sic) been approved as not requiring foregoing notice to IIROC.

Such notice shall be received by IIROC not less than 20 business days prior to the execution of the first trade for the purchase of the investment product pursuant to such distribution and shall include:

(i)            a general description of the investment product and plan of distribution;

(ii)           particulars of the principal business uses from the proceeds of distribution by the issuer, including transaction expenses and commissions;

(iii)          copies of any offering materials including advertisements and/or sales literature in Rule 29.7 to be used by the Dealer Member;

(iv)          if required by IIROC, a copy of a legal opinion addressing compliance with applicable securities laws.

The final paragraph of the draft notice leaves no doubt that this is a new rule:

The conduct of any Dealer Member, its approved persons or its employees and agents in respect of any such distribution not in compliance with IIROC Dealer Member Rules and the terms of this Notice may constitute grounds for enforcement action by IIROC on the basis of such non-compliance and conduct being unbecoming a Member or its personnel (emphasis added).

While making use of the general "conduct unbecoming" section of the IIROC rules as a basis for initiating enforcement action, the specificity of the requirements together with the statement that non-compliance with the notice on its own can result in enforcement action makes this a rule, regardless  of what IIROC chooses to call it.

So what?

IIROC has a constitution and an elaborate rule-making process. New rules must be approved by the Board, published for comment by the CSA and then approved by the CSA. Establishing rules by issuing staff notices circumvents that process, taking away the authority of the Board to pass new rules and of the CSA to approve them.

The requirements of the notice give IIROC staff the right to approve or disapprove of a new non-arm's length product.  There is no identification of the IIROC staff who will make the decisions, the grounds on which they might disapprove of a product or what changes in the product, disclosures or advertising they can demand before granting approval.

The notice does do not state the basis on which IIROC might approve a product for distribution without notice, or whether the provision simply provides the basis for the general exemption for products issued by federally regulated financial institutions.

The requirements in the notice do not establish an appeal process in the event a dealer member disagrees with the dictates or decision of IIROC staff. Is there an appeal to a district council or hearing panel? Can a decision be appealed to the Board? Decisions by district counsels, hearing panels and the Board can generally be appealed beyond IIROC to the securities commission, but without an established process for formal hearings, decisions and appeals there will be no formal decision or no formal record on which to appeal.

The notice period and documents required will already add to the time between completion of the offering materials and the ability of the dealer to sell the product.  That will cause pressure on the dealer to simply accede to IIROC staff decisions or dictates rather than face disallowance of the distribution or changes in materials that it does not believe to be necessary.

2.    The proposed requirements constitute a step by IIROC staff into product approval that goes beyond anything in the current IIROC rules.

At present IIROC has very limited authority over what a dealer member can or cannot sell.  Most of the current rules simply set conditions - proficiency, supervision, margin, etc. - for categories of products.

Even when a dealer sells its own shares or the shares of its holding company in a private placement, the only requirement is that the district council be satisfied that there are resale restrictions to prevent the development of a public market until certain conditions are met.  It does not require any form of pre-approval of the issue itself.

There are of course general conflicts of interest provisions, including the disclosure requirements in National Instrument 31-103 regarding related issuers.

None of these, however, gives IIROC the authority to look at a particular distribution of a particular security and decide whether it can happen.

This kind of extension of authority is clearly one that should go through careful consideration and be subject to reasonable checks and balances, rather than being implemented through a notice.

So what?

After much discussion, the regulators have recently adopted a more principles-based approach to regulation.  Even in terms of conflicts of interest, the prescriptive rules have been reduced in favour or principles and guidelines.  There continue to be prescriptive rules relating to self-dealing, but they take the form of disclosure requirements, client's consent requirements or outright prohibitions, for example prohibiting discretionary trades for clients in the securities of related issuers.

The IIROC notice is completely prescriptive, requiring approval by IIROC staff of the distribution of specific issues.  Merit review is not something IIROC has ever done before, and not something that has been a part of securities regulation at the commission level for many years.

Such a radical departure from current practice is again something that requires careful consideration through the full rule-making process, including a sustainable rationale for differentiating the situation it deals with from all those others that are dealt with in a totally different way.

3.   The notice grants a total exemption for "securities issued by a federally regulated or provincially regulated financial institution distributed pursuant to an exemption under securities legislation."

Given the broad variety of instruments issued by financial institutions and the recurrent concerns about any interference by securities regulators in the affairs of federally-regulated financial institutions, it is hardly surprising that IIROC should grant such a broad exemption.

However, there is no explanation and of why this is a reasonable measure and why the requirements should end up with what is in essence one law for one set of dealer members (affiliates of federally-regulated financial institutions who sell their products) and another for everybody else.

The initial overview explains that  "in recent years there have specific instances where clients of IIROC Dealer Members have suffered losses as a result of investing in such products," not only products sold by IIROC dealers but also mutual fund dealers and others in Canada, the United States and elsewhere.

It is undoubtedly true that "clients have suffered losses by investing in such products" but not true that none of those losses have come through bank-issued products.  There are certainly those who have lost income for various periods of time, and probably in some cases at least part of their principal, on principal-protected notes or partially-protected notes issued by banks, not to mention index-linked GIC's that have paid no return. Furthermore, both federally and provincially regulated financial institutions have been known to fail, taking client assets with them and wiping out the value of securities not covered by deposit insurance.

On March 23, 2009 IIROC issued the final version of its Notice 09-0087: "Best practices for product due diligence."  Given that notice, which does not exempt bank-issued products, what is the need for an additional regime for non-arm's length products?

The answer is quite clearly the final point in the overview: "in some cases, including those involving IIROC Dealer Members, the client losses have resulted in compensation being paid by industry protection plans such as Canadian Investor Protection Fund ("CIPF")."

This notice results from a couple of cases in which IIROC members have sold worthless securities of affiliated companies to their customers.  These sales were fraudulent in one way or another, needed to prop up the affiliates. That does not mean government-regulated financial institutions won't or don't commit fraud or sell fraudulent securities.

So what?

The new rule adds a significant burden to one set of dealer members but not another, apparently based on a risk determination made by IIROC staff.  Nowhere is there any explanation of that risk analysis. Nowhere is there any analysis of how many non-prospectus, unmarginable, non-arm's length issues IIROC dealer members have been involved in, the types of securities issued, their nominal value, the level of risk they impose either to clients or CIPF or why something more is needed than the product due diligence and suitability requirements already in place.

On the other side there is no assessment of the likely costs of going through the process the notice seeks to establish.

A demand for cost-benefit analysis is something of a knee-jerk reaction for dealers anxious to delay or avoid regulatory changes, even when such changes are justifiable.  It is often very difficult to quantify costs that are spread unevenly across different types of dealers, and impossible to quantify the benefits from unknown problems avoided.

However, in this case it should be possible present a more detailed argument for the utility of the proposed regime:

  • How common are distributions of these non-arm's length, non-prospectus issues?
  • Are there frequently serious conflicts of interest that are not being adequately dealt with?
  • Are the filings required under the notice things that are normally prepared anyway, or is the notice requiring completion of steps that are not part of current practice?  If so, are the extra steps really necessary?  Do they really contribute to consumer protection, or just add unnecessary costs that will ultimately be borne by the investors?
  • What will be the practical effect of the requirements in the notice?
  • How many cases of fraud or other serious malfeasance in the sale of non-arm's length securities have their been in relation to the number of distributions?  What have these cost clients or CIPF?
  • Are there other ways for IIROC to monitor such distributions or prevent problems with them than imposing a new filing and approval process?

And equally important:

  • Is there anything about securities issued by federally-regulated financial institutions that makes them so different from those of other affiliates of dealer members that a special regulatory regime needs to be implemented for one but not the other?

The cases of fraud through the sale of non-arm's length securities are jarring to the investors and to IIROC, but they are few and far between.  Cases of fraud by federally-regulated financial institutions are also few and far between.  The notice gives no indication of any study of the relative incidence or risks of such cases and how they justify imposing a whole new set of requirements.

4.   The notice adds best practices for due diligence without explanation.  It is unclear to what extent these are going to be matters for enforcement by IIROC, although there are indications that they are going to become another set of non-rule requirements.

The notice states:

IIROC has identified best practices for Dealer Members in conducting product due diligence and addressing conflict of interest concerns. For all products these include inquiry and analysis as to

  • audited financial statements for the issuer
  • independent valuations for assets
  • management services and functions provided at arm's length basis
  • description of ownership structure of issuer and identification of persons and entities not dealing at arm's length
  • full disclosure as to the use of proceeds
  • full disclosure of management fees or other compensation
  • full disclosure of distribution structure including commissions, referral fees, promotions and inducements.

For funds and structured products, additional factors include:

  • audited financial statements of the fund
  • pricing of the investment product and valuation of the portfolio of the fund by an independent third party
  • independent custody of the portfolio of the fund
  • annual disclosure listing the portfolio of the fund
  • where the monthly pricing and accounting functions are performed by the issuer itself or an affiliate, an independent specified compliance procedures review conducted by an external auditor or independent party (at least every quarter) and a report of findings made available to unit holders
  • commissions on underlying fund asset trades being pre-determined and competitive with street rates.

This could mean either that dealer members should consider the presence or absence of these items, and how important that presence or absence is in relation to the issue, or it could mean that IIROC intends to ensure that they are all in place.  In the former case, they are guidance, in the latter, they are rules.

We have already heard from clients that IIROC is treating them as rules, insisting for example on formal independent evaluations of assets even where there are other facts or factors in support of the valuations used in offering memoranda and financial reports.  The specificity of the second last bullet point on funds certainly comes across more like a rule than a "best practice."

So what?

IIROC must be clear about what are rules and what are guidelines.  The former are enforceable as written, the latter leave discretion to the dealer member provided that the result is reasonably likely to end in compliance with the overarching rule.

It is also noteworthy that none of the factors listed above appear in IIROC's notice on product due diligence.  Does that mean they are meant to address conflicts of interest?

For example, is pricing of the investment product and valuation of the portfolio of the fund by an independent third party (a) a necessary protection, (b) something to think about in evaluating the product or (c) simply one way to address conflict of interest concerns in appropriate situations? Does it relate to different types of portfolios?  For example, is there a difference between a portfolio of listed securities for which pricing is already public and one in which some of the securities are more difficult to price?  Does the ratio of the former to the latter make a difference? Is IIROC going to insist on independent pricing in all situations, as it already appears to be doing? If not, what are the criteria for deciding when independent pricing is necessary and when it is not?

This kind of notice can leave dealer members at the mercy of ad hoc decisions lacking consistency and failing to provide anyone but the dealer involved with any clue as to what to do to satisfy IIROC about the next issue.

If these issues are of concern to you, Sutton Boyce Gilkes Regulatory Consulting Group can help you draft a comment letter.

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