Background
On March 26, 2010 IIROC published for comment the first of the rules rewritten as part of its new rulebook project. Rules Notice 10-0085 describes the rules and several changes included in them, which are the main topic of this commentary.
The notice also contains links to the proposed rules, the old rules and a table of concordance. Comments are due by June 24, 2010 and are to be sent to:
Sherry Tabesh-Ndreka
Policy Counsel
Investment Industry Regulatory Organization of Canada
121 King Street West, Suite 1600
Toronto ON M5H 3T9
A second copy should be addressed to the attention of:
Manager of Market Regulation
Ontario Securities Commission
20 Queen Street West
19th Floor, Box 55
Toronto, Ontario
M5H 3S8
The Project
The project goals are outlined on IIROC's website:
- Restate the rules in plain language style
- Streamline rules by focusing on core requirements and moving details to Guidance Notes
- Improve clarity and understanding of rules
- Eliminate obsolete, duplicative and unnecessary requirements
- Reorganize rule structure more logically
- Clearly state the objective of each rule
Proposed rule changes
Although it is not reflected in the stated goals, in the course of the project IIROC decided that it could not just rewrite the existing rules and eliminate the obsolete or unnecessary, in some cases it would need to make substantive changes.
The number of substantive rule changes in proposed Rules 3100 and 3200 is not small. Here is the list, broken down to show our reactions.
Welcome changes
- Removal of the requirement to provide leverage risk disclosure to institutional clients.
- Clarification and extension of the use of letters of undertaking from financial institutions opening options and futures accounts.
- Elimination of requirements to file options and futures reports that IIROC has not been collecting anyway.
- Permitting managed account agreements to incorporate by reference objectives and risk tolerance stated elsewhere.
- Removal of prohibition against a managed account holding related securities of the dealer in favour of a prohibition against purchases of related securities of the dealer in a managed account.
- Clarification of exemptions from conducting due diligence on financial institutions in foreign countries.
The reasons for these changes are well explained in the request for comments and we see no need to add to or comment on them.
Unwelcome changes
- Limitation of 12 months on discretionary accounts.
- Prohibition of time and price discretion except in discretionary or managed accounts.
- Application of the client priority rule to those involved in investment decision making for managed accounts.
- Requirement to obtain an acknowledgement from retail clients that they have received a copy of the leverage risk disclosure statement.
Changes of questionable validity or utility
- Extension of conflict of interest provisions on managed accounts to sub-advisors.
- A change to the language of current rule 1300.1(o) to state that both orders and recommendations have to be within the bounds of good business practice.
- Addition of a specific requirement to use due diligence to identify new clients and determine whether they are insiders of publicly traded companies.
- Clarification that a dealer member is required to verify that those clients it treats as institutional fit within IIROC's definition of "institutional client."
- A specific requirement to maintain account documents and records that meet not only IIROC's requirements but also those of other applicable legislation.
- Limitation of 6 months on hold mail arrangements, subject to conditions on any extension beyond that period.
Limitation of 12 months on discretionary accounts
We preface our consideration of the proposed changes regarding discretionary accounts by noting that the covering IIROC notice and the proposed rule itself are different. The notice states that: "Proposed Rule 3200 will prohibit operating a discretionary account for a period in excess of twelve months." Proposed Rule 3200 in fact does no such thing, it simply continues (in Rule 3273) the current limit of twelve months on the duration of a discretionary account agreement. It does not prohibit renewal of the agreement for additional twelve month periods (ad infinitum if the client is willing), which is the current practice for long-term discretionary accounts.
Proposed Rule 3272(1) does include a definition of "discretionary account," one element of which is that: "the term of the discretionary authority does not exceed twelve months," but that definition does not appear to us to prevent the re-establishment of a new discretionary authority for another twelve months under another agreement.
However, for the purposes of this discussion we will accept the intent of the rule change, even if it is not achieved in the actual rule.
The notice starts with a faulty rationale for the proposed rule change: "The intent and nature of discretionary accounts is to accommodate temporary situations for which a client may want to provide discretionary authority to his/her advisor."
This bit of mythology was invented, so far as we can recall, by CSA staffers in the course of rejecting proposed changes to the IDA discretionary account rules in 2001.
In fact, prior to 1979, there was no restriction on the duration of a discretionary account. The rules were fairly straightforward:
- A written agreement with the client
- The account had to be handled by a director of the firm or all discretionary orders approved in advance by a director,
- Discretionary orders had to be identified.
The concept of and rules surrounding managed accounts were introduced in 1979, and most of the rules about what came to be called "simple discretionary accounts" continued, with the addition of a requirement for an annual renewal of the discretionary account agreement.
The 2001 proposed amendments referred to above sought to eliminate the annual renewal of discretionary agreements as a wasteful paper chase, but did not find favour with CSA staff. They were withdrawn by the IDA.
The current rule requires a dealer member to convince IIROC it has a good reason before it can enter into a discretionary agreement for more than a year. While we agree that approving normal course arrangements with specific clients is not a sensible way for IIROC to spend its time, the rationale given for not simply dropping the annual renewal is that even under the current rule: "client awareness and satisfaction of the Corporation without any checks and balances is not necessarily sufficient to address issues that may arise from granting discretionary authority on a long term basis."
Well, there are other checks and balances in the current rules, like designation of a particular supervisor for discretionary accounts and a monthly review of account performance by the designated supervisor. Why these are no longer considered sufficient is not explained. Nor are the issues that remain unaddressed further delineated.
Discretionary accounts that do not fit the definition of managed accounts are a topic crying out for thorough policy review, not misinformed tinkering. They have never been as popular with dealers in Canada as in the United States, where the rules require a written agreement of the customer (with no duration limits), pre-approval of discretionary orders by the member and regular reviews of account activity.
However, some Canadian dealers permit discretionary accounts to be maintained on a long-term basis by getting annual renewals of the agreement. The request for comments presents no real rationale for preventing continuation of the practice. There are also discretionary accounts handled by directors that were established before the 1979 rule changes. Those arrangements would have to be changed by force of the rule changes, probably much to the chagrin of the clients.
The proposed change fails to consider current practices, and there is no indication in the notice of any awareness of or attempt to determine current practices.
For example, some dealers make a distinction between managed accounts, in which all decisions are made by the portfolio manager, and discretionary accounts, in which the client has a lot of say in the decision-making but leaves some of it to the firm. Some firms have qualified portfolio managers who have discretionary accounts because the client wants more of a say in the day-to-day decision making than is normal for a managed account.
Along the same lines, we have seen cases in which the client wants to give his or her representative the power to take action (particularly loss mitigation) when he or she is not available for the normal pre-trade consultation. We recall the case of a surgeon with a speculative bent who spent long hours in the operating theatre and was happy to have his representative able to take action when contact was impossible. That kind of arrangement is not temporary.
The problem with limiting discretionary accounts or making their administration too onerous has always been that it drives them underground, which provides a regular flow of disciplinary penalties for IIROC but hardly prevents discretionary arrangements from continuing. Limiting them could in fact be viewed as a disservice to clients since an undocumented discretionary arrangement evades the protections offered by the more rigorous supervision applied to documented discretionary accounts.
Prohibition of time and price discretion except in discretionary or managed accounts
Proposed Rule 3271(1) states:
Each Dealer Member must ensure that persons trading on its behalf do not engage in any discretionary trading, including time and price discretion, unless discretion is exercised in a discretionary or managed account in accordance with the requirements set out in Rule 3200.
The request for comments states that: "Proposed Rule 3200 more clearly sets out the prohibition against discretionary trading, including the prohibition against time and price discretion."
In fact, this is a complete reversal of the current rule 1300.3, which in the definition of discretionary account states:
an account shall not be considered to be a discretionary account for the sole reason that discretion is exercised as to the price at which or time when an order given by a customer for the purchase or sale of a definite amount of a specified security, option, futures contract or futures contract option shall be executed.
There is no further explanation in the notice for the change, which might be appropriate for a clarification but is hardly so for a significant rule change.
So what?
It is a common practice for clients to grant a level of discretion on timing and price in execution of an order, and dealers like to at least think that their trading acumen may result in a better execution for the client if they are permitted to exercise it. IIROC apparently begs to differ.
We also wonder whether all dealers are aware of the change, given the way it is soft pedalled in the notice.
Application of the client priority rule to those involved in investment decision making for managed accounts.
Proposed Rule 3284 will continue the current exemption of pro accounts that participate in centrally managed programs from the client priority rule, with the exception of accounts of those involved in the decision-making process.
The current rule (1300.20) was introduced after a thorough review of managed account rules by a special IDA committee. Its rationale was that in centrally managed programs in which all clients get the same thing at the same time using average prices, there is no benefit to the clients in separating pros who participate in the program, and since everyone participates equally there is no ability for the pros to put their own interests ahead of those of the clients.
The notice states:
This revision is consistent with the purpose and scope of the existing Rule as set out in previously issued guidance. This amendment is proposed on the basis that it is inappropriate for those involved in the investment decision making process of a managed account program to receive client priority through their participation in the managed account program.
The only guidance we are aware of is in IDA Bulletin 3241, which explained Rule 1300.20 when it was initially implemented. That Bulletin states:
The implementation of decisions for such accounts usually takes the form of block purchases or accumulations which are allocated on an average price basis. The application of By-law 29.3A to such investments is unnecessary, as the participation of non-client managed accounts is generally minor, the investment decisions are not being made by the employee account holder, who cannot therefore take advantage of client orders, and the separation of non-client accounts makes the implementation of investment decisions unnecessarily complicated.
So yes, the notice did indicate that the investment decision makers weren't involved, but the more important principle the situation is not amenable to them taking advantage of client orders remains.
So what?
Admittedly, separating out the orders for the investment decision makers is a minor administrative hassle, but why bother with a change that accomplishes nothing? In fact, filling the client orders first and the decision-maker orders second could end up with the decision-makers getting a better fill. We suggest that a simple rule is best.
Requirement to obtain acknowledgements from retail clients that they have received a copy of the leverage risk disclosure statement
The request for comments explains that the proposed new requirement in Proposed Rule 3309(1)(ii) to obtain a client's written acknowledgement of receipt of a leverage risk disclosure statement is designed to put it on a par with margin agreements and options and futures disclosure statements.
The requirement to enter into a margin agreement is necessary at least in part because it gives the dealer rights to take actions to protect itself, not just to let the client know what margin means. On that basis it really isn't a good analogy to the leverage risk disclosure statement.
The analogy to options and futures risk disclosure statements may be more apropos, but maybe the first question should be whether customer acknowledgements that they have received something the dealer is required to give them serve any utility at all? Does it make more sense to add another or remove the existing ones?
Even if you accept the principle that client acknowledgements are warranted in some cases, are they warranted in all cases? And is the explanation of the risks of complicated instruments like derivatives to be put on a par with the more straightforward concept of leverage risk? And is it necessary to get an acknowledgement of subsequent leverage risk disclosures if you already have one of a previous disclosure?
So what?
The inexorable addition of new written acknowledgements complicates processes, introduces transactional delays and diverts the attention of dealer supervisors and compliance people from more fruitful procedures. We think IIROC should think very carefully about what it really accomplishes in terms of investor protection before adding new acknowledgements simply because of those already in place.
Changes of questionable validity or utility
In the interests of brevity, we offer brief comments on the following proposed changes:
- Extension of conflict of interest provisions on managed accounts to sub-advisors (Proposed Rule 3283):
Proposed Rule 3282 limits the use of sub-advisors to those subject to equivalent conflict of interest rules or those who have entered into an agreement with the dealer to abide by the IIROC conflict of interest rules. It is clearly appropriate to ensure that dealer members make sure contractually that their sub-advisors comply. But adding specific prohibitions on sub-advisors in Rule 3283 seems to us to be beyond the powers of IIROC, which has no jurisdiction over the non-member sub-advisors. How is IIROC to enforce the prohibitions?
- A change to the language of current Rule 1300.1(o) to state that both orders and recommendations have to be within the bounds of good business practice (Proposed Rule 3102(4):
Rules 1300.1(p) through (s), the suitability requirements, are not dealt with in the proposed new rules, so will presumably appear elsewhere in the revised rulebook. The good business practice section that has always been associated with them does appears in Rule 3102 with an addition that recommendations have to be within the bounds of good business practice.
It's hard to see how a recommendation could be outside the bounds of good business practice without, more importantly, being unsuitable, because it would have to put the client at risk in the first place in order to put the firm at risk. In any case, to have any practical outcome a recommendation outside the bounds of good business practice would have to result in an order outside the bounds of good business practice, so would be covered in any event.
- Addition of a specific requirement to use due diligence to identify new clients and determine whether they are insiders of publicly traded companies (Proposed Rule 3202):
As noted in the covering notice, the requirement to determine whether a client is an insider of a publicly traded company is already included in National Instrument 31-103. We fail to see the need to duplicate every provision of every other rule in the IIROC Rules. Doing so is fairly innocent in this case, since it is unlikely that the rule will ever change. In other cases, however, keeping consistency through rule changes becomes a problem. We suggest as a principal that duplication be avoided.
- Clarification that a dealer member is required to verify that those clients it treats as institutional fit within IIROC's definition of "institutional client" (Proposed Rule 3407(2)):
True, but does it really need to be stated? The general know-your-client requirement to "learn the essential facts" already covers the need nicely.
Is this necessary? Does the "other applicable legislation" need IIROC's help?
- Limitation of 6 months on hold mail arrangements, subject to conditions on any extension beyond that period (Proposed Rule 3210):
When is a rule not a rule? This proposal boils down to a limit that a dealer can override in its policies and procedures, provided the dealer complies with requirements it has to comply with regarding all hold mail. So what is the point of the limit in the first place? If it were a hard and fast limit we would argue against it anyway, since many of the circumstances that prompt clients to hold mail requests aren't similarly limited in duration.
So what about the rewritten rules? Are the goals of the project realized? A few comments:
The proposed rule includes vague generalizations that we think have no place in rules. For example, section 3102, in addition to requiring that dealers and their personnel observe high ethical standards and not engage in unbecoming business conduct, requires that they "be of good character and business repute."
Now just what does this mean? Does cheating at cards, or at love, not indicate bad character? Does either make someone ineligible for employment in the securities industry?
Most people start their working life without any business repute. Are they thereby disqualified from working for an IIROC dealer? Are those who have been disciplined by IIROC similarly disqualified, given the likelihood that their business repute has taken a serious hit?
Similarly, section 3202 requires that a dealer:
use due diligence to establish:
(i) the identity of every new client, and if there is any cause for concern, then make inquiries as to the reputation of the client
What is the implication of the last part of this? Should the dealer refrain from dealing with a client with a bad reputation? Are those of bad reputation forever denied access to the capital markets?
What goes where?
Section 3201 states that Proposed Rule 3200 sets out a dealer member's obligations to learn and remain informed about the essential facts about clients. However, the rule requiring a dealer to learn the essential facts about clients appears only in Proposed Rule 3102(3), while Proposed Rule 3200 deals only with updates and obtaining the relevant information in Form 2.
Whose rules are they, anyway?
Several provisions require that a dealer's policies and procedures contain specific provisions, for example, section 3223(2):
The Dealer Member's policies and procedures must stipulate that any changes to an account application are approved in the same way that an account application is approved for a new account.
The stipulation is being set by the IIROC rule, so it should just be stated as an IIROC rule: "Changes to an account application must be approved..."
To whom do the rules apply?
Some of the proposed rules fail to set the onus properly. For example, the supposed clarification of the prohibition of discretionary trading outside the rules, in Proposed Rule 3271, reads:
Each Dealer Member must ensure that persons trading on its behalf do not engage in any discretionary trading, including time and price discretion, unless discretion is exercised in a discretionary or managed account in accordance with the requirements set out in Rule 3200.
A clear rule would prohibit dealers and registered representatives from using discretion except as allowed under the rules rather than being directed solely at the dealer member. One of the most common facts of undocumented discretionary trading is that the dealer does not know the RR is exercising discretion and generally has no way of knowing.
So What?
The goals of the project are worthy: plain language, clarity, organization. They are certainly worth further work to make sure they are achieved.
If these issues are of concern to you, Sutton Boyce Gilkes Regulatory Consulting Group can help you draft a comment letter.
