sbg regulatory
SBG Commentaries No. 8 - February, 2011
his commentary is of interest to all dealers.

RR Incorporation 

Here We Go Again

You may be forgiven for having missed the current public consultation by a "group of provincial/territorial government officials" on that old political footfall, incorporated registered representatives.  Publication on December 20 didn't exactly help, but it's not like anyone has been trying very hard to bring it to the industry's attention.  The CSA; the British Columbia, New Brunswick and Nova Scotia Securities Commissions; and l'Autorité des marchés financiers put notices about it on their Web sites, but only the AMF includes it in its list of matters out for public comment.

The consultation is noticeably absent from the Web sites of other securities commissions, not to mention those of the Investment Industry Association of Canada, which used to be a champion of the idea, and the Investment Industry Regulatory Organization of Canada, which in one of its former lives (as the IDA) actually passed a rule attempting to push the idea along. 


Comments are due by February 25.  A link to the consultation paper has been posted on the Regulatory Calendar page on our Web site


The consultation paper gives a high level history of the issue and how it has been dealt with by the Provincial securities regulators and the SROs.  We thought a slightly more detailed (and probably more opinionated) history worthwhile.
The desire of RRs to incorporate has long been a sore point in the industry, given on the one hand the widespread ability of other professionals to provide their services through corporations and the practice of most dealers of downloading expenses on the individual RR, and on the other the reluctance of some large dealers to see the development of an alternative business model that they are unwilling or unable to adopt but that might be attractive to some of their top producers.

The practice of paying commissions to the RR's corporation has been longstanding among mutual fund dealers. This reflects in part different historic business models, with mutual fund dealers more often having multi-faceted businesses including financial planning and insurance sales, sometimes carrying on business under the name of the RR's corporation. The creation of the MFDA resulted in more regulation of the mutual fund business, but the MFDA has as far as possible avoided forcing business model changes.

IDA members used to be almost exclusively brokers and dealers, but as the consequences of the collapse of the "four pillars" concept (separation of banking, securities, insurance and trust services) worked their way through the system, more dealers and RRs began to expand into the sale of life insurance and life insurance investment products such as segregated funds.  Some in dealer world also began to move away from the employer/employee model for RRs, downloading most of the costs of doing business to the RRs.  Meanwhile mutual fund dealers began migrating to the IDA to expand their product offerings.
At first the IDA opposed any movement away from the traditional employee/employer relationship between the dealer and the RR.  However, eventually it succumbed to the pressures of change and in May, 2003 began permitting "principal-agent relationships" through the implementation of By-law 39 (now IIROC Rule 39).  This got a fair way down the road in allowing willing dealers to structure their relationships with RRs in the most tax-efficient manner for the RR, but the benefits are still less than could be realized through an independent contractor or incorporated RR model.

An aside on the CSA Distribution Structures Position Paper

In case you wonder why the IDA did not at least try to go all the way with By-law 39, in August 1999 the CSA had published Notice 33-304: "CSA Distribution Structures Committee Position Paper,"  which is noted in the current consultation document. 
This was the most egregious of the attempts by securities regulators to rule by edict that we have decried in some of our recent commentaries.
The Distributions Structures Committee was formed in 1997 and published its report and recommendations for comment, to almost universal opprobrium.  Rather than responding to the comments and continuing with the normal rule making process, it just published the paper as a "Position Paper."
The "position paper" was something new to Canadian securities regulation, but this one was hardly a think piece.  The covering notice described it thus:
An important underlying principle of the Paper is that the positions put forward are intended to apply, subject to the observations below regarding Québec, to members of all existing and proposed self-regulatory organizations ("SROs"). The positions set out in the Paper are expected to form an integral part of the rules proposed by the new Mutual Fund Dealers Association ("MFDA"). The CSA intend to work closely with the MFDA and other SROs to implement the positions set out in the Paper.
In other words, rather than trying to pass its unpopular positions as rules, the CSA decided to do an end run on its own rule-making processes by foisting them on the SROs. It could do so because it already had a veto power over SRO rule changes.
Whatever you may think of that process, the MFDA and IDA had their marching orders on RR incorporation.  Here's what the Position Paper dictated: 
Dealer as principal and salesperson as agent: A principal and agent relationship between a dealer and a salesperson is acceptable provided that the following, and other conditions discussed in the Position Paper, are met: the dealer must be responsible for and supervise all of the activities of its salespersons that relate to the delivery of financial services, other than financial service activities subject to another regulatory regime.
Independent contractor: Salespersons will not be permitted to carry out their financial service activities on behalf of a dealer where they are acting as independent contractors.
Incorporation without registration: Subject to the discussion that follows concerning introducing and carrying dealer structures and service provider structures, salespersons will not be allowed to incorporate in order to conduct registerable activities and financial service activities that are not subject to another regulatory regime.
None of this was justified in the Position Paper by anything that could remotely be called analysis.  Instead, it listed some horrors that the Committee thought might result, with no assessment of the extent of the risks or what measures short of prohibition might be brought to bear to mitigate them.  We could go on much longer about the shortcomings of the "Position Paper" but won't, other than to observe that some of its positions - like limitations on referral arrangements - have since been abandoned in real rule changes. 

The IDA attempt


Not satisfied with half a loaf, after By-law 39 was approved the IDA established a committee to develop a rule that would permit RR incorporation.
The big hurdles in all this are liability and registration.

Any new business structures have to retain the current liability structure.  The registered individual is required to comply with business conduct rules and can be held liable for improper conduct both civilly and by regulatory penalty.  The registered firm is responsible for supervising its registered representatives and can be held liable for their misconduct.

However, in order to get paid for providing services, the RR's corporation has to provide the services.  Otherwise every salaried employee could just have his or her pre-tax salary paid to a corporation.  That's the problem with MFDA Rule 2.4.1 (see below), which specifically refers to: "payments in respect of business conducted by an Approved Person on behalf of the Member" (emphasis added).

Positioning a corporation as the party providing the services threatens to break the liability chain unless the corporation is registered - a process too long and horrible to contemplate unless a special registration class was created, which no one was willing to do. (Think of the costs to change NRD!!)
The proposed IDA rule sought to get around this problem.  While we won't go into details, the result had support from legal opinions on both the tax and liability issues.  What it did not have, and what the CSA seemed to want, was a legal opinion stating that there was absolutely no possibility that a single client could ever be discomfited for a single moment by a RR trying to avoid civil or regulatory liability by hiding behind his or her corporation.  Of course no one could ever give that kind of opinion because no one could stop a RR from trying, however feeble the attempt.

Initially the CSA stalled by throwing the issue into the Registration Reform Project, but eventually various members just decided to oppose the IDA rule and the proposal was withdrawn from consideration even as part of Registration Reform.   Feeble excuses about needing to change securities legislation (noted in the IDA rule proposal) ignored the necessity of making legislative changes that was already an integral part of Registration Reform.

The MFDA Rule
This brings us to MFDA Rule 2.4.1.  Originally it prohibited payment of commissions to a corporation, but its implementation had been suspended since the formation of the MFDA because of the amount of business restructuring it would cause.  The MFDA proposed changing it to permit MFDA members to pay the commissions of those RRs in principal/agency relationships with the dealers to corporations.
As discussions on RR incorporation carried on, some CSA members began to see the proposal to change MFDA Rule 2.4.1 as a compromise.  By approving it the CSA would demonstrate its willingness to be helpful, while maintaining that the obvious tax problems with the rule were not their business, tax policy not being their responsibility. 


Their minds were not even changed by a decision in the middle of all this (Boutilier v. The Queen, 2007 TCC 96 (CanLII)) that trailer fees paid to a mutual fund salesman's corporation by the dealer were income of the salesman and not the corporation and should be taxed accordingly.  The decision left some room for possible structures under which commissions or trailers could be paid to the corporation, but also declined to consider Provincial registration issues on the basis that the case could be decided on other grounds.

So some members of the CSA went ahead with approving MFDA Rule 2.4.1 and presented themselves as trying to accommodate the industry.  They weren't.


Meanwhile IIROC decided, quite rightly, that it had spent enough time on the issue, nor was it willing to go along with the MFDA approach, given the mayhem that could result if its members were suddenly held liable for withholding tax on payments made to RRs' corporations that should have been classified as personal income.


The consultation paper


The consultation paper doesn't suggest a solution; it just sets out three options:


1) An Alberta Securities Commission legislative proposal for a permit regime similar to that available for other professions in Alberta.  It would preserve the current liability and registration requirements while permitting services to be provided through a corporation that would require an annual permit from the securities regulator. Voting share ownership would be limited to registered persons; family members of the RR would be permitted to own non-voting shares. 


This seems to us to be a workable solution, although we wonder why it could not have been included in the Registration Reform proposals. 


The consultation paper notes:


We understand that provincial securities regulators have in principle no objection to permitting individual sales representatives of registered dealers and advisers to incorporate provided regulatory and accountability concerns are met.

The ASC proposal is said to date from 2008, long after RR incorporation had been yanked from the Registration Reform Project in 2005 and too late to get it back in.  So six years after the IDA proposal we are still back at square one. 

2) An Advocis legislative proposal based on insurance industry rules.  It would permit wider shareholding of the corporations through which the services would be offered.


3) Maintain the status quo for MFDA Members and permit IIROC to level the playing field by granting the same option to IIROC RRs, presumably limited to those in a principal/agency relationship to the dealer.


The paper notes that this last option doesn't eliminate the risk inherent in paying remuneration from services provided by a person to a corporation.  It fails to note that IIROC has up to now been (rightly we think) unwilling to go along because of those very risks.


The paper further notes that the first two options may solve the problem, but not Government revenue concerns.  Maybe so, but if revenue is such a problem, how about rolling back the benefits that physicians, lawyers, dentists and others now realize from being able to do what equally independent (from a business viewpoint) RRs can't.


The questions


The consultation paper asks the following questions, to which we present our answers for your consideration:


1. Should governments allow a broader range of registered dealers and advisers to redirect remuneration to a non-registered corporation?

No.  That's not a good solution because it ignores the tax risks.  Furthermore, there is no guarantee that IIROC will go along with it (nor should they).

2. Should governments allow individual representatives of registered dealers and advisers to incorporate?

Yes, in appropriate circumstances - i.e. where they are in effect acting as independent contractors, they should have the same business structure options as other professionals.  This does not mean incorporation is right (or should be permissible) for all or that investor protection needs to be compromised.


 3. If yes to question 2, which incorporation option would in your view be the most effective and balanced alternative?


We prefer the Alberta solution.  The Advocis suggestion involves more risk in that others than the registrant and his/her family could be shareholders, bringing unknown pressures to bear.  It would increase cost and bureaucracy through a vetting process.  We simply don't see the need of it. Allow some basic form of RR incorporation, which will solve the problems the initiative is meant to address.  A permit for the corporation can be a simple add-on to existing individual registration.

4. Are there other provisions or options that should be considered to ensure that the use of a corporation continues to preserve the registrant-client legal relationship for both firms and individual sales representatives and provides for proper oversight of individual sales representatives by their registered dealer and adviser?


The current IIROC rules on principal/agency relationships provide a number of protections through approved agreement requirements, such as access to books, records and premises owned by the agent.  Similar provisions need to be in place for incorporated salespeople.  They can probably be left to the SROs, provided that their rules are harmonized.  The CSA has the authority to approve or disapprove new rules and can therefore ensure that investor protections are in place.


5. Do you have any concerns or comments about potential income tax consequences or regulatory obstacles regarding each option?


We're not sure you can entirely eliminate them, since presumably CRA will continue to look at arrangements on a case by case basis and determine whether the RR, even if acting through a corporation, is in fact more an employee than an agent.  It would be helpful to get CRA on side.


(Another aside.  This points up one of the things little noted in all the blather about why our cumbersome Provincial securities regulation is such a great thing: there's no securities regulatory presence at the table when federal laws and regulations affecting the industry get made.  That's why we end up with inadequate provisions against securities crime in the Criminal Code, complicated and ineffective anti-money laundering regulations and not much of an idea about how CRA might view this effort.)

6. Do you have any concerns or comments about the potential impact of the incorporation options on investor protection?


We have noted some of the protections IIROC has included in its principal/agency rules and believe that similar provisions regarding incorporation can be implemented provided that the tax rules are met.  We would have a problem with just letting dealers pay commissions earned by RRs to their corporations because of the risk that adverse tax rulings would put financial pressures on representatives.


If this issue is of concern to you, Sutton Boyce Gilkes Regulatory Consulting Group can help you draft a comment letter.






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