This commentary is of interest to all registered dealers.
CSA Requests Comments on Proposed Amendments to National Instrument
On June 25, 2010 The CSA published for comment the first set of proposed amendments to National Instrument 31-103: Registration Requirements, National Instrument 33-109: Registration Information and their related companion policies.
Comments are due by September 30, 2010 and are to be sent to:
John Stevenson, Secretary
Ontario Securities Commission
20 Queen Street West, Suite 1903, Box 55
Toronto, ON M5H 3S8
Me Anne-Marie Beaudoin
Autorité des marchés financiers
800, square Victoria, 22e étage
C.P. 246, tour de la Bourse
Montréal (Québec) H4Z 1G3
Fax : 514-864-6381
This is the first set of revisions to the Registration Reform Project rules implemented on September 28, 2009. At least one more set of amendments is already in the works.
A number of provisions of NI 31-103 take effect on September 28, 2010. There are also upcoming deadlines arising from the original rule; for example all firms registered as of September 28, 2009 must file a full Form 33-109F6, the revised registration application form for firms, by September 30, 2009. See our Regulatory Calendar at http://www.sbgregulatory.com/regulatory-calendar.html
Proposed rule changes
As with previous commentaries, we will note those changes that are welcome, those that we think make little difference and note only for information and those that we think are unwise. In relation to the last, we provide the reasons for our disagreement with the proposed changes.
Change of the date on which International Dealers and International Advisors must file the annual notice of their reliance on the exemptions from a year after their initial filing to December 1. A single date is more administratively efficient for all concerned.
- Change to the requirement for rewriting proficiencies. At present an individual is exempt from doing so if they have been registered for at least 12 months within the past 36 months. The 12-month requirement will be dropped so that registration in the relevant category at any time within the past 36 months will qualify an individual for the exemption. Having less faith in courses than the CSA, we support any reduction in the requalification requirements.
The proposed changes include a new subsection 3.3 specifying that an individual will not be considered to have been registered during a period of suspension. The basis for the exclusion is that the individual must have been registered and actively conducting business during the 36 month period.
Removal of requalification requirements for the Certified Financial Analyst (CFA) Charter and CIM designation, although we think there may be an argument for requiring only the courses necessary to get the charter or designation. There is an experience requirement to get the CFA Charter and those chartered are required to adhere to a code of ethics. While these are well and good, the CSA establishes experience requirements and behavoural regulations, so should not need to adopt the CFA Institutes in establishing a proficiency standard.
Substitution of "fair value" for "market value" in several places to facilitate the implementation of International Financial Reporting Standards.
- Extension of the grandfathering exemptions from proficiency requirements for CCOs and representatives of mutual fund dealers and exempt market dealers when the firm adds a jurisdiction.
- Exemption from the Canadian Securities Course (CSC) requirement for Chief Compliance Officers of portfolio managers and investment fund managers who have the CFA Charter.
- Removal of the Quebec exception in section 7.1(3), which permits mutual fund dealers to deal in labour-sponsored capital corporations.
- Removal of a limitation in section 8.6, which permits an adviser to distribute non-prospectus investments funds of which it is the adviser and investment fund manager, to its managed accounts. The limitation to non-prospectus funds will be removed, so that an advisers can distribute prospectus qualified funds (again, for which it is the advisor and IFM) to its managed accounts.
A new section 8.18(7) that clarifies that an International Dealer does not require adviser registration to give advice on a trade it can make under the International Dealer exemption.
Changes to sections 8.18 and 8.26 that clarify that a foreign dealer can rely on the International Dealer or International Adviser exemptions even though it is registered to perform other functions in Canada.
Clarification of how exemptions for SRO members from specific requirements work when the firm is dually licenced. The changes extend the exemptions for IIROC members to similar obligations that might fall on them when registered as investment fund managers. The exemptions for MFDA members are outlined for the relevant combinations of registrations, such as mutual fund dealer and exempt market dealer. Of course this all could have been avoided had the CSA followed through on its plan to eliminate or minimize dual registration, for example by permitting all mutual fund dealers to deal in exempt products.
Allowing SRO members to use the financial reports they file with the SROs in making required financial reports to CSA members.
Removal of the requirement for MFDA members, scholarship plan dealers and investment fund managers to find out if a client is an insider of a publicly traded issuer. The application of this section to those types of dealers never made sense given the types of securities they can trade and the types of activities an IFM undertakes. The change is supplemented by guidance in the companion policy respecting highly concentrated pooled funds.
Removal of the requirement for a dealer to notify clients outside of its home jurisdiction of its non-resident status, address for service and risks that legal rights may not be enforceable in the local jurisdiction, if the dealer has an office in the jurisdiction. While we approve of the change, we continue to think the whole requirement for Canadian firms is nonsense to start off with, so leaving it in place where the dealer does not have a local office is ridiculous. We await a single example from the CSA staff of a case in which a client was unable to enforce legal rights against a dealer in another province because of the dealer's non-residence.
A change correcting a drafting error in section 14.12(1) permitting a dealer, with the client's written permission, to send a confirmation to a registered adviser acting for the client instead of the adviser.
Requirements for investment fund managers to send confirmations of redemptions not ordered through a dealer and annual statements to clients for whom they are holding securities for which there is no dealer of record.
Specific mention in section 11,1 of the Companion Policy recognizing that a risk-based approach can be used in monitoring and supervision. There are various other changes in the section which seem to us to add little.
The Notice asks for comments on whether dealers should be required to include client name securities in monthly statements if the securities have been purchased through the firm. The discussion of the pros and cons is on Page 18 and is somewhat limited in scope. The questions asked, on page 19, deal with:
- To what extent would clients benefit?
- Would including the fair value of illiquid securities on statements be useful?
- In what circumstances does the present practice of having updates sent from the issuer to the dealer work?
- Other than collecting information from the issuer, how else could the dealer collect information on client name securities owned by the client?
- What changes would dealers have to make to include client name securities?
- When does the client relationship begin and end?
- Are there certain types of clients, products or transactions that should be exempted if client name holdings are required to be included on monthly statements. (The CSA already expects to exempt securities held in certificate form or delivered against payment to clients.)
The Notice does not deal at all with questions like insurance fund coverage. CIPF and IIROC permit dealers to send supplementary statements to clients showing client name securities, but they must clearly state that they are not official because anything not held by the firm itself is CIPF covered.
It is also a problem for for exempt market dealers, who do not hold client assets but would have to report on client name securities? Since EMDs often sell shares of private companies and other illiquid securities, they would have to value them at zero.
It also fails to give an explanation as to why any of this is necessary in the first place? What brought this up as a topic for consideration? Is there some evidence that clients are unhappy with what they get now? Those having client name mutual funds already get bombarded with material from the mutual fund companies. Do they need more?
This is a bad idea. If a dealer doesn't hold the securities itshould not have to report on them. Let dealers offer them as an extra service if they see client demand.
WHAT'S OF QUESTIONABLE VALIDITY?
A proposed addition to section 3.4 is supposed, according to the Notice and Request for Comments, to be "a requirement that the registered representative understand the structure, features and risks of each security the individual recommends to the client."
While the concept is unexceptionable, the actual draft requirement reads, in its tracked changes version:
An individual must not perform an activity that requires registration unless the individual has the education, training and experience that a reasonable person would consider necessary to perform the activity competently and to understand the structure, features and risks of each security the individual recommends.
Actual understanding and the ability or education to understand are two different things. And the proposed rule does not not even what say what is necessary, but what a reasonable person would consider necessary. Furthermore, the whole provision is redundant since it is impossible to make a suitability judgement without knowing the product. There is already a considerable amount of guidance on the topic, not least of all a CSA Staff Notice issued September 2, 2009. We suggest that at the very least this provision should be moved to the Suitability section, 13.3.
Elimination of dual registration
The proposed amendments will prohibit an individual for being registered to deal or advise with more than one registered firm. They continue to permit a dealing or advising representative to be an officer, partner or director of an affiliated firm.
This is a backward step, a return to the rules in some jurisdictions before NI 31-103. The rationale given in the Notice and Request for Comments is: "the conflicts of interest in such cases are generally too serious to permit an individual to be sponsored by different firms, and our intent is not to allow for such multiple registrations except in exceptional circumstances.
Amendments to the companion policy NI 31-103CP explain what those exceptional circumstances might be.
The current rule is permissive, but section 2.1 of the companion policy states that the regulators will not normally grant registration to trade or advise for more than one firm, even where the firms are affiliates, unless they are satisfied that:
- There are valid business reasons for the individual to be registered with both firms
- The sponsoring firms have demonstrated that they have policies and procedures adddressing the resulting conflicts of interest.
The proposed rule changes turn the same criteria around into two of the criteria for granting an exemption from the prohibition. The two new criteria are:
- The individual will have sufficient time to adequately serve both firms
- The sponsoring firms will be able to deal with the conflicts
What is the difference between the current rule and the proposed revision? We suspect that a main difference may be that there is a fee for an exemption but none for a decision to deny a registration application. Either decision is appealable.
However, in our view both the original rule and the proposed revision undercut the basic movement in NI 31-103's handling of conflicts of interest towards a more principles-based approach. This seems to be one area in which the CSA staff just can't let go of control. There are clear conflict of interest issues, but also clear requirements to have controls over conflicts. In most cases, one would suspect, no dealer wants one of its representatives going around directing investment dollars to an unaffiliated dealer. That makes it hard to discern what bogeyman the CSA is seeing in the issue.
The situations in which dual registration is sought are most likely to involve affiliates offering different services, for example dealers and their representatives providing advisory services to some clients through an investment dealer and discretionary management to others through an affiliated portfolio manager. Why this should be subject to an automatic prohibition is not made clear in the notice.
Furthermore, the addition of a decision criterion that the two firms must not only have policies and procedures regarding conflicts, but "will be able to deal with the conflicts" gives CSA staff another open-ended criterion for a decision. That provision is already in the companion policy, but at least there it is guidance rather than rule. How on earth will CSA staff decide whether a firm will or will not be able to comply with its policies and procedures? Proof of the pudding and all that...
Extension of the conflict of interest provisions in section 13.5 to IIROC members who have managed accounts
Section 13.5 restricts advisers from trading for their clients in the securities of "responsible person(s)" or their associates without the client's written consent. It also prohibits trades between the accounts of clients, including investment funds, and responsible persons or their associates or the accounts of (other) investment funds for with the adviser manages.
The proposed rule will extend these provisions to IIROC dealers handling fully managed accounts, on the grounds that even though they do not have to be registered as advisers, they should be held to the same standard.
While we agree with the principle, the application is fraught with difficulties. IIROC already has similar rules in place in its Rule 1300.19. The difference is in the definition of "responsible person," as follows:
- The IIROC definition does not include the dealer member itself. Instead, requirements refer to the dealer member itself, rather than in the class of "responsible persons."
- The IIROC definition of individual responsible persons is limited to those persons who are directly involved in managing accounts, or who formulate or are aware of investment management decisions.
The IIROC rule was designed to take account of the multiple operations of IIROC dealers. The 31-103 rule does not and will therefore have unfortunate consequences in the IIROC setting.
For example, because the 31-103 definition includes the dealer itself, a dealer will be prevented from conducting trades between proprietary accounts and managed accounts, even where the dealer might be willing to do so at a better price than is available in the market, for example in an illiquid stock. The provision would seem to eliminate the possibility of a managed account at a dealer buying securities from a firm underwriting or bought deal by the dealer.
Similarly, dealers will have to keep records of all issuers of which any of their partners, directors and officers are partners, directors or officers, no matter how remote they are from the investment management function, so as to get the client's permission to trade in those issues.
The IIROC rules were deemed to be sufficient when approved by the CSA. We don't believe that the proposed changes add anything useful, all the while threatening to complicate matters for IIROC dealers.
When it published the final NI 31-103 in July, 2009, the CSA promised that its removal of the sub-adviser exemption, which had appeared in the previously published version and which would have exempted unregistered sub-advisers who are registered in other jurisdictions, was temporary. Sub-advisers are exempt in Ontario under OSC Rule 35-502 but need to get specific exemptions in all other jurisdictions.
A year later we have amendments but no mention of the sub-adviser exemption. The need to get exemptions elsewhere than in Ontario is a significant waste of time and effort for all.
What happened to the promise?
WHAT'S POINTLESS (Noted for your information)
- The name of the instrument - NI 31-103: Registration Requirements and Exemptions - is to be changed to NI 31-103: Registration Requirements, Exemptions and Ongoing Registrant Obligations. But, we suppose, why be brief and to the point if you can avoid it.
- Removal of a specific section permitting mutual fund dealers in British Columbia to trade in scholarship plans, harmonizing the rule with the rest of the CSA because only MFDA members who are also registered as scholarship plan dealers actually trade in scholarship plans. It harmonizes the rule but is being done only because no one is affected.
- Removal of subsections (e) and (f) of section 8.18, which gives details of the types of trades in which foreign dealers can rely on the International Dealer exemption, as theye are redundant of subsections (a) through (c).
- Change of the exemptions for International Dealers in section 8.18(3)(d)(ii) (and the corresponding provision of section 8.26 for International Advisers) enabling them to deal with permitted clients, to limit the exemption to Canadian permitted clients . This limitation is redundant because foreign dealers can deal with foreign clients without benefit of an exemption under 31-103, not to mention the exemption being granted anyway in the next sub-paragraph.
- Changes to the notice that International Dealers must give to clients under sections 8.18(4) and International Advisers must give clients under section 8.26. Frankly, we don't see much in the way of added clarity in the reformulation.
- A somewhat bewildering wording change to section 8.26(4)(d) regarding the calculation of an International Advisor's aggregate consolidated gross revenue, no more than 10% of which can be derived from Canadian business in order to use the exemption. The current rule is abundantly clear that it is based on revenue during the most recently completed fiscal year. The new wording replaces "during" with "as at," supposedly clarifying that the calculation is to be done at the end of the year rather than on an ongoing basis during the year. We wonder how you calculate revenue "as at" a particular date without specifying the period within which the revenue was generated.
- Extension to MFDA members of the exemption already given to IIROC members from a prohibition on lending to customers. MFDA rules already prevent this except, as the notice notes, in limited circumstances, so the exemption does not really change anything except in limited circumstances.
- Exemption of SRO members from the complaint handling requirements of section 13.15. This is unnecessary because the SROs have rules that make their members compliant. At one time one of the drafting principles for 31-103 was not to add exemptions that were unnecessary because SRO rules were consistent with and therefore forced compliance with NI 31-103; an exemption was needed only because of necessary inconsistencies such as those related to the more elaborate IIROC suitability regime. That approach has apparently gone by the boards.
- Clarification of the non-application of rules to Quebec mutual fund dealers who comply with Quebec's mutual fund dealer regulations. (We could talk about harmonization, but this commentary is already long enough.)
- Clarification on designation of a UDP. We fail to see how the revised version is any clearer than or adds anything to the rule. Perhaps the CSA just prefers a "must" formulation to a "must not...unless," which we can support.
- Various changes to the referral arrangements section that eliminate any direct involvement in the referral agreements by registered individuals, but appear to us to accomplish nothing of any consequence.
- Replacement of the possible subjects for independent dispute resolution from matters relating to trading or advising to a laundry list of complaints such as breach of confidentiality or personal financial dealings with a client. We are unsure what in the laundry list wouldn't have been included under the existing rule, except perhaps personal financial dealings with a client. That in and of itself opens a whole realm of possible situations which rightly don't belong under the rule. Could a bank demand to use arbitration to recover on a bad loan to a representative who happened to handle an account for the bank when the loan was made? However, given the low likelihood of most of the situations we can imagine, we don't list it as a proposal to disagree with.
If these issues are of concern to you, Sutton Boyce Gilkes Regulatory Consulting Group can help you draft a comment letter.