Exempt Market Dealers – A Regulatory Check-up

The Ontario Securities Commission ("OSC") recently released its 2013 annual review summary report for dealers, advisers and investment fund managers (the "Report").

The OSC regulates or oversees through recognized self regulatory organizations the activities of approximately 1300 registered firms and 66,000 individuals in Ontario.  The Report largely focuses on registrants directly regulated by the OSC: exempt market dealers ("EMD") portfolio managers and investment fund managers.

In this post, we summarize OSC findings in its compliance reviews of EMDs.

Know-Your-Client and Suitability

The OSC has focussed substantial resources on reviewing the know-your-client ("KYC"), know-your-product ("KYP") and suitability practices of EMDs.  Based on this review, the OSC is concerned that many EMDs are not adequately meeting their KYC, KYP and suitability obligations. The OSC identified the following key deficiencies:

  • failure to assess the suitability of trades and the sale of unsuitable investments, especially when there is a high investment concentration in issuers that are related or connected to the EMD;
  • insufficient KYP due diligence on new products;
  • improper reliance on the accredited investor exemption;
  • inadequate collection and documentation of KYC information; and
  • inadequate process for collection, documentation and maintenance of KYC information.

Issues Respecting UDPs and CCOs

EMDs are required to maintain a compliance control and supervisory system that complies with securities law. The ultimate designated person ("UDP") is responsible to supervise the compliance activities and to promote compliance.  The chief compliance officer ("CCO") is responsible for establishing and maintaining policies for assessing compliance by the EMD, and individuals acting on its behalf, with securities legislation.

The OSC has noted the following:

  • UDPs should ensure that adequate staff and resources are allocated to their firm's compliance function, taking into account the size, nature, complexity and risk of their business.
  • UDPs should communicate and reinforce to all staff that compliance with securities law is a firm-wide responsibility.
  • CCOs should ensure that they have an appropriate amount of involvement, time and resources to fulfill their responsibility to monitor and assess compliance with regulatory requirements.
  • Firms and their CCOs should perform ongoing self-assessments of their compliance with Ontario securities law and take action to improve their internal controls, monitoring, supervision and policies and procedures when necessary.
  • Firms should provide regular training to their staff so that they understand the firm's policies and procedures and applicable regulatory requirements.
  • Firms should consider engaging external legal counsel or a compliance consultant to provide advice on compliance, including making recommendations to improve the firm's compliance system.
  • CCOs should continuously educate themselves on compliance and regulatory topics, such as by attending compliance-focused seminars and participating in compliance officer associations.
  • Firms should appoint individuals to act as alternates in the brief absence of the CCO or UDP (such as during vacations).
  • Firms should keep detailed records of activities they conduct to identify compliance deficiencies and the actions taken to correct them.

Compliance Reports to the Board

The OSC notes that it continues to find cases where the EMD's CCO does not provide any annual report or only a perfunctory report to the firm's board of directors that assesses the firm's, and its registered individuals', compliance with securities law.

Failure to Provide Notice of Ownership Changes or Asset Acquisitions

EMDs are reminded to give notice of proposed ownership changes in, or asset acquisitions of, registered firms. The OSC notes examples of:

  • EMDs or registered individuals (including the UDP, CCO or dealing representative of the firm) that have acquired 10% or more of the securities of another registered firm, or their sponsoring firm, without first providing the OSC with the required notice;
  • EMDs or registered individuals that have acquired a security or securities in addition to the 10% or more securities that they already own without first providing the OSC with the required notice; or
  • EMDs that have not provided the OSC with the required notice as soon as the EMD knew, or had reason to believe, that 10% or more of its voting securities were going to be acquired by a non-registrant, including an officer, director, permitted individual or employee of the firm (barring exceptional circumstances, the OSC expects to receive notice of these transactions at least 30 days prior to the transaction taking place).

Inaccurate Calculations of Excess Working Capital

EMDs must meet their capital requirements to maintain registration in good standing.  To assist EMDs in correctly preparing their capital calculations, the OSC has listed below the common deficiencies identified in its reviews over the last year:

  • the amounts for current assets and current liabilities are accounted for on a cash basis instead of the required accrual basis;
  • inclusion in current assets of accounts receivable especially from related parties that are not readily convertible to cash;
  • inclusion of cash that is committed to serve specific purpose (e.g., collateral);
  • failure to add back 100% of long term related party debt to current liabilities if the debt is not subordinated;
  • failure to deliver a copy of subordination agreement to OSC;
  • repayment of  subordinated debt without prior notice to regulators;
  • if securities are listed among current assets, the appropriate market risk deduction was not calculated; and
  • form 31-103 F1 is not prepared at least monthly.

Conflicts of Interest when Selling Securities of Related or Connected Issuers

The OSC has significant concerns with EMDs that distribute the securities of related or connected issuers, particularly EMDs that solely distribute these types of securities. The significant deficiencies that the OSC identified include:

  • misappropriation of investor funds;
  • concealment of poor financial condition of the related or connected issuer;
  • sale of unsuitable, high-risk investments to investors; and
  • high investment concentration in the securities of a related or connected issuer.

The OSC comments that these deficiencies are in large part attributable to the lack of separation between the mind and management of the EMDs and their related or connected issuers, which gives rise to significant conflicts of interest. Investor proceeds are not being used in accordance with what has been disclosed to investors and in some instances are used to pay for the personal expenses of officers or directors or to satisfy obligations to existing investors. The OSC also identified the sale of unsuitable, high-risk investments, which form a high concentration of investors' portfolios.

The OSC has stated that EMDs should:

  • collect information from the individuals acting on their behalf regarding the conflicts they expect to arise with clients;
  • avoid conflicts of interest that are contrary to the interests of clients and where controls or disclosure are not appropriate responses to these conflicts; and
  • ensure their organizational structures, lines of reporting and physical locations will enable the firm to control these risks and conflicts of interest effectively.

Inadequate Disclosure of Conflicts of Interest

EMDs are not meeting their disclosure obligations where there is a direct or indirect relationship between the issuer or selling securityholder and the underwriter. An offering document must contain a statement on the front page of the offering document that summarizes the basis on which the issuer is a related or connected issuer of the EMD, as well as a cross reference to the applicable section in the body of the offering document where further information concerning this relationship is provided.

An EMD that trades in, or recommends the securities of, a related or connected issuer must provide specific disclosure about the issuer.

The OSC has stated that EMDs should:

  • draft prominent, specific, clear and meaningful disclosure about material conflicts of interest and explain how the conflict of interest could affect the service being offered;
  • avoid providing generic disclosure, giving partial disclosure that could mislead clients, or obscuring conflicts of interest in overly detailed or complex disclosure;
  • disclose conflicts of interest to clients before or at the time they recommend the transaction in question and keep evidence of this disclosure; and
  • update disclosure to clients about conflicts of interest, since previous disclosure may no longer be relevant to (or remembered by) the client.

Inadequate Risk Disclosure Information

Some EMDs do not deliver adequate, or any, risk disclosure information to clients before acting for them. This includes a description of the risks of using borrowed money to finance the purchase of a security and a description of the types of risks that clients should consider when making investment decisions. Registered individuals should spend sufficient time with clients to adequately explain the risk disclosure information that is delivered to them.

EMDs should:

  • present risk disclosure information in a clear and meaningful manner;
  • have policies and procedures in place that require their registered individuals to demonstrate that they have satisfied their obligations to adequately explain the risk disclosure to clients;
  • keep evidence of compliance with client disclosure requirements at account opening, prior to trades and at other required times (e.g., through detailed notes and signed client acknowledgements);
  • review relevant documents (e.g., KYC forms, term sheets and offering memoranda) regularly to ensure that they contain the required risk disclosure information, and
  • promote client participation, for instance by helping clients understand investment risks and encouraging them to review the sales literature and to consult with necessary professionals, including lawyers and accountants, where appropriate.

In upcoming posts, we will summarize OSC findings in its compliance reviews of portfolio managers and investment fund managers.

CCO compliance review conflicts of interest EMDs Exempt market dealers KYC KYP OSC risk disclosure suitability UDP



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