On September 14, staff of the Compliance and Registrant Regulation (CRR) Branch at the Ontario Securities Commission (OSC) published their Annual Summary Report for Dealers, Advisers and Investment Fund Managers (Report). The OSC encourages registrants to use the Report to learn more about recent and proposed regulatory initiatives, the OSC’s expectations for registrants, and how staff interpret initial and ongoing requirements for registration and compliance. Although we hope you find our takeaways from the Report useful, the discussion below doesn’t replace the Report or consultation with your counsel about the Report’s implications for your business.
A. Focus Areas for 2020-21 Compliance Reviews
Staff expect their upcoming compliance reviews to prioritize the following areas:
- COVID-19 impact on registrants;
- Complaint-handling processes;
- Suitability assessments, including concentration;
- Review of some firms to confirm their level of operational activities; and
- Marketing practices, including environmental, social and governance (ESG) offerings.
During the Portfolio Management Association of Canada’s Fall Regulatory and Compliance Webcast on September 24, a CRR staff member indicated that they expect the marketing practices sweep to begin shortly, either in late October or in November.
AUM Law’s focused and general compliance risk assessments can save you time and money by enabling you to pro-actively identify and address issues before they flare up into problems or you are audited by the OSC. But if the OSC calls you for an audit before you call us, we can conduct a strategic and expedited “911” review, so that you can begin identifying and addressing any material issues and are better-positioned to make a good first impression with OSC staff in the initial meeting. Contact us to learn more about these services.
B. Spotlight on Compliance Deficiencies
In 2019-20, CRR staff conducted compliance reviews in the following areas, among others:
- A suitability sweep of exempt market dealers (EMDs) and portfolio managers (PMs);
- High-risk firms identified through the 2018 Risk Assessment Questionnaire (RAQ) or the “Registration as a First Compliance Review Program”;
- Desk reviews of firms reporting financial statement losses in their 2017 and 2018 audited annual financial statements;
- Desk reviews of U.S.-based firms relying on the international dealer, international adviser, and/or non-resident investment fund manager registration exemptions (International Exemptions Review);
- Investment fund managers (IFMs) that had recently acquired or purchased assets of another IFM; and
- IFMs that are members of a self-regulatory organization (SRO).
As usual, the Report includes aggregate data on the type and severity of compliance deficiencies identified during last year’s reviews. The largest number of deficiencies related to compliance systems (40%, up 2% from 2018-19), and there was a tie for second place. Know-your-client (KYC), know-your-product (KYP) and suitability matters tied with client reporting matters, with each category representing 13% of deficiencies identified during the past year’s reviews. The largest number of significant deficiencies in 2019-20 concerned compliance systems (9%), KYC/KYP/suitability (8%), and conflicts of interest/referral arrangements (7%).
As they have in the past few years, staff organized their discussion of compliance deficiencies by theme. Below, we have highlighted topics that we think will be of particular interest to our readers.
1) Compliance Function
Some Annual Compliance Reports Got “Needs Improvement” Grades: Staff noted that chief compliance officers (CCOs) at some firms failed to prepare annual compliance reports, as required by section 5.2 of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) or prepared cursory reports that didn’t contain enough detail to support the CCO’s assessment of the firm’s compliance function and/or the firm’s and employees’ compliance with securities legislation.
Service Provider Oversight: CRR staff are continuing to see situations where IFMs are performing little to no oversight of their outsourced fund administration and portfolio functions, or of their custodian. Common deficiencies included failures to:
- Obtain and evaluate a Service Organization Controls (SOC) report, when one was available from the service provider;
- Document and maintain evidence of the specific monitoring activities performed;
- Periodically validate the accuracy of prices used by the service provider in portfolio valuation; and
- Review material and complex corporate actions to confirm they were accurately processed and recorded by the service provider.
2) KYC, KYP and Suitability Obligations (EMDs / PMs / SPDs)
The good news is that, in this year’s suitability sweep, CRR staff generally saw improvements in firms’ KYC and suitability processes, compared with prior years’ reviews. However, they are continuing to see deficiencies in some areas, including:
- Inadequate collection and documentation of up-to-date KYC information;
- Inadequate documentation of suitability assessments (e.g. failure to document how a product that did not align with the client’s investment objectives nevertheless was suitable when other components of a client’s profile were considered);
- Managed accounts with portfolios that didn’t align with the client’s target asset mix reflected in their KYC documentation;
- Clients over-concentrated in a single issuer/issuer group or industry/asset class;
- Advisers and dealers not considering a clients’ total holdings of illiquid securities when assessing concentration risk;
- Inappropriate use of client-directed trade instructions (e.g. firms requesting such an instruction instead of conducting a suitability assessment first);
- Non-compliance with investment limits under the offering memorandum (OM) prospectus exemption;
- Inadequate documentation to support the determination that investors qualified as “accredited investors”; and/or
- Relying on third parties to collect KYC information for some clients without an advising representative (AR) or dealing representative (DR) of the firm meeting or speaking with such clients directly.
KYC and suitability obligations remain an area of ongoing concern for securities regulators. AUM Law can conduct a focused review of your client-facing documentation, policies and procedures and then help your firm can make any changes needed to comply with existing laws and implement the changes required by the client-focused reforms (CFRs) by the December 31, 2021 deadline. Please contact us to discuss how we can help.
3) NOT Now – Internal Firm Suspensions Require a Notice of Termination (All)
A firm that internally suspends a registered or permitted individual must file a Notice of Termination (NOT), so that the regulators and the public (through the NRD database). Firms that do not file a NOT, as required, run the risk of being held responsible for any registerable activity the individual conducts, even while under a firm-imposed suspension.
Staff indicated in the Report that some firms have been reluctant to file a NOT due to concerns that having the individual reinstated will be time-consuming. To address that concern and encourage firms to file NOTs as required, CRR staff have committed to a streamlined review process for assessing an individual’s suitability for registration after a firm-imposed suspension. In particular, CRR staff will permit firms to file Form 33-109F7 Reinstatement of Registered Individuals and Permitted Individuals (instead of Form 33-109F4) and will not require a new application fee, if certain criteria are met, including the following:
- The firm notifies staff in advance of the issue that led to the suspension;
- Staff is satisfied with the remedial actions that the firm has indicated it will take;
- The firm files a timely NOT;
- The firm notifies staff at least five business days in advance of its intention to reinstate the individual;
- There is no new detrimental information from the time the NOT was submitted; and
- There are no changes to information previously submitted in items 13 through 16 of Form 33-109F4.
AUM Law can advise you on, prepare and complete registration-related filings such as NOTs, as required. Please contact us if you have questions about or need assistance with matters like these.
4) Cross-Jurisdictional Registration Issues
Servicing Non-Ontario Clients without Required Registration (PMs / EMDs): According to the Report, Staff continue to see firms and representatives who do not have the required registrations in the relevant jurisdictions to trade in, or advise on, securities for clients outside Ontario. For example, some firms and/or their representatives are purporting to rely on the client mobility exemptions for Canadian clients without satisfying the criteria for those exemptions. Staff encourage firms to, among other things:
- Take an inventory of the residency of the firm’s existing clients;
- If the firm determines that any of its clients are located in jurisdictions where the firm and/or its registered individuals are not registered and do not have a valid exemption to rely upon, take immediate steps to come into compliance or discontinue the offering of any advisory or dealing services to the relevant clients;
- Train employees on the limitations of conducting dealing or advising activities in other jurisdictions;
- If applicable, take adequate steps to confirm that all requirements to rely upon the client mobility exemption are met (including verifying that the individual and firm do not exceed the allowable number of eligible clients in each jurisdiction and submitting Form 31-103F3 Use of Mobility Exemption to the regulator in the relevant jurisdiction); and
- Maintain adequate records for all of the above.
International Firms with Canadian Clients (EMDs / IFMs / PMs): During its International Exemptions Review, staff found that some firms had not filed up-to-date forms with the OSC to properly rely on the exemption and/or did not always provide clients with the required disclosure (or maintain evidence that the disclosure was provided). In addition, some international advisers had not maintained sufficient evidence to demonstrate that the advice being provided to Canadian clients with respect to Canadian securities was incidental to the advice being provided on foreign securities. Also, CRR staff noted that some firms, who were providing advisory services to permitted clients registered as advisers in Canada, were improperly purporting to rely on the international adviser exemption in section 8.26 of NI 31-103, instead of complying with the exemption criteria for international sub-advisers in section 8.26.1.
Please do not hesitate to contact us if you need advice or assistance regarding the application of Canadian registrant regulation requirements to your cross-border activities.
5) Distribution of a Registered Firm’s Own Shares (EMDs / PMs)
The Report discusses two compliance issues arising from situations where registered firms distribute their own shares to investors. First, staff reiterated that, even where the firm is relying upon a prospectus exemption to effect the distribution, the firm still must comply with its registrant obligations (e.g. relating to KYC and suitability) in connection with the distribution.
Second, staff emphasized that when firms distribute their own shares to existing and prospective clients, the resulting relationship is one that presents the highest degree of conflict of interest recognized by National Instrument 33-105CP Underwriting Conflicts (NI 33-105). In such situations, it is unclear if the firm is acting in the capacity of an issuer or, as a registered firm, by advising or recommending an investment in the firm’s shares to its existing clients (either as a PM through a managed account or as an EMD). In addition, this business model could create the perception that investors who are clients might be favoured over non-investor clients (e.g. with respect to access to proprietary information or the allocation of investment opportunities). The Report outlines steps that firms can take to respond to this conflict. Among other things, staff recommend that firms:
- Disclose and explain the conflict to potential investors and obtain an appropriate acknowledgement from them;
- Disclose all risk factors relating to the investment in the firm;
- Advise potential investors to seek independent advice regarding the investment and provide all information needed for such advice; and
- Develop and implement appropriate policies and procedures to, among other things:
- Identify and address all related conflicts of interest;
- Address the fair allocation of investment opportunities among clients; and
- Prohibit sharing of the registered firm’s business information with shareholders of the firm that are also clients, in a manner that might prejudice other clients.
6) Captive Dealers (EMDs)
Staff reminded EMD-only firms that distribute securities of a related or connected issuer with common mind and management (Captive Dealers) that they must adequately respond to the material conflicts that arise in this business model. The EMD’s financial incentives to sell its related or connected issuer’s securities may come into conflict with its regulatory obligations, such as those concerning suitability and fair dealing. Staff recommend that Captive Dealers, among other things, to assign a responsible individual, such as the CCO or ultimate designated person (UDP), who has not been directly involved with the trade in question, to confirm that investors understand:
- The relationship between the Captive Dealer and the related or connected issuer;
- The investment’s key features; and
- The concentration risks associated with investing in a limited number of related or connected issuers.
Staff also encourage Captive Dealers to ensure that the relevant employees have been trained to explain the nature of the material conflicts of interest inherent in the business model and the importance of avoiding, managing and/or disclosing them and understand their KYC, KYP and suitability obligations.
7) Financial Conflicts of Interest (All)
Staff identified certain financial conflict of interest situations such as the payment of consulting fees or placement fees to registered firms by companies that the firms’ funds or managed accounts invested in and where the conflict of disclosure to clients was non-existent or inadequate. According to staff, if a registered firm is paid by issuers of securities that it recommends to its clients, it should:
- Structurally segregate its corporate finance business from its advisory business and implement internal information barriers;
- Enhance its monitoring controls over clients’ suitability assessments;
- Fully disclose the issuer relationships and compensation arrangements in offering documents and account opening documents;
- Disclose all conflicts of interest in the relationship disclosure information (RDI) required by section 14.2 of NI 31-103;
- Provide clear and meaningful disclosure in plain language about the nature and impact of each conflict; and
- Obtain the client’s written acknowledgment that they understand the nature and impact of each disclosed financial conflict of interest before selling the product or service to them.
8) Inappropriate Reliance on Custodian to Satisfy Account Statement Delivery Obligations (PMs)
Staff reminded PMs that they cannot meet their statement delivery obligations by relying solely upon their custodian to deliver position and transactional information to clients. If a PM has entered into a service arrangement with a dealer member (DM) of the Investment Industry Regulatory Organization of Canada (IIROC), the PM can satisfy its obligation to deliver statements to a client if that client’s DM, acting as custodian, sends a DM statement to the client, provided that the PM:
- Does not hold any of the investments it manages for the client;
- Verifies that the investments it manages for the client are held in a separate account for the client where the DM knows the client’s name and address;
- Discloses the service arrangement to the client in accordance as called for by Section 3 of CSA Staff Notice 31-347 Guidance for Portfolio Managers for Service Arrangements with IIROC Dealer Members;
- Confirms that for each of the client’s accounts at the DM, a DM statement is delivered to client at the required frequency with the required content;
- Takes reasonable steps to verify that the DM statements are complete and accurate;
- Complies with client requests or agreements to receive PM statements from the PM, supplemental to the DM statement; and
- Verifies that the market value data it uses to prepare the client’s annual investment performance report is consistent with the data in the relevant DM statement delivered to the client.
Staff also note that PMs should maintain their own records of clients’ investment positions and trades, including evidence to support reconciliations between their records and the DM’s statements and establish policies and procedures to verify that DM statements are complete, accurate and delivered on a timely basis.
9) Trade Confirmations for Managed Accounts (PM / EMD)
The Report addresses a frequently asked question about whether a firm registered as an EMD, IFM and PM must send trade confirmations to its managed account clients for each purchase or sale of a security of a proprietary fund where the firm also acted as the registered dealer for the trade. According to staff, since the firm is already subject to obligations as a PM when it purchases the security on behalf of the managed account, there are no additional obligations that apply if it conducts the trades through its dealer registration. Provided that the managed account client consented not to receive trade confirmations for each transaction in the account, staff would not expect the firm to provide real time trade confirmations.
10) Other Deficiencies
We’ve briefly summarized below some additional staff recommendations and commentary that we think our readers may find relevant.
Custodial and Prime Brokerage Agreements (IFMs): CRR staff reminded IFMs that they need to have written agreements in place between the prospectus-exempt funds managed by them and the funds’ custodian and/or prime broker.
Funds Purchasing Securities from “Responsible Persons” (IFMs / PMs): According to staff, some registered advisers have been selling securities owned by the adviser’s firm to an investment fund managed by the adviser, contrary to the prohibition in paragraph 13.5(2)(b) of NI 31-103 on advisers knowingly causing investment funds they manage to purchase securities from a “responsible person”. Staff emphasized that firms should have policies, procedures and pre-trade controls to identify prohibited transactions like these and prevent them from occurring.
Impact of IFRS 16 on Working Capital (All): Some firms are not applying IFRS 16 Leases correctly, or at all, which has resulted in some firms incorrectly calculating their excess working capital balances. In some cases, this resulted in the firm being capital-deficient.
Insurance Coverage (All): Firms should check that their coverage is adequate, that bonding policies provide for a double aggregate limit or full reinstatement of coverage, that claims of other entities covered under a global policy do not reduce limits or coverage available to the registered firm, and that the registered firm should have the right to claim directly against the insurer for losses under a global policy.
Personal Trading (All): CRR staff are continuing to see deficiencies in firms’ personal trading policies and procedures. Identified deficiencies included inadequate policies and procedures, failures to enforce the firm’s policy, failing to maintain complete information on the person trading accounts of all “Access Persons”, and failing to require written pre-approval of Access Persons’ trades.
C. Regulatory Actions – Conduct Concerns During the Registration Process
The Report also includes data on CRR regulatory actions, including data comparing the different kinds of regulatory actions taken in the past five fiscal years. In addition to providing an overview of all regulatory actions concerning registrants, this year the Report highlights CRR staff’s approach to handling conduct concerns that arise during the registration process.
CSA Guidance Has Helped: Staff discussed the decrease since fiscal 2018 in the number of regulatory actions involving denial of registration. They believe that the 2017 publication by the Canadian Securities Administrators (CSA) of Staff Notice 33-320 The Requirement for True and Complete Applications for Registration (SN 33-320) has provided helpful guidance to firms conducting due diligence on the individuals they’re sponsoring and deterred some non-disclosure by registrants. Staff have also been conducting early-stage conference calls with firms where concerns have been identified, which has led to firms reviewing and, in seventeen cases in fiscal 2020, withdrawing applications that otherwise might have resulted in denial of registration.
Non-Disclosure in Registration Applications Is Still a Problem. Nevertheless, CRR staff are continuing to identify material non-disclosure of regulatory, criminal and/or financial information in registration applications, and this concern still constitutes a substantial number of the cases reviewed by CRR where registration is ultimately denied.
How Staff Handle Conduct Concerns in Registration Process: The Report includes a flow chart outlining the typical process CRR staff follow if a Registration Team refers a matter to the Registrant Conduct Team for investigation. According to the flow chart:
- CRR management will share their initial regulatory concerns with the firm.
- The Registrant Conduct Team will take steps that may include interviewing third parties who may have relevant information, as well as the individual applicant.
- If the Registrant Conduct Team recommends that an application be granted subject to terms and conditions or that the application be refused, the applicant will be given an opportunity to be heard (OTBH), except in the rare situation where the matter is referred to the OSC’s Enforcement Branch.
- Before an OTBH commences, the applicant can accept the proposed terms and conditions if the sponsoring firm agrees. If the OTBH goes forward, the Director of CRR will make a decision and give written reasons. If the Director refuses the application or grants it subject to terms and conditions, the applicant can ask an OSC panel to review the Director’s decision.
AUM Law has extensive experience helping firms get their employees prepare a strong application package and engage with regulators should any challenging situations arise. Please contact us to discuss how we can help.
D. Policy Initiatives
As usual, the Report summarizes certain policy initiatives affecting registrants and provides links to the relevant publications. This year, the Report covers:
- Burden reduction initiatives (see our bulletin article here);
- A status update on the client-focused reforms (see our bulletin article here and our recently updated publication In a Nutshell: Implementing the Client-Focused Reforms);
- Crowdfunding (see our bulletin article here); and
- Syndicated mortgages (see our article on the most recent developments here).
If you would like to discuss the themes highlighted in our article above or any other aspect of the Report and its relevance for your business, please do not hesitate to contact us.
September 30, 2020