Dealers who place clients in related investments should ensure that their holiday reading list includes the recently released CSA Staff Notice 31-343 Conflicts of Interest in Distributing Securities of Related or Connected Issuers. The Notice sets out concerns of the staff of the Canadian Securities Administrators (CSA) regarding the conflicts of interest they consider are inherent when registrants trade in or advise on securities of related and connected issuers. CSA staff have zeroed in on firms that are registered solely as exempt market dealers and distribute securities of related or connected issuers, where the mind and management of the dealer and the issuers (and/or their managers) are one and the same. CSA staff refer to these dealers as captive dealers. The Notice identifies the compliance issues that CSA staff have found raised by captive dealers who have been the subject of compliance reviews and initial registration applications, and provides staff guidance on acceptable (and unacceptable) practices to address the conflicts and compliance issues.
The CSA's concerns with captive dealers
According to CSA staff, the business model of captive dealers creates an inherent material conflict of interest between the captive dealer's financial incentive to sell its related or connected issuer's securities in order to be profitable, and its regulatory obligations, including know-your-client, know-your-product and suitability obligations, and its duty to act fairly, honestly and in good faith with clients. CSA staff explain that they consider that many captive dealers have been deficient in the way they manage and address conflicts of interest and have failed to adequately satisfy their KYC, KYP and suitability obligations. The Notice makes it clear that CSA staff regard these failures as significant compliance deficiencies. The CSA have taken regulatory action against registrants and issuers as needed, including suspension and referrals to enforcement.
Although the Notice expressly focuses on captive dealers, CSA staff suggest that other registrants should consider the conflicts inherent in distributing related investments, even when those dealers are registered in other capacities and have other business activities. Given the far reaching nature of some of the acceptable practices suggested in the Notice, we recommend that all registrants be cognizant of the Notice and CSA staff's concerns, but also be reminded that the practices suggested by CSA staff arose out of a perceived need to alleviate very specific and often egregious compliance practices of the captive dealers reviewed by staff, which are not considered to be wide-spread in the investment management industry. Registrants must be familiar with the regulatory requirements that apply to them, and should consider guidance from CSA staff, but the ultimate decision on what practices and internal controls to adopt in order to comply with applicable law, is that of each registrant depending on its specific facts and circumstances. We caution against reading too much into the guidance provided in the Notice, particularly in the absence of the compliance issues and business structures identified in the Notice.
Steps a captive dealer should consider
A registrant who would fall within CSA staff's concept of a captive dealer should review its policies, procedures and controls, on a priority basis, to determine whether it would meet the CSA's expectations including the following:
- Decision-making roles in related or connected issuer business and captive dealer business should be separated;
- Policies and procedures should describe, in detail, how conflicts of interest are identified and addressed;
- KYC, KYP and suitability assessments should be fully documented, for instance by keeping a due diligence checklist and documents that demonstrate review of key documents;
- Captive dealers should consider having what the CSA refer to as "independent review committees" to, among other things, review policies and procedures to ensure they address conflicts of interest, KYC, KYP and suitability obligations, and the captive dealer's duties to its clients. The independent review committee could also conduct reasonable due diligence on related or connected issuer securities, and identify those securities that pose too severe a conflict of interest to be distributed generally and consider whether trades in such securities should be restricted to certain investors or classes of investors only;
- Clients should be provided with meaningful, clear, and plain language disclosure regarding related or connected issuer investments, including providing a simplified document to clients (for example, a document similar to the fund facts document used by public mutual funds);
- A responsible individual (such as the chief compliance officer or ultimate designated person of a firm), who has not been directly involved in any way with trades in question, should be assigned to ensure that investors understand the relationship between the captive dealer and the related or connected issuer, the key features of the investment and the concentration risks associated with investing in a limited number of related or connected issuers;
- Staff training is recommended to ensure that registered individuals and other relevant staff understand the nature of the conflicts of interest inherent in the business model and the importance of avoiding, managing and/or disclosing them.
CSA staff also suggest that it may be helpful to consider enlisting unrelated dealers to distribute securities of a captive dealer's related or connected issuers, which would help in demonstrating to CSA staff that a third party has reviewed the investments and found them suitable for distribution. Captive dealers should also consider recommending investments other than those of related or connected issuers, as CSA staff consider that investment diversification is an important factor to help reduce financial dependence of the captive dealer on a related or connected issuer.
In compliance reviews, CSA staff will focus closely on whether captive dealers have implemented the above practices. Firms should be able to demonstrate compliance with these expectations, or be ready to explain why they have not adopted the practices and why the alternative practices they follow are sufficient to deal with the conflicts of interest.
CSA staff will also be looking very carefully at applications for registration by new firms with a business plan that would suggest that the firm would be a captive dealer, and will focus on an assessment of the likelihood of harm to investors and the capital markets. For example, registration may not be granted where the applicant proposes to distribute securities of a related or connected issuer whose financial statements raise concerns about its financial viability. CSA staff's review will also include an assessment of the captive dealer's business plan, both in the short term and longer term, and its policies and procedures manual to test if it has an adequate compliance system in place to control and/or disclose conflicts of interest.
The Notice signals CSA staff's current focus on ensuring appropriate investor protection, particularly in the exempt market-place, as well as appropriate standards of conduct by registrants.