On January 11, 2008, the Canadian Securities Administrators (CSA) published a revised version of National Instrument 23-102 Use of Client Brokerage Commissions as Payment for Order Execution Services or Research Services (the Instrument) as well as Companion Policy 23-102 CP (the Policy). The Instrument and Policy were originally published in July 2006 (the 2006 Instrument and Policy). [See Stikeman Elliott Securities Law Update of August 2006] In response to numerous comments received, the CSA has made substantive amendments to the 2006 Instrument and Policy by limiting the application of the Instrument, broadening the definition of permitted services that may be paid for by soft dollars and relaxing the disclosure requirements.
The Instrument and Policy seek to regulate soft dollars arrangements across Canada, stipulating the types of goods and services that may be acquired with brokerage commissions and prescribing related disclosure requirements. The Instrument and Policy apply to registered advisers, who obtain the goods and services, and to registered dealers, who accept the brokerage commissions.
2006 Instrument and Policy
The 2006 Instrument and Policy applied to all types of transactions where brokerage commissions or similar transaction-based fees were charged, and imposed duties on advisers to ensure that soft dollars were used to benefit the client and were reasonable in relation to the value of goods and services received. They further specified that the goods and services acquired using client brokerage commissions were restricted to "order execution services" and "research", and prescribed detailed disclosure requirements for advisers.
The 2006 Instrument and Policy were open for comments until October 19, 2006, and the CSA had stated that once adopted, there would be no phase-in period for advisers.
The CSA has identified four common themes emerging from the elicited comments:
- Concerns surrounding the application of the 2006 Instrument and Policy to principal transactions in securities where there was no independent pricing mechanism;
- A desire for the harmonization of requirements to the greatest extent possible with those in the UK and US, with a preference for US harmonization;Difficulties in meeting the disclosure requirements and questions of the usefulness of such disclosure to clients; and
- The lack of a transition period.
2008 Instrument and Policy
In its publication notice, the CSA identified five areas of substantive change between the 2006 Instrument and Policy and their current iteration: (i) the breadth of the application of the Instrument and Policy; (ii) definitions of order execution services and research services; (iii) the framework for client brokerage commission practices; (iv) disclosure of client brokerage commission practices; and (v) the addition of a transition period.
Application of the Instrument and Policy
The application of the Instrument and Policy has been narrowed. The Instrument applies to any trade in securities "for an investment fund, a fully managed account, or any other account or portfolio over which an adviser exercises investment discretion on behalf of third party beneficiaries, where brokerage commissions are charged by a dealer." The Policy clarifies that "client brokerage commissions" include commissions where the amount "paid for the security is clearly separate and identifiable", such as with exchange-traded securities or where an independent pricing mechanism exists that enables advisers to "accurately and objectively" determine the amount of commissions or fees charged. The rationale for this limitation stems from the practical difficulties in applying such obligations with respect to transactions where a mark-up is charged, such as principal transactions and certain over-the-counter trades. Advisers that obtain goods and services other than order execution in conjunction with transactions that don't fall within the application of the Instrument will still be subject to their fiduciary duties, but will not be able to rely on the Instrument to demonstrate compliance.
Definitions of Order Execution Services and Research Services
The Instrument requires that soft dollars only be used for order execution services and research services. While the definition of "order execution services" was not revised in the Instrument, the Policy provides a temporal standard, which would generally include goods and services provided or used between the point at which an adviser makes an investment decision (as opposed to "an investment or trading decision") and the point at which the resulting securities transaction is concluded. This amendment to the temporal policy is intended to clarify that to the extent that a good or service assists the adviser with determining the how, when or where to execute a transaction, the CSA would consider this to be part of the order execution process. Thus, order execution services may include post-trade analytics from prior transactions and order management systems, depending on their use.
While the CSA's temporal standard may differ from that of the US Securities and Exchange Commission (SEC), the CSA does not believe that the difference would cause a conflict with respect to the eligibility of specific goods or services, but may simply result in different categorizations of goods and services between the two jurisdictions.
The definition of research services now includes databases and software to the extent that they are designed to support research, and the Policy has reduced the focus on the characteristics of the research in favour of a greater focus on the use of the research services. Research services may now include publications marketed to a narrow audience and directed to readers with specialized interest, seminar and conferences fees and "market data from feeds or databases that has been or will be analyzed or manipulated".
The Policy states that goods and services that relate to the operation of an adviser's business rather than to the provision of services to an adviser's clients to be outside the scope of permitted goods and services. Examples listed in the Policy include office furniture, trading surveillance or compliance systems, portfolio valuation and performance measurement services, legal and accounting services and marketing services. The amendments appear to bring the CSA approach to research services closer to the standard of the SEC.
The Framework for Client Brokerage Commission Practices
The CSA has also reviewed the relationship between the use of goods and services and obligations to clients. To that end, the CSA has removed the requirement that research add value to investment or trading decisions. The requirement that the amount of brokerage commissions paid by clients for order execution services or research be reasonable in relation to the value of the services has also been changed. Instead, an adviser must make a "good faith determination" that the amount of client brokerage commissions paid is reasonable in relation to the value of the order execution services or research services received. The determination of reasonableness may be made either with respect to a particular transaction or the adviser's overall responsibilities for client accounts. Further, a service may benefit more than one client, and may not always directly benefit each particular client whose commissions were used as payment. Unsolicited goods or services that are not used by an adviser will not represent a violation of an adviser's obligations so long as the adviser does not include the unsolicited goods in his or her assessment of value received in relation to commissions paid. To the extent that an adviser uses unsolicited goods or services, however, the adviser should include these in the assessment of value received for commissions paid. The Policy states that advisers should have adequate policies and procedures in place to ensure that all clients whose brokerage commissions were used for the payment of goods and services received fair and reasonable benefit.
The Policy clarifies the meaning of "client" for reporting purposes as "the party with whom the contractual arrangement to provide advisory services exists." For an adviser to an investment fund, the client would generally be considered to be the fund. The Policy states that if the adviser is also the trustee or manager of the fund, or affiliated with the trustee or manager, the adviser should consider whether its relationship with the fund presents a conflict of interest under National Instrument 81-107 Independent Review Committee for Investment Funds, and whether disclosure should be made to the Independent Review Committee.
The CSA has increased the scope of the narrative disclosure required, while decreasing the scope of quantitative disclosure. Under the Instrument, the required narrative disclosure includes: (i) a description of the process for, and factors considered in, selecting dealers to effect securities transactions; (ii) a description of the nature of arrangements entered into; (iii) the names of dealers and third parties that provided goods and services other than order execution, and the types of goods and services provided, separately identifying each affiliated entity and the types of goods and services provided by each affiliated entity; (iv) the procedures for ensuring that over time all clients whose brokerage commissions were used as payment for goods and services have received reasonable benefit from such usage; and (v) the methods by which the overall reasonableness of commissions in relation to the order execution services or research services is determined.
The current draft of the Instrument, however, is more limited in its quantitative disclosure requirements, requiring (i) the disclosure of the total client brokerage commission paid by the client during the reporting period, and (ii) disclosure on an aggregated basis, where the level of aggregation has been determined by the adviser, of the total client brokerage commissions paid, along with a reasonable estimate of the portion of those aggregated commissions that represent the amounts paid, or accumulated to pay for, goods and services other than order execution.
The Policy states that the appropriate level of aggregation should be considered in order to provide a client with sufficient information regarding the use of client brokerage commissions. By way of example, for advisers that offer only private managed accounts, disclosure may be aggregated at the firm level, for others the disclosure may be aggregated by account type. More "granular disaggregation" can be provided in situations the adviser deems appropriate, such as in the case of a mutual fund, where it may be appropriate to disaggregate to the level of the particular mutual fund rather than across all funds. The CSA believes all advisers should also include firm-wide disclosure. The intention is to provide advisers with the flexibility to base their determination of the appropriate level of aggregation on their business structure and client needs. This should relieve advisers of some of the expected burden that would have been imposed by the 2006 Instrument and Policy.
In response to concerns regarding the lack of a transition period, the CSA has proposed a six month transition from the effective date of the Instrument and Policy.
Comments to the Instrument and Policy are requested by April 10, 2008. The CSA has also published in its corresponding notice a list of four questions for specific comment, addressing the following: the potential difficulties caused by the proposed temporal standard and its lack of consistency with US requirements, the requirement that the estimate of the aggregated commissions be split between order execution and other goods and services, the possibility of allowing advisers the option of following the disclosure requirements of another jurisdiction with similar requirements, instead of those proposed in the Instrument and Policy, and the length of the transition period. While no implementation date has been proposed, even assuming the CSA avoids publishing further amendments, we expect the Instrument and Policy would likely not be in full force until early 2009.