On September 23, the Ontario Securities Commission released OSC Notice 33-736 – 2011 Annual Summary Report for Dealers, Advisers and Investment Fund Managers. While the report was prepared by the OSC’s Compliance and Registrant Regulation Branch (the Branch) to assist dealers, advisers and investment fund managers in complying with Ontario securities laws, it provides useful guidance for registrants and applicants for registration in all Canadian jurisdictions. The report primarily covers the OSC’s 2011 fiscal year and (i) reviews recent developments in light of the new registration regime; (ii) considers Canada’s response to global financial developments, including with respect to OTC derivatives regulation and the potential systemic risks posed by hedge funds; (iii) discusses the OSC’s recent focus on registrant misconduct; (iv) provides information for firms and individuals applying for registration by, among other things, identifying common deficiencies in registration applications and providing corresponding guidance; and (v) identifies trends in deficiencies and suggested practices for registrants, advisers, investment fund managers and dealers based on ongoing compliance reviews.
Common deficiencies from registration applications
Of particular interest for firms and individuals applying for registration is the information regarding deficiencies commonly found in applications for registration. The report notes that the processing of an application for registration may be delayed due to inadequate detail. Accordingly, applicants would be well advised to carefully review the Branch’s findings prior to submitting registration applications.
The report categorizes specific deficiencies by form, including: (i) Form 33-109F6 Firm Registration, where insufficient information may be provided regarding such things as proposed business activities, ownership and bonding and insurance; (ii) Form 33-109F5 Change of Registration Information, where sufficient details of the relevant change are not always provided; (iii) Form 33-109F4 Registration of Individuals and Review of Permitted Individuals, where deficiencies include insufficient evidence of proficiency and incomplete information regarding previous employment and other activities; and (iv) Form 33-109F5 Change of Registration Information, where the report notes that the OSC is often not provided notice when an individual becomes a shareholder of his or her sponsoring firm.
During the course of the year, the OSC also conducted compliance reviews of selected registered firms to assess compliance with Ontario securities laws. The outcomes of the reviews ranged from enhanced compliance, which consists of the OSC issuing a report to a firm identifying areas requiring corrective action (31% of firms reviewed), to enforcement branch referral where serious breaches of securities laws were identified (9% of reviewed firms). Between the extremes were firms requiring significantly enhanced compliance, which involves an enhanced monitoring regime (57% of firms) and the imposition of terms and conditions on registration (3% of firms).
The report also discusses the various deficiencies identified by the compliance reviews and provides guidance in addressing these issues.
All registered firms
Excess working capital
According to the report, some firms are not calculating excess working capital accurately on Form 31-103F1. Specifically, current assets that are not readily convertible into cash, such as prepaid expenses and security deposits with service providers should be excluded from the calculation. The report also expresses concerns with respect to accounts receivables that are not readily convertible to cash, especially those from related parties. According to the report, any receivables that are not convertible to cash in a “prompt and timely manner” should be excluded from the calculation of excess working capital.
Inadequate insurance coverage
The report also cites the fact that some registered portfolio managers and investment fund managers fail to maintain an adequate amount of insurance coverage over their clients’ assets as assets increase during the year. The report therefore recommends that registered firms, in determining an adequate level of insurance coverage, take into account the expected growth in a registrant’s business. Firms should also ensure that a “double aggregate limit” or “full reinstatement of coverage” is provided under their bonding or insurance.
Social media procedures
Although the use of social media by registered firms to market products and services is currently limited, the report also provides suggested practices for firms to consider. Namely, the report recommends (i) setting policies and procedures for the review, supervision, retention and retrieval of materials on social media; (ii) designating an appropriate individual to be responsible for the supervision and approval of communications; and (iii) reviewing the adequacy of systems and programs to ensure compliant record retention and retrieval capability.
The report also states that there is often no evidence that a registered firm’s Chief Compliance Officer (CCO) has submitted an annual report to the firm’s board of directors, or equivalent, that assesses compliance by the firm and its registered individuals with securities law. In response, the report suggests that a CCO prepare and maintain a written annual compliance report that is presented to the firm’s board and that describes what steps were taken to perform the compliance assessment, the result of the assessment and what has been done or will be done to address significant instances of non-compliance. In cases where the CCO has presented the compliance report orally, it may be appropriate for the minutes to the board meeting to document the discussion and describe the appropriate information.
The report expresses concern with portfolio managers effecting trades between client accounts (cross trades). On this issue, the report reminds portfolio managers of the restrictions on certain managed account transactions and inter-fund trades by public investment funds. A portfolio manager that crosses trades between client accounts (where it is permissible to do so) should: (i) ensure that the executed price for cross trades is fair to both clients; (ii) ensure that the fees charged on cross trades are reasonable; (iii) ensure that cross trades are executed through a dealer; (iv) establish policies and procedures containing guidelines on cross trades; and (v) ensure that the methodology for allocating cross trade opportunities among client accounts is fair and equitable to all clients.
Soft dollar arrangements
On the topic of client brokerage commission disclosure, the report notes that some portfolio managers are not providing the required disclosure to clients regarding soft dollar arrangements. As such, portfolio managers that are required to provide such disclosure should establish policies and procedures containing guidelines on providing adequate disclosure, ensure that the period of time chosen for the periodic disclosure is consistent from period to period, determine the form of disclosure based on client needs and provide the required disclosure in conjunction with other initial and periodic disclosure relating to the performance and management of the account.
Delegation of KYC obligations
The delegation of “know-your-client” (KYC) and suitability obligations also drew the attention of the Branch. Specifically, some portfolio managers enter into arrangements with mutual fund dealing representatives and firms, or financial planners, for the referral of clients to the portfolio manager for a managed account. The Branch thus expressed its concern that portfolio managers are not having meaningful discussions with referred clients to fully understand the clients’ financial circumstances and risk tolerance. Rather, portfolio managers may instead be relying on the mutual fund dealing representative or financial planner to perform these duties and, in some cases, unregistered individuals working for the portfolio manager firm may be performing the required duties.
In response, the report states that an advising representative of the portfolio management firm should have a meaningful discussion with each client regarding KYC information before managing a portfolio, explain the firm’s investment process and strategy and other relationship information to the client, assist the client in completing necessary forms and agreements, regularly communicate the investment holdings and performance, and keep each client’s KYC information up to date.
Investment fund managers
Inappropriate expenses charged to funds
According to the report, some investment fund managers (IFMs) allocate expenses to their investment funds that are unrelated to the operation of the funds. Examples of this practice include expenses related to the operation of the investment fund managers’ business, such as capital market participation fees, expenses relating to social events and expenses relating to the wholesaling activities of the IFM.
As a result of these practices, the report recommends that IFMs establish policies and procedures, as well as a system of controls, to ensure that the IFM’s investment funds are only paying for expenses that are related to the operation of the investment funds. Further, the report suggests expense allocations should be reviewed on a regular basis to ensure that only appropriate expenses are charged and paid for by the investment funds.
The report also considers the requirement of investment fund managers that are also reporting issuers to have an independent review committee (IRC) to review and assess the adequacy and effectiveness of the investment fund manager’s written policies and procedures. According to the Branch, not all IRCs properly document assessment results. Thus, investment fund managers should ensure that they receive and maintain records of the regular assessments conducted by the IRC and address any matters raised in the IRC’s reports in a timely and appropriate manner.
Investment funds modernization project
The report also provides an update on the investment funds modernization project. Specifically, phase one amendments are expected in final form by the end of 2011 with an effective date in early 2012. With respect to point of sale disclosure, the Canadian Securities Administrators plan to publish for further comment any proposed requirements that would implement point of sale delivery for mutual funds.
Exempt market dealers
KYC and suitability information
The report identifies various issues regarding the collection of KYC information, assessment of suitability and knowledge of products recommended to clients by exempt market dealers (EMDs). The report also sets out a number of suggested practices to address these deficiencies. Specifically, EMDs and their registered individuals should ensure that they: (i) have a process is in place to collect and document sufficient KYC information for each client; (ii) have clients sign-off on completed KYC forms; (iii) have an in-depth understanding of the general features and structure of a product, the product risks (including the risk/return profile and liquidity risks), the management and financial strength of the issuer, costs and any eligibility requirements for each product before recommending the product to clients; (iv) perform an independent analysis of products before recommending them to clients; and (v) perform ongoing due diligence of the issuer and products.
The Branch also expressed concern that prospectus-exempt securities are being sold in reliance of the “accredited investor” exemption to investors that do not meet the relevant qualifications. As such, the report states that EMDs should have a process in place to collect and document sufficient KYC information for clients in order to determine whether the applicable definition for “accredited investor” has been met. EMDs should also explain the definition of “accredited investor” to clients before completing the KYC form to ensure that assets are properly characterized and documented.
Supervision of dealing representatives
On the issue of supervision, the report discusses the issue of EMDs not adequately supervising their dealing representatives, especially where representatives are working in locations different than that of their supervisor. As such, the report suggests that EMDs provide ongoing training for dealing representatives to ensure that representatives (i) are aware of the securities laws impacting their activities; (ii) understand their sponsoring firm’s policies and procedures; (iii) have an in-depth understanding of the products they recommend to clients; and (iv) are informed of any changes to the above on a timely basis. According to the report, EMDs should also develop written policies and procedures regarding the supervision of dealing representatives’ activities, including the activities to be supervised and by whom, the frequency of supervision and how the supervision will be evidenced.
In order to respond to the issue of individuals acting on behalf of EMDs who are not registered as a dealing representative, the report suggests that EMDs, among other things, assess whether a change in an individual’s role, responsibilities or activities within the firm requires registration and assess whether changes to the firm’s business activities require registration in another category.
Inappropriate marketing practices
The marketing practices of EMDs is identified by the report as a particular area of concern, with “many” EMDs cited as providing outdated or misleading information to clients. According to the report, marketing materials should: (i) provide clear and adequate disclosure to ensure that the information is “complete, accurate and meaningful”; (ii) substantiate all claims made, with reference to information supporting the claim so that investors can easily assess the merits of the claim; (iii) be updated regularly to ensure all information is complete, accurate and current; and (iv) provide prominent, specific and clear disclosure to clients that explains any conflict of interest and how it could affect the client.
On-site compliance reviews
Using a risk assessment questionnaire sent to all Ontario registered EMDs in October 2009, the Branch identified a number of EMDs for on-site compliance reviews. The reviews, conducted in December 2010 focused on key risk areas and found a number of further deficiencies, including with respect to the inappropriate use of investor monies, non-disclosure of outside business activities and inadequate working capital and insurance coverage. The report provides a number of suggested practices to deal with these additional deficiencies.