In its latest annual review summary report for dealers, advisers and investment fund managers (the “Report”), the Ontario Securities Commission (“OSC”) provides some helpful guidance for registrants.
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, portfolio managers (“PMs”) and investment fund managers.
In this post, we summarize OSC findings in its compliance reviews of PMs.
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 PMs. Based on this review, the OSC is concerned that many PMs are not adequately meeting their KYC, KYP and suitability obligations. The OSC identified the following key deficiencies:
- inadequate collection and documentation of KYC information; and
- inadequate relationship disclosure information.
Issues Respecting UDPs and CCOs
PMs 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 PM, 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 PM’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
PMs are reminded to give notice of proposed ownership changes in, or asset acquisitions of, registered firms. The OSC notes examples of:
- PMs 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;
- PMs 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
- PMs that have not provided the OSC with the required notice as soon as the PM 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
PMs must meet their capital requirements to maintain registration in good standing. To assist PMs 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.
Inadequate personal trading policies
Some PMs have inadequate policies and procedures for the personal trading of their advising representatives, research analysts, traders and other persons (known as “access persons”) who have access to their clients’ trading and investment information.
The OSC noted instances where PM firms did not:
- maintain personal trading policies and procedures,
- enforce the firm’s established personal trading policies,
- require written pre-approval for personal trades of access persons,
- review and maintain the personal trading records of access persons to ensure they complied with the firm’s personal trading policies, or
- have complete information on the personal trading accounts of all access persons.
The OSC suggests the following guidance for a PM’s personal trading policies:
- include an annual acknowledgement in writing from all access persons that they understand and will comply with the firm’s personal trading policies,
- appoint a qualified person, such as the CCO, to be responsible for monitoring the firm’s personal trading policies,
- define who is an access person,
- clarify the application of policies to spouses of access persons and accounts that access persons have control over,
- maintain a restricted securities list,
- establish blackout periods,
- require written pre-approval of access persons’ personal trades by a qualified person, such as the CCO,
- require direct receipt of access persons’ personal trading records (such as account statements),
- require the review and timely reconciliation of access person’s pre-approved trades to their personal trading records, and
- set out details of repercussions for non-compliance with the policies, and reporting of non-compliance to senior management.
- PMs should maintain records of personal trade pre-approvals and personal trading records of access persons.
- PMs should assess compliance with the personal trading policies as part of the CCO’s annual compliance report to the board.
Inadequate investment management agreements
The OSC notes that PMs do not have adequate investment management agreements (IMAs) with their clients. In particular, the OSC found instances where:
- the IMA did not state that the PM must manage the client’s assets in accordance with their KYC and suitability information or that the PM is responsible for proxy voting.
- the IMA did not clearly state the type of investment authority the PM has over its client’s assets. For example, the IMA states that the client grants the PM authorization to make investment decisions in their accounts without stating that the PM has discretionary trading authorization.
- PMs did not sign an IMA with all clients, or could not locate copies of IMAs we requested.
- IMAs were not current. For example, the fee arrangements had changed from what was outlined in the IMA, but the IMA was not updated to reflect the change.
- a PM inappropriately attempted in the IMA to limit the extent of their legal obligation to obtain KYC and suitability information from the client. The IMA stated that the client had sole responsibility for their KYC and suitability information.
The OSC offers the following guidance:
- PMs need to have a written IMA with each client that sets out the services to be provided, the roles and responsibilities of each party, and addresses all aspects of the investment advisory process.
- Since the IMA is a legal document, PMs should consult with legal counsel on its terms and keep it current.
- Each completed IMA should be reviewed, approved and signed and dated by senior management of the PM and the client, with a copy provided to the client.
- The terms of an IMA should include, but not be limited to:
- the type of authority the PM has over the client’s assets (such as discretionary or non-discretionary trading authority),
- how the client’s assets managed by the PM will be held (such as in the client’s name at a third-party custodian),
- any client instructions or restrictions,
- who is responsible for proxy voting and insider reporting obligations,
- how any conflicts of interests that impact the advisory services to be provided are addressed,
- fee arrangements with clients, including how and when investment management fees (including performance fees) are calculated and charged, and
- the notice period for terminating the agreement.
- IMAs should state that the PM is required to manage the client’s assets in accordance with the client’s investment needs and objectives, risk tolerance, financial circumstances and any client instructions or restrictions.
Inadequate supervision of advising representatives and research analysts
The OSC noted several cases where a PM firm did not adequately supervise its advising representatives (AR), associate advising representatives (AAR), or research analysts.
In one case, a PM firm failed to supervise a number of ARs that the firm sponsored. The ARs operated under the PM firm’s name, but effectively carried out their advising activities independent of, and without adequate oversight by, the PM firm. For example:
- the ARs did not follow, and lacked knowledge of, the firm’s policies and procedures for meeting with clients and documenting their advising activities,
- clients did not sign a standard IMA with the firm; instead, each AR had a different agreement that their clients signed,
- the firm did not have an established process for collecting, documenting and updating KYC and suitability information from clients; instead each AR had their own process that was often inadequate,
- some of the ARs conducted their advising activities from their home office that was not a registered office of the firm, and that was not subject to adequate oversight by the firm,
- the ARs had their own distinct marketing materials and referral arrangements that often were not reviewed and approved by the firm, and
- some of the AR’s books and records were not accessible to the firm.
The OSC offers the following guidance:
- All trades conducted on behalf of a PM’s clients should be authorized, in writing, by an AR (or AAR under the supervision of an AR), before the trades are placed with dealers.
- An AR designated to supervise the advice of an AAR should document his or her pre-approval of the advice made by the AAR to clients.
- PMs should train their investment staff on the advising activities they are permitted to perform under their AR or AAR category of registration (if registered) or not permitted to perform (if not registered).
- PMs should refer to CSA Staff Notice 33-315 Suitability Obligation and Know Your Product for guidance on meeting their suitability and KYP obligations.
- PMs should assess whether a change in an individual’s role, responsibilities or activities within the firm requires them to be registered.
Delegating KYC and suitability obligations to referral agents
The OSC has increased its focus on the practice by some PMs of delegating their KYC and suitability obligations to referral agents such as mutual fund dealing representatives and financial planners. The OSC advises that in the future, it intends to respond to this type of conduct more aggressively, for example, by recommending a suspension of registration or by referring the matter to the OSC Enforcement Branch.
The OSC noted a case where a referral agent, an individual who had formerly been registered with an MFDA member firm, but was no longer registered in any capacity, had referred a large number of clients to a PM, and where no AR of the PM had spoken with those clients before trades were made on their behalf. The referral agent also met with the clients on an ongoing basis to review their investment portfolios, and discussed with the PM the selection of specific securities for inclusion in, or removal from, the clients’ portfolios. Many of the activities performed by the referral agent required registration, and should have been carried out by an appropriately registered individual acting on behalf of the PM.
The OSC reminds PMs that client who is referred to a PM becomes the client of that PM for the purposes of the services provided under the referral arrangement. The PM receiving a referral must meet all of its obligations as a registrant towards its referred clients, including KYC and suitability determinations. PMs may not use a referral arrangement to assign, contract out of or otherwise avoid their regulatory obligations.
PMs that use referral agents should carefully review their practices to ensure that only appropriately registered individuals are performing registrable activities. Registrable activities include meeting with investors to ascertain their investment needs and objectives, risk tolerance and financial circumstances, discussing and recommending investment opportunities, and performing ongoing portfolio reviews.