As we discussed in our post of October 22, the Compliance and Registrant Regulation Branch’s annual report for fiscal 2010 reviews deficiencies identified by staff of the Ontario Securities Commission (OSC) in its review of advisers, investment fund managers and dealers. The Report also highlights initiatives taken by the OSC relating to registrant regulation and provides staff guidance on dealing with identified deficiencies. In a departure from prior reports, the fiscal 2010 report also covers the introduction of the new registration regime, reorganization of the Compliance and Registrant Regulation Branch and common deficiencies found in reviews of registrant applications.
With respect to ongoing compliance requirements, the Report indicates that the percentage of registrants requiring "significantly enhanced compliance" increased from 32% in 2009 to 50% in 2010. Compliance reviews resulting in referral to the Enforcement Branch also increased from 4% in 2009 to 10% in 2010. In addition to general guidance applicable to all registrants, the Report also includes OSC staff views on specific issues relating to investment fund managers, portfolio managers and exempt market dealers, some of which are highlighted below.
Investment fund managers
Investment fund managers will want to pay particular attention to section 3.3 of the Report, which describes OSC staff concerns surrounding non-prospectus investment funds that enter into “side letters” with one or more investors, giving preferential rights and terms to such investors as compared to other investors of the same class of fund units. Examples of such “preferential treatment” noted include preferential portfolio transparency, redemption rights, fund reporting and management and fund performance fees. Citing their concern about “disadvantaging” other investors, staff state that side letters giving such preferential treatment can harm the fund and its other investors through, for example, allowing investors who have portfolio transparency and more frequent redemption rights the opportunity to act on such rights and redeem units before others.
According to the Report, investment fund managers that provide such side letters fail to meet the standard of care prescribed under section 116 of the Securities Act (Ontario), which also requires they exercise their powers and discharge their duties honestly, in good faith and in the best interests of the investment fund. Further, the staff have taken the position that such preferential treatment is a material conflict of interest that requires identification under s. 13.4(1) of NI 31-103 Registration Requirements and Exemptions, and to which a firm must respond under s. 13.4(2).
As such, staff suggest that investment fund managers avoid entering into side letters that provide preferential treatment to some investors, and consider instead creating separate classes of units if different rights and terms are required. They also suggest that rights and terms attaching to each class of units be disclosed in the fund’s offering documents.
Other deficiencies specific to investment fund managers include: (i) offering documents that suggest that net asset value (NAV) calculation errors will not be adjusted retroactively and (ii) prohibited investments made by the fund.
Section 3.2 of the Report focuses on portfolio managers and highlights deficiencies identified through the Branch’s normal course compliance reviews. This section also deals with the OSC’s in-progress sweep of marketing practices and new or proposed rules that will impact portfolio managers. Among the identified deficiencies, staff note that some portfolio managers rely on mutual fund salespersons or financial planners to perform KYC-related duties, such as meeting with clients to assess investment needs and risk tolerance. According to the Branch, this action is contrary to securities laws, as registrants may not delegate their obligations respecting KYC and suitability.
The Report also highlights the Branch's concerns with portfolio managers that market performance returns achieved by their advising representatives while employed at another firm. Their concerns relate to marketing of performance returns that were not generated by the advising representative or where the other firm employed a different investment strategy employed. While they cite prohibitions on making misleading statements under section 2.1 of OSC Rule 31-505 Conditions of Registration, staff do acknowledge and explain, however, the limited circumstances in which such marketing may not be misleading. Other issues considered include best execution obligations and risk management and internal controls.
Exempt market dealers
OSC staff based their selection of Exempt Market Dealers (EMDs) reviewed in response to risk assessment questionnaires which were sent to all EMDs registered in Ontario. According to the Report, many EMDs fail to collect and document client information necessary to satisfy KYC and suitability obligations. The Report also cites insufficient disclosure to clients regarding investment products and notes that a number of EMDs reviewed did not have an adequate compliance system to ensure compliance with securities legislation.
According to the Branch, the Report can serve as a self-assessment tool for registrants to strengthen compliance and improve internal controls. As part of its mandate to foster a culture of compliance through outreach and other initiatives, the Report also refers registrants to the updated section of the OSC website entitled “Information for Dealers, Advisers and Investment Fund Managers”, which provides further information about the registration process and ongoing obligations under the new registration regime.