On July 12, 2012, the Investment Industry Regulatory Organization of Canada (IIROC), the investment dealer self-regulatory organization that is the Canadian equivalent of the Financial Industry Regulatory Authority (FINRA), published for comment a concept proposal on the introduction of a new class of IIROC member, called a “Restricted Dealer Member”. The IIROC proposal is being made in response to concerns expressed by the Canadian Securities Administrators (CSA) relating to the scope of activities being undertaken by exempt market dealers (EMDs), that were previously identified in the CSA Staff Notice 31-327 Broker-Dealer Registration in the Exempt Market Dealer Category (CSAN 31-327).
IIROC’s proposed framework seeks to facilitate the migration to IIROC membership of approximately 22 FINRA member broker-dealers that are currently carrying out brokerage activities with Canadian clients as either EMDs or in a temporary similar category of restricted dealers. Under the proposal, migration to IIROC membership will require such firms to surrender their current EMD or restricted dealer registrations, as well as their international dealer or international adviser exemptions, and to apply for investment dealer registration under provincial securities law as well as seek IIROC membership. The proposal will also allow a FINRA broker-dealer to directly seek cross-membership with IIROC.
Under National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103), since October 2009, an EMD has been permitted to trade in any security that has been, or could be, distributed pursuant to a prospectus exemption. This includes brokerage services to “accredited investors”, which includes a class of individual investors meeting certain high-income or net-worth criteria, in addition to investors who would be considered “Institutional Customers” under IIROC’s Dealer Member Rules. In the past, the CSA had granted certain exemptive relief to EMDs which facilitated prime brokerage and other brokerage services (for example, relief from the prohibition on EMDs providing margin).
EMD registration was frequently sought by foreign firms as a way of expanding their Canadian business beyond the limitations of the international dealer registration exemption, which generally prohibits trading in securities of Canadian issuers. Following the implementation of NI 31-103, the CSA received numerous registration applications from U.S. firms regulated by FINRA seeking to obtain EMD registration status. Many U.S. firms were also already registered in Ontario as limited market dealers and had been converted to EMDs.
However, the CSA started to have some policy concerns about the breadth of activity conducted by these foreign EMDs under NI 31-103. These concerns were expressed in CSAN Notice 31-327 in September 2011. The CSA surveyed registered EMDs and identified a number of existing EMDs, including firms that have an affiliated IIROC Dealer Member, that are carrying out brokerage activities for accredited investors. The services of concern include (i) securities brokerage and trading, (ii) prime brokerage and securities lending, (iii) execution, clearing and settlement services and related record-keeping services, (iv) custody of customer funds and securities, and (v) subject to certain exemptive relief, lending money, extending credit and providing margin to clients. As an interim measure, the CSA ceased registering foreign EMDs in 2011 and new applicants have been temporarily registered by the CSA as restricted dealers instead, subject to specific terms and conditions.
- U.S. FINRA broker dealers can directly seek cross-membership with IIROC to become investment dealers in Canada
- These “Restricted Dealer Members” would be exempt from normal IIROC financial reporting and financial compliance, but otherwise subject to all IIROC rules and fees
- Trading to be restricted to non-retail Canadian customers – international dealer and international adviser exemptions will not be available to Restricted Dealer Members
PROPOSED IIROC RESTRICTED DEALE R MEMBER CATEGORY
IIROC’s new Restricted Dealer Member proposal is guided by the following key principles:
- the benefits of globalized markets and cross-border access;
- recognition of regulatory overlap between U.S. and Canadian regulatory regimes;
- providing a financially viable alternative arrangement to FINRA-regulated firms;
- fostering a level paying field among firms conducting similar brokerage activities and avoiding opportunities for regulatory arbitrage; and
- acknowledgment that “Institutional Customers” and truly sophisticated and wealthy “Retail Customers” are capable of assessing the risks of doing business with a U.S. entity.
The proposed IIROC Restricted Dealer Member category will have the following key requirements, among others:
- Comparability of FINRA’s regulatory framework: IIROC proposes exemptions from certain of its financial operations requirements, including certain financial reporting, minimum capital, minimum insurance coverage and margin obligations, provided IIROC is satisfied that (i) U.S. regulation is based on comparable regulatory principles and produces comparable regulatory outcomes, and (ii) IIROC continues to have a robust co-operation and information-sharing arrangement with FINRA. Restricted Dealer Members will be required to file quarterly with IIROC a segmented unconsolidated income statement which separately discloses revenue, expense and net income for its Canadian operations, and an annual audited reconciliation of its consolidated excess net capital, as set out in its annual SEC filing, to the firm's unconsolidated excess net capital as set out in its FOCUS report.
- Restricted Dealer Member eligibility criteria: Restricted Dealer Members must be (i) an entity formed under U.S. federal or state law, (ii) a member of FINRA, and (iii) a member of the Securities Investor Protection Corporation (SIPC). Canadian client assets must be insured by SIPC against loss due to insolvency of the Restricted Dealer Member. Restricted Dealer Members cannot participate in the Canadian Investor Protection Fund (CIPF) and its Canadian clients will not be eligible for CIPF coverage.
- Restricted Dealer Member category not to be used by Canadian investment dealers: Restricted Dealer Membership is limited to firms with a head office or principal place of business in the U.S. and firms with more than 50% of their securities being owned, directly or indirectly, by foreign entities or residents, as well as an as-yet unspecified de minimis business test.
- Scope of business activities: Business activity must be consistent with, and not exceed, the scope of business activity approved by FINRA in the firm’s membership agreement with FINRA, including providing IIROC with notice of “material changes” in the operation of the firm for which the firm has made an application for approval or non-objection to FINRA.
- Records of Restricted Dealer Members: Restricted Dealer Members must provide IIROC with an undertaking to furnish true and complete copies of all books and records which are required to be maintained in accordance with its IIROC membership agreement.
- Attornment/Appointment of agents: Restricted Dealer Members will be subject to attornment and appointment of agent-for-service provisions, including associated requirements that are typically imposed on non-resident firms.
- Cost recovery: Restricted Dealer Members must reimburse IIROC for any increased compliance costs resulting from IIROC’s compliance reviews having to be conducted in foreign jurisdictions. Restricted Dealer Members will be subject to the same membership and annual fees as a full IIROC member.
- Participating organization restriction: Restricted Dealer Members cannot be a participating organization in a Canadian marketplace overseen by IIROC, so they must continue to trade through a Canadian investment dealer to reach Canadian stock exchanges or alternative trading systems. IIROC is nevertheless considering applying universal market integrity rules to Restricted Dealer Members.
- Limited retail customer coverage: Restricted Dealer Members will only be able to deal with a prescribed type of “Retail Customer” and “Institutional Customer”, as defined under the IIROC Dealer Member Rules.
- Unavailability of the international dealer and adviser exemptions: Restricted Dealer Members will no longer be able to rely on the “international dealer” or “international adviser” exemptions set forth in NI 31-103.
- Introducing/carrying broker relationships: A Restricted Dealer Member can be an introducing broker, but can only be a carrying broker for another Restricted Dealer Member. It cannot be a carrying broker for a full Dealer Member.
- Participation rights: Restricted Dealer Members will be eligible to participate on IIROC’s Board, District Councils and advisory committees.
FINRA-regulated firms with EMD registration, including firms that have been temporarily registered by the CSA as restricted dealers, would be transitioned to IIROC Restricted Dealer Member status by making a streamlined application to the IIROC Board of Directors.
Except for individuals seeking IIROC approval as a “Registered Representative” or “Investment Representative” who would be entitled to a one-year transition period, existing partners, directors, executives, chief compliance officers and supervisors will be exempt from IIROC’s minimum proficiency requirements as long as the individual remains approved in the category. However, all individuals that are sponsored by new firms applying for registration will generally be subject to IIROC’s minimum proficiency requirements.
IIROC is welcoming feedback on the scope and direction of the proposed IIROC Restricted Dealer Member category, including specific comment on:
- whether the Restricted Dealer Member proposal should be implemented as a grandfathering proposal for existing EMDs or restricted dealers that have been identified by the CSA as conducting brokerage activity or whether the proposal should continue to be available to potentially new entrants to the Canadian marketplace;
- whether the proposed IIROC Restricted Dealer Member category should be subject to a de minimis threshold, and if so, whether the de minimis threshold should be premised on any of the following: (a) a prescribed number of Canadian clients, (b) a prescribed percentage of the aggregate consolidated gross revenue of the Restricted Dealer Member being derived from the investment dealer activities of the Restricted Dealer Member, as calculated at the end of the firm’s most recently completed financial year, or (c) a prescribed percentage of the aggregate consolidated gross revenue of the Restricted Dealer Member being derived from Canadian resident clients in respect of Canadian securities, as calculated at the end of the most recently completed financial year; and
- whether a retail customer restriction should be applied to Restricted Dealer Members, and if so, on what basis such a restriction should be dependent (e.g., “accredited investor”, “permitted client” or a retail client who owns financial assets having an aggregate realizable value that exceeds C$10-million before taxes but net of any related liabilities).
Concurrently with the release of IIROC’s concept proposal, the CSA released Staff Notice 31-331 Followup to Broker-Dealer Registration in the Exempt Market Dealer Category, supporting the view that IIROC should be responsible for oversight of FINRA-regulated firms that are conducting brokerage activities in Canada.
The IIROC proposals raise a number of questions which will need to be addressed during the comment period. For example, the only rule exemptions IIROC is proposing are on the financial operations side. All other business conduct, sales compliance and other member regulation provisions will apply fully to Restricted Dealer Members. Reconciliation of these requirements with FINRA rules will require some careful analysis to determine if there are any conflicts. The application of these Canadian IIROC rules to purely U.S. business is also unclear. Annual fees for IIROC dealer members are based upon their revenue as well as a risk component. Presumably IIROC will not seek to charge its annual fees based upon including U.S.-derived revenues, but this remains to be seen.
IIROC is inviting stakeholders to provide comments by October 10, 2012. During the consultation period, IIROC will engage in discussions with various other Canadian market participants regarding the proposal and its potential implications for their participant rules. At the conclusion of the consultation period, IIROC may make changes to its bylaws and Dealer Member Rules. If so, it is anticipated that the CSA would also propose corresponding changes to NI 31-103 that would further the policy objectives of the IIROC amendments.