Distributing Related Party Exempt Products

Jan / 22 / 2015

Can an Exempt Market Dealer sell the securities of a Related Issuer or does the Issuer need to engage a third party Dealer?

EMDs that are established for the sole purpose of selling related party products (“Captive EMDs”) are often treated by the Commissions as having a risker business model. These firms are good candidates for on–‐site regulatory visits and may also be subject to greater scrutiny when applying for registration.

However, there remains no prohibition against selling related party exempt products.

This article will explain current regulatory concerns with related party exempt products and will discuss reasonable steps that Captive EMDs can use to address these concerns.

The Related Party Product Scare

In its 2014 annual notice on registrant regulation (OSC Notice 33–‐745), the Ontario Securities Commission stated the following:

We continue to have significant concerns with EMDs that trade in, or recommend, the products of related and/or connected issuers (often referred to as “related party products”), particularly those EMDs that trade solely in these products. Material conflicts of interest arise with these relationships, in large part due to the lack of separation between the mind and management of the EMD and the issuer.

The Ontario Securities Commission appears to have further announced their discomfort with related party products by proposing that the Offering Memorandum exemption (when allowed in Ontario) not be applied to these offerings.

The regulators’ concern about related party products stems from recent high profile cases where captive EMDs sold securities that were either very poorly designed or operated in an unethical manner.

The Commissions’ ongoing interaction with Captive EMDs through on site reviews and registration filings, appear to have further shaken their confidence in these types of registrants.

Why the Industry Needs Captive EMDs

However, Captive EMDs are critical to the Canadian capital markets as they give Issuers the ability to speak directly with investors; without this outlet a few national and regional Dealers will decide what opportunities get financed.

Furthermore, the distribution channels of national and large regional Dealers are becoming more restrictive as they gradually cull their product shelf to better manage risk. If the Dealer is connected to a financial product manufacturer, offerings that compete with those of the manufacturer are unlikely to get on the shelf. Hence captive EMDs are critical for the development of new investment ideas and opportunities.

Why do the Regulators perceive Captive EMDs as “risky”?

Why do the management of captive EMDs often struggle with addressing their regulatory expectations?

The simple answer is that they are experts in their business and not in the operation of a registered Dealer. Furthermore, registrant regulation is fundamentally different from regulation in most other industries.

Most industries operate under prescribed regulation. For example Canadian Agricultural Regulation mandates the ingredients, and minimum and maximum milk fat content (by weight and/or calories) for light cheese.

Registrant regulation; however, is principally based on concepts and ideas, rather than defined rules. The difficult topics such as, “suitability”, “know your product obligation” and “business trigger” are concepts that management must apply within the context of their business, industry standards, and regulatory expectations.

Management of Captive EMDs often struggle with the practical application of regulatory rules and concepts.

Tips for Captive EMDs

Though the needs and circumstances of each Captive EMD are unique, there are general guidelines that management of such firms can follow.

Tip #1: Fall out of in love with your financial offering.

Management of Captive EMDs often treasure their financial products in the same manner that parents treasure their children. They can be blind to or diminish the risks and blemishes of their financial offerings. This lack of unbiased self–‐ examination is a primary reason that many of these firms get into regulatory trouble, and are accused of unsuitable selling.

Management should clearly identify product risks and analyze expected performance under different scenarios. Depending on the product’s features, risk should be analyzed based on security of capital as well as the security/timeliness of cash flows.

Management should also carefully review the implicit and explicit liquidity of the offering and how this impacts its suitability for various types of investors. Explicit constraints are provisions such as lock–‐up periods or restrictions on how frequently investors can redeem their units. Implicit liquidity constraints can arise because of a fund’s inability to accommodate significant redemption requests within a short time period.

Tip # 2: Avoid offering guaranteed returns unless backed by a significant amount of money and a lot of experience.

Large financial institutions can make a very good return by offering investors a guaranteed return and investing those monies at a higher rate. However; these institutions are also subject to stringent regulation and have personnel with a strong background in lending.

Exempt market products that offer guaranteed returns are effectively serving as mini lending institutions, but without the regulation and, in many cases, without the experienced personnel.

Guarantees can quickly disappear at the first sight of a major market disruption, or operation and lending mistakes. Unless the product manufacturer has strong lending experience and financial backing to make good on the guarantee (if returns cannot be paid from the fund), they should avoid offering guaranteed returns.

Tip #3: Provide enhanced ongoing disclosures

Exempt market product manufacturers should consider adopting disclosure standards comparable to those of public issuers. Not only does this serve to reduce the perceived risk of the offering but further cements the Issuer’s relationship with investors.

Lack of transparency is one of the stated reasons why exempt market products are considered to be high risk.

Tip #4: Access knowledge, experience and judgment on registrant regulation matters

As noted previously, registrant regulation is largely based on concepts rather than prescriptive rules. As a result, Management of Captive EMDs should actively seek knowledge, experience and judgment on regulatory compliance matters.

The registrant outreach program that many Commissions have instituted is an excellent source of insight, along with publications such as annual reports on common registrant deficiencies.

Firms should also consider engaging staff or external consultants who have relevant experience with registrant compliance.

Tip #5 Don’t not try to avoid registration by forwarding investors to a third party EMD or having staff registered under an EMD that is not organized.

Recent changes to the exemptions under National Instrument 31–‐103 have clarified that financial product manufacturers cannot simply avoid registration by passing their investors onto a third party EMD.

Firms should also be careful about accessing distribution by having their staff registered as Dealing Representatives with a third party EMD.

Unless the EMD is in the business of operating a branch network, the manufacturer may be simply exposing itself to the weaknesses of another firm whose motivation may be to defray operating costs.

Captive EMDs currently suffer from a poor image because of recent scandals. However, they are also Canada’s only hope against an oligopolistic industry where a few national firms determine what investment ideas will be offered.

To navigate the current environment Captive EMDs need, a better understanding of their role as securities registrants and, a practical application of their regulatory obligations.

Ara Compliance Support

Ara Compliance Support is a boutique firm that provides ongoing compliance support to independent Exempt Market Dealers and Portfolio Managers. Our focus is to help our clients reduce their compliance risk, and apply their time more efficiently. For more information, please contact us at 416‐941‐1263 or at info@aracompliance.com

Compliance Process…The Missing Link

Sep / 10 / 2014

“Everyone thinks they have a plan until they get punched in the mouth.”

Mike Tyson


The application and ongoing refinement of methodology and process are the key to success in many fields including, professional sports, motor vehicle design, software development and, investment management.

However one of the areas where an organized approach is often lacking is in management of compliance for small and mid–‐size Exempt Market Dealers and other securities registrants.

The Seeds of Confusion

In 1989 the Ontario Securities Commission, introduced a “closed system” of registration, which meant that any firm in the business of trading securities had to be registered. The Exempt Market Dealer (“EMD”) registration was established as a category for firms that only traded in exempt securities or exempt transactions. At the time the Commission’s objective was simply to have jurisdiction over such firms in the event of an investigation or, if needed, to issue cease and desist orders.

However, as many operating businesses started to adopt the EMD license an expectation that such firms would have a formal compliance structure began to develop.

With the introduction of the EMD requirement across Canada, on September 28, 2009, many of these expectations became formalized under National Instrument 31–‐ 103. Over time these expectations have been refined and/or clarified through amendments to the National Instrument, its Companion Policy and through various other published guidance.

For many industry participants (especially those operating in business a long time) this trend appears as regulatory overreach and as adding unnecessary costs to the business.

In an attempt to deal with this hornet’s nest of compliance confusion, firms have sought refuge in seminars, lawyers, consultants and other sources of technical information. Some have even chosen to seek registration in a stricter IIROC category (the equivalent of crawling into the hornets nest itself, on the basis that there is no difference being stung by a few hornets versus being stung by all of them).

Unfortunately what has never been explained is that the first and most important regulatory requirement of a member firm is to have an organized process for managing compliance.

When a new regulatory requirement or expectation is adopted, the Commission is effectively saying, “Please adjust your processes to take care of this new thing.” While many industry participants often hear, “Here as some more rules and regulations that will take up a lot of your time and money and, possibly drive you out of the business.”

What is a Compliance Structure?

A well–‐organized compliance structure is a series of processes that are integrated into the business, and that do not require management’s ongoing direction. It should include:

♦ Tasks lists that can be diarized;

♦ Forms and logs;

♦ Guidance to staff on specific matters that must be brought to management’s attention;

♦ Record keeping protocol to document significant and supervisory matters and client communications;

♦ A database and appropriate software to organize client and transaction information;

♦ Periodic independent reviews and checks; and

♦ Formal training for all affected parties.

A compliance manual and some forms to be completed by clients are not a compliance structure.

Client Reporting

To illustrate the importance of process, I’ll review how the client reporting mandates set under National Instrument 31–‐103 assume certain processes.

These reporting requirements are intended to provide clients with greater disclosure so they can make better investment decisions. To understand the intention behind these series of rules, one has to visualize six different stages of the client account process.

Step 1: A client walks into firm’s office, enquires about the firm’s offering and decides to open a client account. Matters that the client should be aware of at the time of account opening are set out under section 14.2 of National Instrument 31–‐ 103. To address this requirement the firm is expected to have an organized “client fulfillment process” that includes the delivery and appropriate explanation of account opening materials (including a disclosure document that has been previously reviewed and approved by management) and, a process for documenting the client’s receipt/understanding of what they have been given.

Step 2: Though most clients will only open an account when they are ready to purchase, let’s assume that this is done in two stages. When the client calls to make a purchase transaction section 14.2.1 sets out further disclosures that the client must receive regarding the costs and charges relating to the purchase (so they can make an informed decision at that time.). This assumes that the firm has a formal order acceptance process. This could include; providing Dealing Representatives with a script or checklist of matters to consider/discuss prior to accepting an order, a review/ follow up discussion by supervising staff, etc.

Step 3: The trade is settled and a confirmation along with other materials are sent to the client. Section 14.12 sets out requirements of what should be included in the trade confirmation sent to the client. This assumes the firm has a database for recording purchases and settlements, software to generate the trade confirmations and a process for post trade delivery of such information to the client.

Step 4: At quarter end, month end (if a reportable transaction occurred during the month) or, more frequently if requested by the client, a statement of activity during the period must be sent to the client. Starting July 15, 2015 the National Instrument clarifies that if the EMD has possession of the client’s securities or any of the conditions under 14.14(7) or 14.14.1(1) apply, the statement (or a supplemental statement) must show the market value of settled security positions. Starting July 15, 2015, the statement must also show the cost of securities held in the account, as defined under 14.14.2(2). This assumes that the firms that must report positions on the client account statement have a database where such positions are recorded and a process for calculating their market values periodically.

Step 5: Section 14.17, describes a report on compensation earned by the firm and certain charges to the client, that must be provided annually to each client starting July 15, 2016. This assumes that the firm has an organized database of commissions and charges from which to generate the report.

Step 6: Section 14.18, describes a performance report that must be provided annually to clients, starting July 15, 2016, if the firm has to report settled positions under Step 4 above. This further assumes that the firm has a properly organized database of prior purchases and settlements and, a process for updating the market values of settled positions along with appropriate software.

My intention is not to minimize the work involved in meeting the above requirements. However, for a firm that has an organized account/ order acceptance protocol and a database of purchase and redemption activity, the client reporting 4 requirements are largely an exercise in database management, report generation and training.

EMDs and other securities registrants who fail to establish and maintain organized compliance processes are gambling that securities regulation, and their obligations will stay steady. Firms that have organized compliance processes know they never will.

Ultimate Designated Confusion

Sep / 13 / 2013

The Ultimate Designated Person (“UDP”) category of registration is a curiosity.

The UDP was traditionally viewed as a name that had to be filled in to complete a firm registration…a figurehead with no genuine functional role.

However, over time, and especially since the introduction of NI 31-103, the role of UDP, began to take shape.

A UDP’s responsibility is formally set out under Part 5.1 of National Instrument 31-103, and is explained in the Companion Policy as follows:

The UDP is responsible for promoting a culture of compliance and overseeing the effectiveness of the firm’s compliance system. They do not have to be involved in the day to day management of the compliance group.  There are no specific education or experience requirements for the UDP. However, they are subject to the proficiency principle in section 3.4.

To understand this regulatory hieroglyphic, one has to first consider the key condition to qualify as UDP.  Part 11.2 explains that the UDP must be the individual who functionally serves as CEO of the registerable business.

In the novel “The Great Gatsby”, F. Scott Fitzgerald describes the main character, Jay Gatsby, as follows:

If personality is an unbroken series of successful gestures, then there was something gorgeous about him (Gatsby).”

Just as personality cannot be reduced to a series of successful gestures, the effectiveness of a firm’s compliance structure cannot be reduced to a series of forms, logs and approval protocols administered by the Chief Compliance Officer (“CCO”).

The UDP category is recognition that the individual who manages the day-to-day compliance functions (the CCO) is often not the person with most influence over whether a firm maintains compliance with its regulatory obligations.   The CEO can either enhance or undermine a firm’s compliance structure.

NI 31-103 has simply applied a UDP label to this individual and removed any impediments such as specific exams or experience that could stand in the way of holding him or her accountable as UDP.

The CSA may have provided little guidance on specific actions that a UDP must take, to avoid offering a “safe harbor” of steps he/she can complete and be free from regulatory harm.

Below, I have discussed some of the key roles and expectations of a UDP.

A UDP must first exercise care in the selection of a CCO.  The CCO must have an appropriate level of knowledge, experience and judgment to administer and oversee the compliance function.   This individual should typically have access to resources, including published materials, consultants, appropriate courses/seminars and input from CCOs at similar firms, as appropriate.

More importantly, the CCO must have enough time to administer his/her role.  Many smaller EMDs get into regulatory trouble because no one in the organization has the time to keep abreast of regulatory developments, or the regulatory implications of business changes, or to perform expected compliance tasks, on a day to day basis.

A UDP will be faulted personally for appointing a CCO who does not have sufficient time or resources to effectively perform his or her role.

Once appointed, the UDP must continue to oversee the CCO’s activities.  Depending on the size and complexity of the firm, oversight can include controls such as, establishing goals or projects for the CCO and ensuring their completion, formalizing regular meetings with the CCO to review compliance matters, and advising the CCO of specific matters (e.g. complaints) that must be brought to the UDP’s attention.

The UDP must take care to ensure there is documentary evidence of each key supervisory step.

The UDP should be generally familiar with his/her firm’s policies and procedures, and assess whether they are appropriate for the business.  For example, a UDP should be generally familiar with the type of information collected from clients, and whether it is appropriate for the Firm’s type of business and operations.  However, a UDP is not expected to understand details such as, steps one has to take verify the identity of persons who have trading authority over a client’s account.

A UDP cannot be passive.  If he or she is made aware of a regulatory problem or systematic control weakness, he/she must take immediate and appropriate action.   Action can be simply consulting with counsel, or assigning specific tasks to others in the organization.  However, the UDP must also verify successful conclusion of the matter that was brought to his/her attention.

Perhaps the most cryptic obligation of a UDP is to establish a culture of compliance within the firm.   Many UDPs who have run successful businesses are well aware of the importance of business culture and tone.

It starts with the background and attitude of individuals a Firm hires to market its financial offerings and perform other key functions.  Formal and informal rules such as compensation arrangements, how staff are evaluated, and the firm’s policies regarding staff conduct influence how staff may act when “no one is looking”.

Perhaps the most important influence of compliance culture is the UDP’s daily decisions and actions on compliance matters.  For example, a UDP will undermine a firm’s compliance structure if he or she is willing to bend company policy for certain staff, tries to gloss over unethical conduct of high performing representatives, fails to maintain an open and supportive relationship with the CCO, or does not take routine compliance matters such as attendance at compliance seminars or completion of documentation seriously.

Just as personality cannot be reduced to a series of successful gestures, a compliance structure cannot be limited to a series of tasks.  The role of a UDP is to ensure that regulatory expectations and ethical conduct permeates the daily operations of a registered firm.

Are we all going to become like IIROC?

Jun / 30 / 2013

The introduction of specific requirements for EMDs and PMs under NI 31-103 and, the Commissions’ ongoing guidance/ revisions have led many industry participants to question whether they are effectively operating on the same level as IIROC dealers.

The answer is a bit more complicated.

If one strips out all sales compliance requirements from the IIROC rule book, one will be surprised to find these are conceptually the same as for EMDs and PMs. IIROC does have a more rule-centered approach.  For example Dealer Member rule 2500 specifies that a member firm can maintain one account opening form for multiple accounts of the same client.  NI 31-103 does not comment on this.   However the basic sales compliance principals of suitability, appropriate sales practices, client disclosures, complaint handling and record keeping are the same.

What makes IIROC a bitter pill for smaller firms to swallow is regulatory capital, and associated fees/ costs.  For example an approved “panel auditor” must audit an IIROC firm’s statements.  Only 24 such firms have been approved in Canada.  The regulatory capital calculation form, the JFQ&R, is a healthy 27-page document and the capital requirements are substantially greater.  Regulatory capital requirements and costs for IIROC firms are higher because they can take on market risk.  For example IIROC Firms can let clients to trade on margin, can hold prop accounts or, underwrite securities on a principal basis.  IIROC firms can also act as participating organizations on public exchanges.  Firms who don’t require such activities as part of their business model are simply taking on unnecessary and substantially greater regulatory cost and burden.

Social Media (Guidance from the SEC)

May / 08 / 2013

Lately there has been a fair bit of regulatory discussion about social media.  However other than some general commentary under NI 31-325, the industry has received very little official guidance.  Folks who are interested in learning more about best practices in this area (and probably where the Canadian regulators may get inspiration when they publish guidance) may wish to take a look at a document from the SEC summarizing their findings and recommendations from reviews of Investment Advisors that use social media.  http://www.sec.gov/about/offices/ocie/riskalert-socialmedia.pdf.  It’s an interesting read on compliance challenges arising from the use of social media.

Hello world!

Apr / 01 / 2013

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Vipool Desai


Vipool is President of
Ara Compliance Support,
which he co-founded
in 2006.