Conflicts of Interest in distributing securities of related or connected issuers

November 30, 2015

On November 19, 2015, the Canadian Securities Administrators (“CSA”) issued CSA Staff Notice 31-343 Conflicts of Interest in distributing securities of related or connected issuers (the “Notice”), wherein the CSA indicated that the identification of, and response to, conflicts of interest are fundamental regulatory obligations.  The CSA states that they consider a conflict of interest to be any circumstance where the interests of different parties, such as the interests of a client and those of a registrant, are inconsistent, competing or divergent.  National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (“NI 31-103”) and its companion policy (“Companion Policy”) provide a principles-based framework that requires registrants to identify and respond to material conflicts of interest.  Whenever a registrant trades in or advises on securities issued by “related or connected issuers” (as defined in National Instrument 33-105 Underwriting Conflicts), the registrant must manage any conflicts that may arise. 

In the Notice, the CSA notes that firms registered solely as exempt market dealers, which distribute securities of related or connected issuers with common mind and management (“Captive Dealers”) raise serious concerns in terms of how they respond to these conflicts of interest.  According to the CSA, the inherent conflict of interest in the Captive Dealer business model may affect a registrant’s ability to meet its know-your-client (“KYC”), know-your-product (“KYP”) and suitability obligations, and its duty to act fairly, honestly and in good faith with clients (“Fair Dealing Duty”).  In the Notice, the CSA provided additional guidance (including “acceptable practices” and “unacceptable practices”) which will assist Captive Dealers (and possibly other registrants) in meeting their regulatory obligations. 

Registrant Obligations

Conflicts of Interest

Registrants must comply with Part 13, Division 2 Conflicts of Interest of NI 31-103, which requires them to take reasonable steps to:

  • identify existing material conflicts of interest and those that the firm reasonably expects to arise between the firm and a client, and
  • respond appropriately to existing or potential conflicts of interest

The Companion Policy outlines three methods to respond to conflicts of interest: avoidance, control and disclosure.

KYC, KYP and suitability

The KYC, KYP and suitability obligations and the Fair Dealing Duty apply to all registered dealers and advisers, and apply to trades made under prospectus exemptions. Many prospectus exemptions allow issuers to raise capital from persons who can assess the merits/risks of the investment without a prospectus. A certain number of these investments are higher risk, illiquid and the information available to investors at the time of investment (and possibly after investment) will be limited. Any offering document used will not be reviewed and approved by the regulators, and the continuous disclosure obligations for reporting issuers may not apply. Registrants play a critical role in ensuring that investors understand the risks associated with their investments and that the investments are suitable.  CSA Staff Notice 31-336 Guidance for Portfolio Managers, Exempt Market Dealers and Other Registrants on the Know-Your-Client, Know-Your-Product and Suitability Obligations provides additional guidance on the applicable securities legislation requirements relating to KYC, KYP and suitability.

Concerns with Captive Dealers

The Captive Dealer business model creates a material conflict of interest between the Captive Dealer’s financial incentive to sell its related or connected issuer’s securities, and its regulatory obligations, including KYC, KYP, suitability, and its Fair Dealing Duty.  The inherent conflict of interest in the Captive Dealer business model gives rise to inconsistent, competing or divergent interests, which make it difficult for a Captive Dealer to fulfil its duties to investors objectively. A registrant’s primary obligation is to ensure that the securities it recommends to investors are suitable for them.  The Notice sets out a number of significant compliance deficiencies among Captive Dealers.

Responding to Conflicts of Interest

Captive Dealers should avoid material conflicts of interest that they are unable to address through controls and/or disclosure. Avoidance includes ceasing to provide a service, or dealing with a client, or not trading in a particular product or products. Captive Dealers that solely or primarily trade in related or connected issuer securities are more likely unable to address conflicts of interest through controls and/or disclosure.
When reviewing Captive Dealer businesses, the CSA will assess each business in relation to its related or connected issuers and their investment products, to assess the nature and severity of the existing conflicts of interest. In compliance reviews, the CSA has seen instances where Captive Dealers could not demonstrate that they had met their conflicts of interest obligations under Part 13 of NI 31-103, because they did not:

  • understand when, as a result of material negative changes to their business (for example, significant financial losses of a related issuer), they could no longer manage their conflicts of interest, and therefore should respond by avoiding them;
  • identify and document that they identified and responded to conflicts of interest, and why their response was appropriate;
  • assess each related or connected issuer product they sell in relation to each trade; instead they assumed that the suitability of one related or connected issuer product makes all of their related or connected issuer products suitable for an investor; and/or
  • consider the concentration of related or connected issuer products in an investor’s investment portfolio.

In the Notice, the CSA encourages Captive Dealers to:

  • separate decision-making roles in related or connected issuer and dealer businesses;
  • establish policies and procedures that require an ongoing assessment of their Captive Dealer business models and the products they trade;
  • establish an independent review committee to conduct product due diligence and to consider on an ongoing basis whether to avoid, control, or disclose conflicts of interest;
  • consider offering securities of third-party issuers in addition to those of related or connected issuers, and ensure that dealing representatives are aware and understand that the firm offers a diversified product shelf;
  • provide balanced product training to sales staff by someone other than the issuer; and
  • provide balanced training to sales staff outlining their responsibility to meet their KYP, KYC and suitability obligations
Captive Dealers’ Registrant Obligations

Captive Dealers that do not avoid conflicts of interest should demonstrate instead that they are controlling and/or disclosing them appropriately.  Below are some effective practices, among others, for controlling and/or disclosing conflicts of interest. During compliance reviews, the CSA will focus closely on whether Captive Dealers have implemented any of these practices and if not, the Captive Dealers will be required to explain what alternative or additional methods they have in place.

As set out in the Notice, the following are some acceptable practices:

  • Develop policies and procedures that describe how the registrant will identify and respond to conflicts of interest.
  • Document the registrant’s independent KYP assessment, for instance, by keeping a due diligence checklist and documents that demonstrate the registrant’s review of key documents such as offering documents, business plans and financial statements.
  • Have an independent review committee who will:
    • review policies and procedures to ensure they address conflicts of interest, KYC, KYP, suitability, and the Fair Dealing Duty;
    • conduct initial due diligence on related or connected issuer products, including an assessment of the accuracy and reliability of materials provided by the related or connected issuers; and
    • identify those products that pose too severe a conflict of interest to be distributed generally and consider whether trades in such products should be restricted to certain investors or classes of investors only.

The independent review committee’s review and approval of any product for distribution does not relieve the Captive Dealer of its obligation to ensure the product is suitable for each client.

  • Provide clients with meaningful disclosure, including:
    • the issuer’s audited financial statements
    • a simplified document, similar to a mutual fund fact sheet, with appropriate highlights and risk disclosures about the investment, including clear disclosure of the conflicts of interest and the concerns it raises
    • other relevant information, in plain language
  • Assign a responsible individual (such as the chief compliance officer or ultimate designated person), who has not been directly involved in any way with the trade in question, to ensure that investors understand:
    • the relationship between the Captive Dealer and the related or connected issuer;
    • the key features of the investment (e.g. that the security is sold under a prospectus exemption and therefore may be illiquid, the risks of the investment and the compensation received by the Captive Dealer for the trade); and
    • the concentration risks associated with investing in a limited number of related or connected issuers.
  • Provide training to ensure that registered individuals and other relevant staff understand the nature of the material conflicts of interest inherent in the business model and the importance of avoiding, managing and/or disclosing them.
  • Have unrelated dealers distribute the securities of your related or connected issuers, demonstrating to CSA staff that a third party has reviewed the products and found them suitable for distribution.
  • Sell products other than those of related or connected issuers; product diversification is an important factor to help reduce financial dependence of the dealer on an issuer.

As set out in the Notice, the following are some unacceptable practices:

  • Fail to identify and document the registrant’s assessment and response to the conflicts of interest inherent in the registrant’s Captive Dealer structure.
  • Assume that disclosing a conflict of interest alone is sufficient to respond to it.
  • Inadequate policies and procedures to identify, determine the risk of, and respond appropriately to conflicts of interest.
  • Assume that the related or connected issuer has complied with KYC, KYP or suitability requirements. Each Captive Dealer has an independent obligation to comply with these requirements and to keep compliance records. Registrant’s cannot delegate the KYC, KYP and suitability processes.
  • Present conflicts of interest disclosure in an obscure or confusing manner, such as in lengthy and complex documents. This disclosure should be in plain language, and easily understood by a reasonable person.
  • Ask a client to waive conflicts of interest disclosure and/or a suitability assessment. Permitted clients may waive their right to a suitability review in writing.
Registration Applications from Firms Proposing to be Captive Dealers

In assessing new registration applications, the CSA will consider applications by Captive Dealers on a case-by-case basis. The likelihood of harm to investors and to the capital markets will be the main factors in the CSA’s determination. Such review will include an assessment of the Captive Dealer’s business plan, both in the short term and in the longer term, and an assessment of the firm’s policies and procedures manual to test if it has an adequate compliance system in place to control and/or disclose conflicts of interest. Failure to disclose conflicts of interest to CSA staff may result in a recommendation of refusal of registration.

Compliance Reviews of Captive Dealers

During compliance reviews of Captive Dealers, the CSA will, among other things, discuss with such Captive Dealers why they did or did not adopt some or all of the effective practices in the Notice and assess whether the practices they have adopted are sufficient to address conflicts of interest in the Captive Dealer business model.  The CSA will closely monitor registrants’ compliance with conflicts of interest, KYC, KYP and suitability requirements, and will take appropriate regulatory action to ensure compliance with securities legislation.

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