The Investment Industry Regulatory Organization of Canada (IIROC) is seeking comment with respect to how firms should deal, if at all, in “non-arm’s length” investment products. The regulator has issued a draft Notice to its Members which would set out staff expectations of Dealers when they and their Approved Persons distribute investment products in which the Dealer has an interest.
Much of the securities industry is primarily regulated by IIROC. Formed in 2008 through the combination of the Investment Dealers Association (IDA) and Market Regulation Services Inc. (RS), IIROC would have had its work cut out for it, even had the financial markets not so dramatically imploded at about the time the newly constituted regulator opened its doors. The events of the past year and a half have served to focus the energies of all financial market regulators and caused them to re-assess their priorities. Judging however by its recent regulatory initiatives, of which the draft Notice is but one, IIROC has redoubled it commitment to advancing investor protection by way of implementing the Client Relationship Model, or CRM.
For some years now, IIROC, together with other senior Canadian securities regulators, has been rethinking the regulatory model under which the distribution of securities to investors, particularly retail investors, takes place. They posited that investor protection could be made more effective by focusing on the relationships between the various parties in the capital markets, rather than on the types of products or the specific activities that market participants were carrying on.
CRM began life as something called the “Fair Dealing Model” and evolved to the present day Client Relationship Model1. The CRM seeks to regulate on the basis of the relationship a client — think individual investor — has with the financial services provider, rather than on the basis of the financial services or products that the client buys and sells. To that end, the rules seek to make clear the roles and responsibilities of the client and the financial services provider / advisor without regard to the type of account relationship (i.e., self-managed, advisory, managed-for-you).
The CRM has many facets, and we saw some of these implemented with the coming into force of a bundle of new regulations falling under the rubric of “Registration Reform”. Embodied within both a new National Instrument, NI 31-103 Registration Requirements and Exemptions, as well as a slate of new IIROC Rules and Policies, “Reg Reform” (as it is known to the industry) marks the first major step of the larger project which will eventually complete the CRM program. Reg Reform mandated new or enhanced disclosure requirements, so that clients will eventually be furnished with a comprehensive package called the “relationship disclosure information”. Also under Reg Reform, dealers are required to make an inventory of all of the conflicts of interest which could have a bearing on the client, and develop policies and procedures which address such conflicts.
This is the overall context in which IIROC has issued the draft Notice. IIROC specifically cites concerns regarding “conflicts of interest, product due diligence and suitability.” The Notice draws a comparison between sales of non-arms length products and situations in which a Dealer Member borrows money directly from a client. Dealers are required to make an internal assessment of the conflict, and only if the dealer concludes that the conflict can be “adequately addressed” should the dealer move to the next stage, which is subjecting the product to a thorough due diligence review. One wonders how a dealer can conduct meaningful due diligence on itself or a related party. IIROC notes that in a public distribution, there are any number of parties who can provide a sceptical and objective point of view, including underwriters, selling syndicate members, rating agencies, analysts and prospectus review staff of securities regulators. “In any distribution where such third party involvement is not mandated or otherwise applicable, members should consider arranging for substitute review or enhanced measures to ensure that appropriate due diligence is conducted…and the appropriate level of disclosure and other requirements are satisfied.”
Another concern cited by IIROC is the possibility that the industry protection fund, the Canadian Investor Protection Fund or CIPF, may not be available to cover client losses resulting from the purchase of non arm’s length products in the event of the insolvency or bankruptcy of a Member. IIROC notes that “in the case of non-arm’s length products of issuers related to the Member, the nature of the relationship and the determination of whether or not the loss is a market loss or insolvency loss (insolvency loss being the only loss covered by CIPF) may result in CIPF coverage not being available.”
Clearly, the area of greatest concern is the distribution via the Dealer’s sales channel of related party, less liquid, non-prospectused product. So the Notice proposes a requirement for Dealer members to provide IIROC with written notice 20 business days prior to the execution of a first trade in a distribution of a non arm’s length product which has neither a prospectus nor is eligible for margin under IIROC rules.
The notice requests comment from dealers and other interested parties on: relevant criteria for determining non-arm’s length investment products; best practices for dealers in conducting product due diligence and addressing conflict of interest concerns in the distribution of investment products; and the form that the new IIROC notification requirement should take.
While the intent of the Notice is understandable enough, IIROC members and their related parties would do well to examine the draft language. It is not at all uncommon for IIROC members to sell non arms-length products, and the process for making those distributions may just get a bit more complicated.
Comments are due May 6th, 2010.
1 The CRM itself is the subject of a Request for Comments issued by IIROC April 24, 2009 as Notice 09-0120. This document contains a broad overview of the CRM Program, as well as draft Rules for its implementation. View the document