ASC Exempt Market Dealer Sweep Prompts Best Practice Guidance

Darin Renton -

The Alberta Securities Commission (ASC) recently completed a compliance “sweep” of 66 Alberta-based exempt market dealers (EMDs). The results of the sweep, which involved EMDs of many stripes, were released on May 10, 2017 as ASC Notice 33-705 - Exempt Market Dealer Sweep (Report). Overall, the ASC found a spectrum of compliance levels.  Some firms achieved a high level of compliance or were found to be “at least generally compliant”. At the opposite end of the spectrum, compliance levels of certain firms necessitated regulatory action on the part of ASC staff.

The sweep focused on compliance systems, sales practices and marketing (including KYC, KYP and suitability) as well as conflicts, relationship disclosure and client reporting issues. The EMDs reviewed included some that offer third-party exempt market products, others that are primarily involved with oil and gas-related venture capital and private equity (or with hedge funds and other pooled investment funds investing in publicly traded securities) and a third group that focus on mortgage-based investments.

The purpose of the Report is to summarize the results of the sweep and provide guidance to assist firms in complying with their regulatory obligations. Some of the highlights are summarized below.

Know Your Client

Many of the EMDs were deficient in the collection and documentation of Know Your Client (KYC) information, with required information often missing from forms. Under CSA Staff Notice 31-336 - Guidance for Portfolio Managers, Exempt Market Dealers and Other Registrants, KYC information is to be updated annually where the EMD is in regular contact with the client and at the time of each new trade where the EMD acts for the client only on occasion. Other issues included the misuse of the prospectus exemption qualification (a serious breach of securities law, as the Report pointed out) and “investment cap circumvention” (where the $10,000 cap for non-eligible investors was finessed through multiple transactions in that amount on the same day).

Know Your Product

Many firms failed to meet Know Your Product (KYP) requirements. For example, the Report notes a lack of attention to risks related to the exempt market. Moreover, reliance was placed on third-party reports and reports prepared by the issuer, with little or no independent review. The Report states that KYP due diligence should include (among others) background checks, an assessment of the issuer’s track record, verification of claims in offering documents and marketing materials, stress testing of the product with respect to economic and financial variables, an analysis of pricing and an independent consideration of the risk factors disclosed in the offering documents.

Suitability

Section 13.3 of NI 31-103 - Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) requires registrants to take reasonable steps to ensure that a proposed purchase or sale is suitable for the client. The ASC’s expectation that firms will be able to demonstrate suitability on a trade-by-trade basis was not met in a number of cases. The ASC noted a mismatch between the assessed risk tolerance of investors and their investments and concluded that investors were often invested too heavily in exempt market securities as a class. Moreover, KYC forms used by many firms did not collect information about the use of leverage, which can create serious liquidity problems, particularly when combined with an over-concentration in exempt securities.

The ASC identifies a number of practices to address over-concentration in exempt market securities. It also expects EMDs to have specific policies and procedures to address suitability for clients over 60, investors with limited knowledge and other vulnerable investors. These policies and procedures include:

  • Enhanced due diligence (focusing on holdings outside the firm and other illiquid assets, such as real estate-backed exempt market securities);
  • “Red flag” second-level review by the CCO of transactions:
    • with concentration near or over 10 per cent of net financial assets;
    • for clients over 60 years of age or with limited investment knowledge;
    • that are leveraged; or
    • in which the client barely qualifies for the prospectus exemption; and
  • Discussing and documenting concentration issues and establishing stricter/lower concentration thresholds for clients requiring liquidity.

These requirements are consistent with the themes of CSA Consultation Paper 33-404 - Proposals to Enhance the Obligations of Advisers, Dealers, and Representatives toward their Clients.

Sales and Marketing Practices

The ASC reminds EMDs to establish marketing policies and procedures consistent with the guidance in CSA Staff Notice 31-325 - Marketing Practices of Portfolio Managers. Other ASC guidance focuses on review, approval and centralization of marketing materials as well as procedures for storage and retrieval.  EMDs are encouraged to engage independent third party service providers to verify performance calculations.

Conflicts of Interest

Under section 13.4 of NI 31-103, firms are required to avoid conflicts of interest that pose a serious threat to client interests or market integrity, while mitigating and disclosing less serious conflicts. Here again, compliance was less than ideal; while most firms did have some internal controls, policies and procedures were often insufficient to identify conflicts. The ASC recommends a product-specific disclosure form that discusses conflicts of interest that apply to a particular product.  The ASC wants the CCO or other compliance personnel involved in addressing conflicts to

  • Record and track all existing and potential material conflicts of interest along with the firm’s response to these conflicts; and
  • Discuss directly with each client, in person or over the phone, all material conflicts of interest to ensure the client understands the firm’s conflicts prior to commencing trading activities.

Relationship Disclosure Information

The failure to disclose conflict information forms part of the ASC’s broader concern about Relationship Disclosure Information (RDI). Section 14.2(1) of NI 31-103 requires that registrants provide clients with all of the information that a reasonable investor would consider important.

Consistent with CSA Consultation Paper 33-404, the ASC seeks to raise the bar on relationship disclosure by ensuring that clients have read and understood RDI. The Report accordingly suggests including fields in the KYC form for the client to acknowledge that each section has been discussed with the dealing representative and is understood. This would significantly increase the number of fields in a KYC form that need to be specifically acknowledged by the client, adding further time and compliance cost to the process. It also adds uncertainty with respect to how and when such RDI acknowledgments must be updated.

RDI should be provided in a single document that discloses all fees payable by the client, including those relating to custody for RRSP and TFSA accounts. RDI must be kept up to date and should be delivered in a timely manner. The ASC also emphasizes the importance of drafting RDI in plain language.

Reporting to Clients

The ASC seeks to impose an onerous a requirement for EMD clients to acknowledge receipt of trade confirmations and client statements (e.g., by obtaining an electronic notice of delivery).  The ASC also puts its gloss on certain market practices:

  • Subscription agreement as trade confirmations – A subscription agreement should not be delivered in lieu of a trade confirmation unless it includes information that meets the trade confirmation requirements and delivery meets the timing requirement; and
  • Third-party trade confirmations and client statements – EMDs should not rely on trade confirmations and client statements provided by an issuer or custodian unless oversight procedures are in place.

Other Compliance Issues

Additional issues that were identified included (among others) inadequate supervision and disclosure of outside business activities, use of non-compliant trade names, failures to inform the ASC about significant changes to a firm’s business model, failures to update information on the National Registration Database, allowing registerable activities to be performed by non-registered individuals, and an absence of policies regarding the allocation of investment opportunities among clients.

Conclusion

The above is only a selection of highlights from the Report, which is worth reading in its entirety.  The ASC recommends that firms use this Notice to strengthen their compliance with Alberta securities laws.  Although the Report is focused on Alberta-based EMDs, much of the guidance draws on previous CSA guidance and is consistent with the themes set out in CSA Consultation Paper 33-404.  The best practice guidance seeks to raise the bar in several areas and may over time be taken into consideration by other CSA jurisdictions.

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