Chapter 9 - Opening and Maintaining Accounts PDF

SECTION 4 APPLICATION OF SKILLS 9 Opening and Maintaining Accounts 10 Recordkeeping Requirements 11 Client Complaints 12 Registration 13 Trading Desk Supervision 14 Investment Banking © CANADIAN S...

SECTION 4 APPLICATION OF SKILLS 9 Opening and Maintaining Accounts 10 Recordkeeping Requirements 11 Client Complaints 12 Registration 13 Trading Desk Supervision 14 Investment Banking © CANADIAN SECURITIES INSTITUTE  Opening and Maintaining Accounts 9 CONTENT AREAS Documentation Disclosure and Conflicts of Interest Dealing with Elderly and Other Vulnerable Clients Equity and Mutual Fund Trading and Settlement Funds and Securities Movements Capital Requirements Prospectus and Prospectus-Exempt Distributions LEARNING OBJECTIVES 1 | Explain the rules and compliance issues surrounding account documentation, including anti‑money laundering. 2 | Discuss conflicts of interest and disclosure requirements. 3 | Explain the compliance and supervision issues related to dealing with elderly and other vulnerable clients. 4 | Discuss equity and mutual fund trading and settlement. 5 | Discuss the importance of implementing transaction controls at a dealer member. 6 | Outline the capital rules of the securities industry, and describe the common reasons why dealer members become undercapitalized. 7 | Discuss the various prospectus exemptions, and distinguish between a prospectus and an offering memorandum. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 3 INTRODUCTION In the previous section, we discussed the broad range of responsibilities required of a chief compliance officer at an investment dealer, as well as the skills the chief compliance officer needs to fulfill those responsibilities. We discussed the fact that chief compliance officers must be able leaders who can make good decisions rooted in strong personal values. They must also be the driving force behind the development of sound policies and procedures and the surveillance of business activities to ensure compliance with regulations. In this section, we explore in detail the chief compliance officer’s different areas of responsibility, and we explain how CCOs must apply their skills to the demands of the job. We begin this chapter by discussing the key issues and processes involved in the opening and maintenance of client accounts, with emphasis on compliance risk. Some details in this chapter may not apply to all dealer members, and many processes may be the responsibility of other senior staff, such as the chief financial officer, rather than the CCO. Nevertheless, all CCOs should understand the firm’s inner workings to provide context for the many types of issues that may arise. DOCUMENTATION 1 | Explain the rules and compliance issues surrounding account documentation, including anti‑money laundering. Documentation, in particular the account application, is a fundamental part of any dealer member’s operations. The account application serves as the basic contract for services between the dealer member and its individual clients and therefore plays a critical role as it represents one of the documents that governs the relationship between the client and the dealer member. In addition, given the ever-changing life of a client and the ongoing nature of the client relationship, the account application will evolve and change over time along with changes to the client’s life. Appropriate documentation (and the manner in which it is created) is a regulatory controlled function that can also affect the commercial operation of the dealer member. For these reasons, having proper documentation and robust and clear processes designed to create, amend and store documentation as well as a properly functioning documentation management system is critical to the successful operation and longevity of a dealer member. It is important to note, however, that dealer members are not under any obligation to open an account, with or without proper documentation. ACCOUNT DOCUMENTATION Completing the account application, also called the KYC form, is the first step in establishing all client relationships. With hard‑copy account applications, copies typically go to the client, the business location, the head office, and the advisor. The account application does not require the client’s signature, but the firm must confirm with the client, that the information is correct, and document the confirmation. Such communication should be independent of the advisor. In most instances, the client will execute the account application as evidence of their agreement to its contents, whether such execution is physical or electronic. Many firms now use electronic account applications, which are usually completed by clients, particularly for online accounts. Forms for clients should be easy to understand, with clear instructions and explanations provided for unfamiliar terms. For example, some advisory firms provide explanations of the different types of objectives and different levels of risk tolerance. Clear instructions help to produce complete and accurate forms, which allows registrants to provide appropriate advice and supervision. The advisor should discuss the entire and completed form with the client to make sure it is accurate and that it provides for a common understanding of the important details. Under no circumstances should a client sign any form that is blank or incomplete, with or without granting permission to the registrant or an employee of the firm to complete it. © CANADIAN SECURITIES INSTITUTE 9 4 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 When a client has multiple accounts, the account application should be clear about which accounts it applies to. The form should also address whether the accounts will be supervised separately (whereby all accounts have the same objectives and risk tolerance) or on a portfolio or “household” basis (whereby the accounts collectively meet certain objectives and risk tolerance, though positions in individual accounts may differ). If more than one party is involved in the account, the form must specify which information applies to which party. For example, when assessing the investment knowledge of one person involved in a joint or investment club account, the form should identify the person. New account application forms must be reviewed and approved by a designated supervisor. A thorough review at this time may prevent related compliance issues from arising later. On the other hand, inadequately or improperly completed account applications can result in the following problems: Failure to verify a client’s identity can result in client fraud, insider trading, or money laundering. Failure to verify a client’s address, or permitting the use of a mailbox address, can result in client or advisor wrongdoing. Inconsistencies in client information and investment objectives can result in client complaints of unsuitable investments. Inaccurate date of birth is problematic when dealing with a minor or an elderly person, and also with registered accounts, including registered retirement savings plans and registered retirement income funds, for which serious consequences can arise on deregistration. EXAMPLE Failure to verify a client’s identity Inadequate disclosure of a client’s corporate connections and large holdings in public companies can result in illegal insider trading, market manipulation, or distribution issues. For example, improperly identified clients can deposit large blocks of stock registered in the names of insiders into an account to be sold or transferred to third parties, in contravention of insider trading and market manipulation rules. Failure to verify a client’s address A client operating from a jurisdiction where the advisor and firm are not registered can lead to disciplinary actions by regulators and the possibility of litigation. The person reviewing the account application should also be aware of the advisor’s address in the event that a client or advisor attempts to inappropriately direct mail to that address. Inconsistencies in client information and investment objectives A retired client with modest means having unsuitably aggressive investment objectives can lead to future problems, such as regulatory action or litigation, which can be prevented with a review of the account application. Advisors should engage in a clear and robust discovery process that clearly identifies which objectives are suitable for each particular client based on the facts and circumstances. Documentation is key to demonstrating the advisor’s approach. The head office of a dealer member should make sure that the information on the account application (or the account application itself) is readily available for review. Trading and suitability reviews require a comparison of trades to a client’s investment objectives and risk tolerance. Some firms provide direct electronic access to account applications; others provide access to excerpts of key information. It is acceptable to refer to paper documents, but this can be impractical in larger firms. CHANGES TO CLIENT INFORMATION Changes to KYC information that affect suitability judgments, such as significant changes to financial information or objectives, must go through the same approval process as the initial application. When reviewing such changes, © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 5 it is useful not only to look at the most recent information, but also to review any changes over a longer period. This is particularly true if the change is in response to a discrepancy discovered through a supervisory review, such as unsuitable trades. Clearly documenting these changes to client circumstances and importantly when these changes took effect is critical. Changes to a home or email address are a regular feature in cases of advisor misappropriation of client assets and should be monitored closely. The following forms of control are used to ensure that clients receive statements and confirmations, electronically or otherwise, at their true address: Written instructions required from the client, and the client’s signature checked against a valid signature on file Confirmation letter sent to the client’s old address Telephone confirmation by an independent compliance or operations employee OTHER ACCOUNT DOCUMENTATION Dealer members’ policies and procedures must address account‑opening documentation such as cash, margin, discretionary account, managed account, options, futures, joint account and investment club agreements, third-party and corporate trading authorizations, and broader powers of attorney. Dealer members should consider the following issues regarding such documents, with legal advice obtained where needed: Whose signatures are required? For example, must all parties to a multi‑party account sign every agreement? Whether to require original signed documents, or whether copies or electronic versions are sufficient. Must the documents be witnessed? Some firms have found, on review without counsel, that not all documents with a witness signature line need to be witnessed. Having to obtain a witness signature can cause problems if the client forgets to get a witness. Must documents such as margin, options, and futures trading agreements be signed before trading begins? CIRO requires that a dealer member take action when account agreements are not received within 25 days of account opening. This process can escalate over time until the missing documentation is received. Escalation begins with a reminder to the client and can lead to a restriction of the account, liquidation of transactions, or withheld advisor commissions. ANTI-MONEY LAUNDERING REQUIREMENTS Anti-money laundering regulations and CIRO rules require that dealer members verify the identity and date of birth of any person opening a securities account. This information must be established before any transactions are conducted, other than an initial deposit. With limited exceptions, the identity of all persons authorized to give instructions on an account must be verified. This requirement applies not only to accounts of individuals, but also to those of corporations and other entities (i.e., accounts with third-party authority). When opening non-individual or entity accounts (e.g., accounts for corporations, trusts, or partnerships), dealer members must gather specific information about both the entity and the individuals behind the entity. For corporations, this includes the directors and beneficial owners of the corporation, and for trusts, it includes the trustees, beneficiaries, and settlors of the trust. Client identity can be verified by meeting the client in person and verifying their sources of identification. Generally, government-issued photo identification, such as a passport or driver’s licence, is required. Dealer members must take reasonable steps to keep client identification records up to date. If a dealer member chooses to incorporate any other method into its customer identification program, the AML/ATF regulations should be reviewed to ensure that the program is in compliance with both CIRO and applicable AML/ATF rules. © CANADIAN SECURITIES INSTITUTE 9 6 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Dealer members must also take reasonable steps to determine whether clients are politically exposed persons (PEP). Accounts opened for a PEP must be approved by senior management. The source of funds deposited into, or expected to be deposited into, their accounts must be identified. These accounts must also be subject to enhanced monitoring to identify suspicious transactions. Dealer members must have a person responsible for the firm’s AML/ATF compliance procedures, including an assessment of risk related to money laundering and terrorist activity financing. The procedures must be approved by senior management and reviewed every two years. Firms must also implement an appropriate ongoing education program about AML/ATF. Detailed information about AML/ATF requirements can be found in CIRO’s published AML/ATF guidance as well as on the website of FINTRAC. AML/ATF RESPONSIBILITIES FOR INTRODUCING AND CARRYING BROKERS Introducing and carrying brokers must clearly establish which firm is responsible for ensuring compliance with AML/ATF procedures, including recordkeeping responsibilities, reporting of currency transactions, and filing of suspicious transaction reports. They must also make sure that they have enough information to fulfill these responsibilities. Typically, the introducer is responsible for ensuring its compliance with AML/ATF legislation. In the context of AML/ATF, the issues surrounding KYC and suspicious transaction reporting are complex. They become even more complex when viewed in terms of allocating responsibilities between introducing firms and the firms that clear securities transactions on their behalf. Regulations under PCMLTFA contain no guidance in this regard and provide no compliance exemptions for carriers with respect to carried accounts. Given that the introducer has the primary relationship with the customer and is generally in the best position to know its client, suitability requirements generally fall on the introducer. For most purposes, the direct contact is between the introducer and the client. Likewise, in the context of AML/ATF, the responsibility to know the client logically falls on the introducer. However, the carrier may have the necessary systems for monitoring transactions, and they may deal directly with the client in conducting transactions such as account deposits, withdrawals, and wire transfers. Given the introducer has the primary and ongoing relationship with the client, the advisor of record will be in the best position to firstly know their client and secondly identify any suspicious activity for the client in question. Dealer members are obliged by law to file attempted or actual suspicious transactions. Dealer members should also maintain a log of all transactions which were flagged for secondary review which subsequently are not filed as suspicious transactions (for the reasons so specified). Introducing and carrying brokers should also develop a way to facilitate effective communication between the two dealer members whenever questionable activity, or potential indications of suspicious activity, is detected. A carrier cannot consider its responsibilities fulfilled if it simply reports what it considers potentially suspicious activity to the introducer. The introducer should provide the carrier with enough information to satisfy the carrier that the activity has been appropriately dealt with. Such information may include a suspicious transaction report filed by the introducer or an explanation that sufficiently confirms the activity as having no reason for suspicion. Anyone conducting the annual audits of AML/ATF procedures for the introducer and carrier should be aware of the allocation of their responsibilities. Both parties should also be encouraged to work together and share information to ensure that there are no gaps, and that both parties are properly executing their responsibilities. This reassurance is particularly important because, under PCMLTFA, carriers are not exempt from responsibility for introduced accounts. Because some procedures, such as identity verification, are performed by the introducer as the carrier’s agent, the carrier must make sure that the introducer is properly fulfilling its responsibilities. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 7 CONFIRMATIONS AND CLIENT STATEMENTS Trade confirmations and monthly statements must be sent to clients for all client accounts, except where specific exemptions exist. Limited exemptions exist for trade confirmations of trades in managed accounts. Similarly, CIRO does not require a dealer member to prepare and send a monthly client account statement recording non‑transactional entries such as dividend and interest entries. However, all accounts that hold assets must receive a quarterly statement, even where there have been no transactions. Provincial securities regulations and CIRO rules require that some disclosures be included in confirmations. Many can be done on the form itself, such as CIPF disclosure and the introducing/carrying broker disclosure required by CIRO rules. Other disclosures are specific to the transaction, such as the requirement to disclose whether the firm acted as principal or agent in the transaction. Failure to disclose principal trades accurately is a common finding of CIRO. Dealer members that occasionally trade as principal should therefore have procedures to ensure that these disclosures are accurate. Some required information can be disclosed through codes or addressed by a general statement that the information will be provided to the client on request. For example, the name of the RR involved in a transaction is often provided in a code. However, the code may relate to the RR who normally handles the accounts, not the RR who actually took the order for the account. Because this discrepancy can result in incorrect disclosure information recorded elsewhere (generally with the order) it must be maintained and accessible. Some dealer members put a house account code on the accounts of RRs who have left the firm, pending reassignment or transfer of the account. This practice is acceptable only as a temporary measure. The dealer member should also have controls over blank forms and the mailing process. Forms should be kept secure, and their access should be limited to those involved in their preparation. The mailing process should be secure and separate from sales personnel. These controls prevent the interception of client documents and their replacement by false documents. Although these problems are infrequent, a single incident can be very costly to a firm, in terms of both money and reputation. Most importantly, the dealer should take steps to document the mailing process (i.e., which steps take place and when) and also ensure that quality controls are in place to ensure the process is effective and operating as expected. PORTFOLIO SUMMARIES AND OTHER NON-OFFICIAL COMMUNICATIONS Some dealer members permit advisors to provide portfolio summaries in addition to the monthly statements sent by a firm. In some cases, these statements show positions in addition to the client’s holdings at the firm, such as mutual funds held in the client’s name at a mutual fund company. These summaries can be a valuable source of information to clients and a valid marketing tool for firms. However, because they may contain positions not held at the firm, they can also be misused. CIRO requires that such statements include a disclaimer indicating that they are not official firm statements. Clients should be referred to the official statements for information on holdings at the firm. The summaries should not contain any indication of CIPF coverage. EXAMPLE Non‑official portfolio summaries have occasionally been used to conceal client losses or overstate profits. In one instance, an RR provided portfolio summaries to his clients and then claimed to the firm that these were ideal trading scenarios. The RR told the clients in this case that the summaries represented their true holdings, and that the firm’s official statements could be ignored because they were incorrect. CIRO also requires that controls be implemented regarding unofficial summaries, in cases where the advisor has prepared them or can alter them. This does not mean that all summaries must be approved. Appropriate sampling measures can adequately mitigate any risks involved. Controls and approvals should also be established to ensure that, if such summaries are permitted, they are reviewed and approved prior to their release to clients. © CANADIAN SECURITIES INSTITUTE 9 8 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Some dealer members compile summaries themselves, including positions that the firm holds on its books and information provided by mutual fund companies on client name positions. If these summaries are sent directly to the clients, and there is no opportunity for the advisor to alter them, no controls are needed. ACCOUNT PERFORMANCE REPORTING FOR RETAIL CLIENTS Rules on enhanced client reporting impose the following key requirements: Disclosure of all dealer compensation, including trailing commissions and fixed income commissions Client statements that include information about off‑book securities and book‑value of securities A harmonized, dollar‑weighted method of calculating the performance of a client’s account or portfolio (which takes account of client deposits and withdrawals) ELECTRONIC DOCUMENTS AND SIGNATURES In most Canadian jurisdictions, electronic commerce legislation provides that electronic signatures are legally valid. CIRO also permits the use of electronic signatures. According to legislation, a valid document or electronic form must meet the following requirements: It must be accessible by the other party and usable for subsequent reference. It must be capable of being retained by the other person. It must be organized in the same or substantially the same way as the specific non‑electronic form. The electronic signature must be reliable for identifying the person. The association of the electronic signature with the relevant electronic document must be reliable. To meet the requirements of section 7(a) of PCMLTFA, these last two conditions require that a client signature be obtained on a signature card or account agreement. ADVERTISING, SALES LITERATURE, AND CORRESPONDENCE Dealer members must have written policies and procedures, approved by CIRO, regarding the review and supervision of advertising, sales literature, and correspondence relating to its business. Prepublication approval by a designated supervisor is required for the following materials: Research reports Market letters Telemarketing scripts Promotional seminar texts (not including educational texts) Original advertisements and original template advertisements Any material used to solicit clients that contains performance reports or summaries Monitoring advertising material is a complex procedure because of its broad definition and the many sources of rules and regulations that exist throughout the firm. For example, the sale and marketing of mutual funds is subject to additional regulation in NI 81‑105, whereas contest regulations appear in the Criminal Code. Dealer members must have written policies and procedures consistent with the size and nature of their businesses, and a review and supervision regime must be implemented. To ensure compliance, CCOs should ask the following questions: Are policies and procedures relating to advertising operational and adequate? Do they include a retention policy? And if so, who is responsible for it? © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 9 Is the person responsible for reviewing and approving advertising qualified to do so? Can advisors and business locations initiate advertising? Is this issue addressed in the firm’s policies? Does the firm advertise mutual funds? And if so, does it comply with NI 81‑105? Who is responsible for the firm’s website content? Can advisors have their own websites? Can advisors appear in the media, speak to the press, or write articles? And if not, how are restrictions controlled? Can advisors use social media sites (such as LinkedIn, X (formerly Twitter), or Facebook) to communicate with the general public? Are all issues surrounding the use of social media addressed in the firm’s policies and procedures? The best practice for evidence that marketing and sales materials are supervised is to attach a printed form requiring the initials or signatures of those who must pre-approve the material. A central file should be maintained for these materials. The form should be completed after the final draft of the advertising material is done to confirm that any required changes have been made. It should be noted that CIRO has also published updated guidance on the use of social media and other electronic forms of communication in the context of marketing and advertising. The fact that marketing and advertising may take place in such formats does not change the supervisory requirements of individual registrants and dealer members. A dealer member must retain copies of all advertisements, sales literature, and correspondence and all records of supervision. These items must be readily available for inspection by CIRO. EMAIL, INSTANT MESSAGING, AND THE INTERNET Many dealer members have policies regarding the appropriate use of the internet and email. In larger firms, these policies usually originate with the human resources department; in smaller firms, they might become a compliance mandate. Some firms use filtering software to restrict access to certain websites. All email communication should be done through the email facilities of the dealer member. Employees should understand that email records are retained and can be monitored; they should have no expectation of privacy when sending electronic communications using firm resources or infrastructure. They should also be aware that emails that may compromise or embarrass them or the firm can become public during litigation. In addition, it is for these reasons that only firm-sanctioned email services should be used to conduct registrable activities. Registrants should never use a private email address to conduct such activities. Compliance staff and supervisors should receive guidance about the litigation process, including legal privilege and discoveries. Counsel is often required to deal with emails, correspondence, and other memoranda written casually and without regard to the role they might play in a legal dispute. Chief compliance officers should determine a protocol to obtain access to relevant emails when the compliance department conducts an investigation. They should also implement a process to ensure that copies are made in case an investigation becomes a regulatory matter or claim, such as when an advisor’s employment is terminated for cause. Instant messaging raises similar concerns, with the additional issue that persons using the technology may be unaware that records of their communication are typically routed through the firm’s system and stored. This practice is consistent with specific CIRO rules that require firms to have relevant policies and procedures in place regarding the review and supervision of correspondence relating to its business. The rules also require the retention of evidence that correspondence is being supervised. © CANADIAN SECURITIES INSTITUTE 9 10 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 DISCLOSURE AND CONFLICTS OF INTEREST 2 | Discuss conflicts of interest and disclosure requirements. Section 14.2(1) of NI 31-103 states: A registered firm must deliver to a client all information that a reasonable investor would consider important about the client’s relationship with the registrant. This general statement is followed by a specific menu of items in 14.2(2). CIRO dealer members are exempt from 14.2(2) but must comply with similar requirements under CIRO rules. Dealer members must therefore make sure that policies and procedures are in place to comply with these disclosure requirements. These and other forms of disclosure are discussed below. RELATIONSHIP DISCLOSURE FOR RETAIL CLIENT ACCOUNTS Under IDPC rule section 3216, Relationship Disclosure, every dealer member must provide its retail clients with specific information about the relationship they are entering into with the client. Such disclosure must include the following information: A general description of the types of products and services offered by the dealer member A general description of any limits on the products and services the dealer member will offer A description of the account relationship to which the client has consented, which must state whether: The account opened is an advisory account, a managed account, or an order-execution-only account. The client is responsible for making investment decisions. Recommendations or advice will be provided to the client. A description of the process used by the dealer member to assess investment suitability, including assessment of the client’s KYC information A description of the client account reporting the dealer member will provide A statement indicating that any existing material conflicts of interest and any material conflicts of interest that are reasonably foreseeable and which are not avoided will be addressed in the best interest of the client and will be disclosed to the client, where required, in a timely manner upon identification of the conflict A description of all fees, charges, and costs associated with operating the account or holding the account CIRO does not mandate the format of the relationship disclosure; however, it does impose the following requirements: The information must be provided to the client in writing at the time of account opening. It must be written in plain language. The dealer member is also required to maintain evidence that the relationship disclosure has been provided to the client. DISCLOSURE STATEMENTS In addition to the relationship disclosure, a considerable amount of material must be provided to clients. Some documents must go to all clients; some only to clients investing in specific products or using specific services. In some instances, firms provide all new clients with a specific product disclosure (such as a strip bond disclosure statement) regardless of whether the client invests in the product. In any event, firms should maintain evidence of which documentation and disclosures are provided to clients. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 11 The following disclosures must be distributed to all clients: Disclosure relating to NI 54-101, Communication with Beneficial Owners of Securities of Reporting Issuers Statement of policies respecting connected issuers, if applicable Privacy brochure Information relating to arbitration Fee schedule The following disclosures must be distributed only to clients involved in the particular services or investments: Option risk disclosure statement Leverage risk disclosure statement Futures trading risk disclosure statement Strip bond information statement Fund Facts document New issue prospectus Some types of disclosure must be made available to clients, though not necessarily sent to them. For example, the CIPF brochure must be displayed on the premises and provided on request. DID YOU KNOW? Mutual fund companies must produce the fund facts document for each class of their mutual funds. The document consists of a plain language disclosure document, less than four pages long and highlights the potential benefits, risks, and costs of investing in mutual funds. Its purpose is to provide investors who purchase mutual funds with accessible and effective disclosure. Prospectuses and annual information forms regarding mutual funds must be filed with the provincial securities regulators in the jurisdiction that the mutual funds are to be sold in and with SEDAR+. Fund Facts are also posted to the fund manager’s website and delivered to investors at the time of sale. CLIENT ACKNOWLEDGEMENT Clients must acknowledge receipt of some documents but not others. For example, acknowledgement is required for the Options and Futures Risk Disclosure Statement but not for the Strip Bond Disclosure Statement. When there is uncertainty about whether a client received a disclosure statement for which an acknowledgement is not required, it is usually acceptable for the firm to demonstrate that it provided disclosure in the normal course of its business. The CCO should make sure that procedures exist for the distribution of disclosure forms and that acknowledgements are obtained, where appropriate. DISCLOSURE OF CONFLICTS The Client Focused Reforms introduced, among other things, a requirement to manage conflicts of interest in the best interests of the client. While CIRO’s conflicts-of-interest rule already included a best-interest standard, CIRO made changes to this rule to align with the CSA’s CFRs. The amendments also introduced enhanced standards for the disclosure of conflicts of interest. The disclosure must include a description of the nature and extent of the conflict of interest, the potential impact on and risk that the conflict of interest could pose to the client, and the manner in which the conflict of interest has been, or will be, addressed. © CANADIAN SECURITIES INSTITUTE 9 12 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 As previously discussed, Part 13 of NI 31-103 requires registered firms and individuals to identify, address, and disclose material conflicts of interest. Registrants must address such conflicts in the best interests of the client and provide guidance to explain when a conflict of interest is considered material. To comply with NI 31-103, registrants must avoid material conflicts of interest if there are no appropriate controls available in the circumstances that would be sufficient to otherwise address the conflict in the best interests of the client. Similarly, if a particular conflict is capable of being addressed by using controls, but the specific controls used by a registered firm do not sufficiently mitigate the effect of the conflict, the firm must avoid that conflict until it has implemented controls sufficient to address the conflict in the best interest of the client. As noted in NI 31-103: Both firms and individual registrants acting on behalf of their firms must go through a process to identify material conflicts of interest that currently exist between a client of the firm or an individual acting on behalf of the firm. As part of this process, they must also identify material conflicts that are reasonably foreseeable. The material conflicts so identified must be addressed in the best interests of the client. To the extent that such conflicts cannot be addressed in the best interests of the client, they must be avoided. The firm must disclose any material conflict of interest that may impact a client at the time of account opening, or in a timely manner if the conflict is identified at a later time. For each conflict so identified, the disclosure provided to clients must outline the following matters in a way that is prominent, specific, and written in plain language: The nature and extent of the conflict in question The impact and risk it may pose to the client The way in which it has been or will be addressed It is not sufficient for a registrant to solely rely on disclosure as a means to satisfy its obligations under the conflict provisions. Finally, individual registrants have similar obligations to those of the firm and must report conflicts to their firm promptly. OUTSIDE ACTIVITIES There are few areas that have the potential to generate more types of conflicts of interest than outside activities (and the closely linked outside directorships) by an employee. One layer is the potential conflict between the employee and his or her employer. The complexities increase significantly if the outside activity involves clients. Over and above the conflicts issue, outside activities can also confuse clients who are not certain which organization is responsible for the outside activity in question. Provisions related to outside activities appear in NI 31-103 and CIRO rules. Registrants must disclose any outside activities to their firm and obtain approval before engaging in them. Disclosure allows the firm to verify that the activities are not inappropriate and do not give rise to a conflict of interest. If individual registrants are involved in outside businesses, they must take steps to ensure that these activities do not create any conflicts of interest with their clients or lead the client to believe that the outside activity is, in fact, being offered by the registrant’s firm. Essentially, individual registrants should be reasonably available to their clients and not engaged elsewhere. Any outside activities must be approved by the firm and must not bring the securities industry into disrepute. Under no circumstances should an outside activity be permitted that might cause client confusion or reflect poorly on the firm or the industry. Accordingly, the reputation of others involved with the outside activity should be considered. Registered firms must be able to provide evidence of the due diligence performed as part of the approval process for outside activities. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 13 A firm’s pre-approval processes should be robust and impartial enough to identify any conflicts of interest and the risk of client confusion in advance. They should also ensure that approval is granted only in cases where effective controls and qualified supervisory personnel are first in place. Furthermore, dealer members should take the following facts into consideration: Other activities should not materially impair a dealer member’s duty of care to its clients, nor should they involve the use of client information. Activities outside the dealer member must be clearly seen to be outside the firm and should not be carried on at the firm. The approval and control processes for other activities should be robust and impartial. Other activities should be in keeping with the letter and spirit of CIRO’s business conduct rules. The amount of time devoted to the other activity on a weekly basis should not be excessive. Insurance products are not considered securities; however, when insurance activities are provided through financial planning or other personal entity, they must be reported through the National Registration Database as a separate activity. DID YOU KNOW? Personal financial dealings with clients that include the following arrangements are generally prohibited: Receiving any direct or indirect benefit or consideration from clients, other than through the dealer member Entering into any private settlement agreements with clients Lending money to or borrowing money from clients Having any control or authority over the financial affairs of clients Acting in a certain capacity on behalf of clients, such as in the role of a power of attorney or trustee DEALING WITH ELDERLY AND OTHER VULNERABLE CLIENTS 3 | Explain the compliance and supervision issues related to dealing with elderly and other vulnerable clients. Issues relating to elderly and other vulnerable clients have risen in recent years and continue to rise consistently with current demographic trends. Given the important role they play with respect to the financial health of all clients, advisors and the dealers they are affiliated with are uniquely positioned to play a critical role in the detection and mitigation of issues that vulnerable clients may be exposed to. In fact, when dealing with elderly clients, they may be the first to notice indications of diminished capacity, general vulnerability, or financial exploitation. Given their proximity to their clients and (in certain instances) the duration of client relationships, the advisor is in a key position to detect subtle changes in client behaviour, investment strategies and objectives, and other changes to a client’s mental state that may signal distress or, worse, financial exploitation. The advisor and dealer should properly document all interactions with clients well in advance of such issues arising, so that, if issues do emerge, they are prepared to deal with them in a timely way while continuing to service the client’s account. © CANADIAN SECURITIES INSTITUTE 9 14 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 While some preventive measures are universal, such as the KYC rule, regular updates, suitability, know-your-product requirements, and effective communication strategies, others are unique. These include establishing a trusted contact person and temporary hold periods on certain transactions. All registrants (including advisors, supervisors, and their dealers) must be mindful of the delicate position they are placed in when a client is deemed vulnerable. They must consider whether they may be held liable for their actions (which may include not acting in accordance with client instructions) or are in a position to rely on the protection known as “safe harbour”. Measures to protect vulnerable clients have recently been significantly reenforced as part of the recent regulatory amendments contained in the CSA’s CFRs, which, in large part, were universally adopted by CIRO. These amendments emphasize the importance of the role of all registrants to know their clients and to take reasonable steps to collect information relevant to the clients’ investment needs and objectives, personal and financial circumstances, and any other information necessary to ensure that investments made by the client are suitable. DIVE DEEPER You can find more information about the CSA’s Client Focused Reforms here: https://www.osc.ca/sites/default/files/pdfs/irps/ni_20191003_31-103_reforms-enhance-client- registrant-relationship.pdf As a result of this regulatory impetus, particularly with respect to enforcement priorities, dealer members have an obligation to evaluate their overall approach to dealing with elderly clients and other vulnerable persons. This obligation includes not only the firm’s approach to supervision and compliance, but also to the scope of its training. For example, advisors and other employees who deal with elderly clients should be trained on how to recognize the signs of elder abuse or diminished capacity. Furthermore, from an advertising or marketing perspective, firms should evaluate the titles the firm employs and consider whether the use of such titles might be misleading to elderly clients. Dealer members should employ a multi‑disciplinary and holistic approach (as CIRO has done) to properly manage this issue. DEFINING THE VULNERABLE CLIENT Determining who is considered vulnerable will ultimately drive the application of the additional policies and procedures. It is clear that vulnerability is not restricted to elderly clients, so registrants must be mindful of how they approach any client who may appear to be in distress or in need of assistance. The CSA defines a vulnerable client as someone who has an illness, impairment, disability, or limitation due to age that places the client at risk of financial exploitation. Financial exploitation is generally described as the use, control, or deprivation of financial assets through undue influence or unlawful conduct. The ability to observe and detect a change in long-standing client behaviour is key to being able to support clients who may fall into this category. COMPLIANCE AND SUPERVISION-RELATED ISSUES Categorization of clients is particularly important in supervision at the firm, so care should be taken when attempting to identify vulnerable investors. The firm’s training of employees who are dealing with elderly investors should prepare them to recognize signs of distress. For example, they should watch for signs that abuse might be occurring so that the compliance or legal department can be notified. Supervision based solely on age might be considered discriminatory. However, a specific age such as 60 can be used as the point where additional supervision of a client’s accounts is required. Chief compliance officers should © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 15 consider factors such as proximity to retirement and reduced earning capacity as they formulate their approach to elderly clients and other vulnerable investors. In particular, they should consider the following areas of concern: Information gathering Information gathering during the new account opening process should be a careful and the new account process with all clients. However, with elderly clients, the firm should consider an opening process approach similar to the high‑risk process used for AML purposes. The firm should also consider whether the accounts of elderly clients should be subject to more frequent updating requirements. Suitability As with all clients, the types of investment recommendations made by investment advisors to the elderly must always be suitable according to the client’s KYC information. However, firms should consider whether additional information must be considered for some recommendations made to elderly investors (such as products with deferred sales charges). Product due diligence Similar to suitability, when a firm evaluates new products on its product shelf, consideration should be given by its product review committee (or similar entity) as to whether the product under consideration is less suitable for elderly investors. For example, products that are highly illiquid might be unsuitable for such clients. This type of analysis should probably apply for any client; however, the firm should specifically consider the elderly investor in this case. Titles and designations The firm should evaluate whether it permits the use of certain titles that may suggest a particular proficiency with respect to elderly investors (e.g., “retirement specialist” or any title that employs the adjective “senior”). If so, it should confirm that it has policies and procedures in place to justify such use. Marketing and Similar to its approach to the account opening and suitability assessment processes, the advertising firm should consider whether additional supervision should occur when marketing and advertising materials are prepared that specifically target elderly investors. Regularity of contact From a business conduct perspective, firms and investment advisors may wish to and documentation consider the frequency of contact they maintain with elderly investors. They should also make sure that the manner in which this contact is documented is sufficiently maintained. Powers of attorney and Investment advisors should discuss the need for powers of attorney and related estate estate planning planning documentation, such as last will and testament or beneficiary designations. This consideration may also apply to all clients in general, but specific attention may be needed for the senior investor. The advisor should also seek to educate the client about the importance of having designated individuals, such as professional advisors and trusted contact persons, who are aware of their financial affairs. This discussion should occur as soon as possible to avoid issues that often arise when estate planning is left too late (e.g., the onset of dementia). Given the privacy obligations that a firm and an investment advisor are under, instructions regarding a client’s estate must originate with the client, not the investment advisor. General supervision From a supervisory perspective, firms should be in a position to analyze their client book and surveillance of record and account opening documentation to target clients who may be considered elderly investors. Again, similar to the approach the firm employs when dealing with high‑risk clients from an AML perspective, the firm should consider if any additional supervision should be implemented. This supervision may also include the use of confirmation letters with elderly investors. © CANADIAN SECURITIES INSTITUTE 9 16 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 DIVE DEEPER Under IDPC rule section 3640, Misleading Communications: An Approved Person must not hold themselves out, and a Dealer Member must not hold itself or its Approved Persons out, including through the use of a trade name, in a manner that could reasonably be expected to deceive or mislead any person or company. For complete details, visit CIRO’s website. MEDICAL AND LAW-RELATED ISSUES In addition to business conduct and compliance related issues, advisors to elderly and vulnerable clients are in a unique position to become privy to certain medical or law-related issues. Accordingly, the firm should ensure that they are trained to spot these issues and act on them. There is no formula or list to encapsulate all of these areas, but common examples include diminished capacity, elder abuse, and financial predators. (A financial predator is a person, possibly a friend or family member, who attempts to exert undue influence over the client with the aim of financial gain.) Investment advisors should review their firm’s policy in this regard and, if questions arise, should escalate the issue to the firm’s compliance or legal department. A robust and complete discovery process puts the advisor in a unique position to assist with these types of issues given their knowledge and proximity to the client. EXAMPLE Hilda is an 85‑year‑old investor. Her husband James recently died. James was their advisor’s primary point of contact for all investment‑related matters, although he always discussed investment decisions with Hilda. Hilda visits her advisor with one of her children, Anna, to submit a new power of attorney document appointing Anna as her sole attorney, even though a previous power of attorney is on file. Hilda also asks that her account be changed to a joint account with Anna. When the advisor asks questions about the request, it is Anna who answers. Anna also indicates that the valuable account will be moved to another institution if the requests cannot be fulfilled. This scenario occurs frequently with senior investors. Dealer members should use a coordinated approach, including training and a written policy, to carefully manage these situations and ensure that the interests of the client are kept paramount. The dealer member must also be mindful of privacy and related issues. However, on the assumption that the RR and dealer member truly know their client, additional conversations about this fact scenario might involve Hilda’s lawyer or other professional advisors, coordinated with the dealer member’s legal and compliance department. EQUITY AND MUTUAL FUND TRADING AND SETTLEMENT 4 | Discuss equity and mutual fund trading and settlement. At the client level, a securities trade occurs on the trade date and must be settled between buyer and seller on the settlement date. The buyer must have sufficient funds on deposit either to pay for the trade in a cash account or to fully margin the trade in a margin account. The seller’s shares are withdrawn from his or her account on the settlement date. EQUITIES Currently, most securities trade in a paperless environment. The actual transfer of securities positions occurs in accounts held by securities dealers (and other institutions) with a central depository. In Canada, this depository is the Canadian Depository for Securities Ltd. (CDS). Instead of various independent securities dealers and other © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 17 institutions settling directly with each other, the clearing system handles the settling process through bookkeeping entries for the accounts of the clearing firm members. This method virtually eliminates the need for paper stock certificates. CDS and other international clearing firms produce daily reports to advise members of their cash and securities positions and their settlement obligations. COMPLIANCE ISSUES WITH EQUITY TRADING Compliance problems with the clearing system are rare. More frequently, problems arise with share certificates that are still in use. Because share certificates can be forged, most firms will not release funds to a client who settles a trade with a share certificate until it has been validated by the transfer agent responsible for the issuer of the security. With transfer agents outside of Canada, this process can take significant time. This issue is typical for over- the-counter (OTC) or Pink Sheet securities. For that reason, dealer members should exercise extreme caution and validate the share certificate prior to the release of any funds to a would‑be seller. Securities cages are also usually aware of issues involving stock certificates with restrictions or legends disclosed on the certificates. These certificates are often not transferable until the transfer agent has removed the restrictions. A CCO might request that the compliance department be notified of the deposit of large‑denomination stock certificates for non‑Canadian issuers, particularly if the depositor is unfamiliar to the firm. Canadian firms have been involved in improper offshore distributions of U.S. securities, but early intervention by compliance can prevent such problems. Share certificates are also registered in the name of their owner and must be endorsed by the owner prior to transfer. A dealer member should have procedures for securing and endorsing these signatures. MUTUAL FUNDS Mutual funds are primarily purchased as either single, lump‑sum amounts subject to any minimum investment levels imposed by the fund or in smaller amounts through investment plans that allow for regular contributions. As with equities, mutual funds operate in a certificate-less environment, unless the client specifically requests otherwise. Dealer members send a confirmation of the purchase to the investor showing the number of units credited to the account. The purchase price is the net asset value per share calculated after receipt of the purchase order. Redemptions are based on the valuation date following the fund’s receipt of a redemption request that is in good order, as stated in the prospectus and the policies of the fund. The vast majority of mutual fund trades are cleared and settled through FundSERV, a communication platform that provides standardized formats and centralized processing of purchase, redemption and exchange orders, and account registrations. It also provides participants with a single daily net settlement. LATE TRADING Late trading is prohibited because it permits favoured investors to take advantage of post‑market‑closing news and events that are not yet reflected in the share price set at the market’s close. EXAMPLE Most mutual funds calculate their net asset value (NAV) once per day at market close (4:00 P.M. EST). The resulting value is the NAV for that day. Any orders placed before that time will be filled at that NAV. An investor placing an order at 5:00 P.M., for example, would pay the price based on the NAV calculated at the market close on the following day. This practice is known as the forward pricing rule. Late trading, or after‑hours trading, involves placing orders for mutual fund units after the 4:00 P.M. market close, but still receiving that day’s earlier price, rather than the next day’s closing price. This practice is illegal. U.S. authorities have successfully prosecuted many mutual funds engaged in this practice. © CANADIAN SECURITIES INSTITUTE 9 18 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 DID YOU KNOW? In 2003, regulators uncovered that certain hedge funds, mutual fund companies, and investment dealers were conducting illegal and unethical trading practices involving late trading and market timing, which resulted in heavy fines. SHORT-TERM MARKET TIMING There has been no known incidence of late trading in Canada. However, activities related to market timing have occurred in both Canada and the United States, which have resulted in prosecution and heavy fines. Some mutual fund firms committed fraud by permitting certain clients to trade more frequently than allowed in their fund documents and prospectus. Funds often bar or limit market timing because the practice may increase the cost of administering a mutual fund, which is then borne by all the fund’s shareholders. Mutual funds typically define this limit as selling within 90 days of a purchase. It is not prohibited but is generally subject to a 2% short-term trading fee. EXAMPLE The OSC imposed heavy fines related to market timing on several mutual fund companies. CIRO fined three dealer members that helped facilitate market timing trades. CIRO found that they violated CIRO rules which state that dealers must “ensure that the handling of client business is within the bounds of ethical conduct, consistent with just and equitable principles of trade, and not detrimental to the interests of the industry”. These firms also violated Universal Market Integrity Rule 2.1, which states that dealer members and employees “shall transact business openly and fairly and in accordance with just and equitable principles of trade when trading on a marketplace or trading or otherwise dealing in securities that are eligible to be traded on a marketplace.” Because these activities were not discovered by compliance and supervision mechanisms, CIRO also imposed disciplinary penalties on the firms for not adequately supervising employees or conducting due diligence into their activities. MARGIN ACCOUNTS Margin accounts allow clients to buy securities on credit and initially pay only part of the full price of the transaction. The firm lends the remainder of the transaction price to the client, charges interest on the loan, and then holds the client’s purchased securities as collateral. The term margin refers to the amount of funds that the client must personally provide. The amount of the dealer member’s credit or loans is based on the market value and quality of the securities held in the account. Many common compliance problems stem from credit problems. Under‑margined and unsecured accounts also subtract from a dealer member’s capital, which can result in the firm’s failure. CIRO regulates the amount of credit that firms may extend to clients on the purchase of securities. They specify the requirement for margin agreements and the maximum amount that a firm may finance or the maximum loan value of each type of security. These regulations are rigidly enforced. Some firms do not accept margin accounts; many others maintain margin requirements substantially higher than the rates covered in the regulations. Firms may also eliminate margin eligibility for some securities to avoid what they perceive as unacceptable credit risk. Given that collateral for the position is partly based on the firm’s ability to sell out the position in question, credit risk can be very high. RIGHTS AND OBLIGATIONS The contract that governs margin, known as the margin agreement, defines the rights and obligations of the firm and the client. The margin agreement provides that clients must adhere to the following requirements: Maintain adequate margin in the account Repay the amount loaned upon demand Pay interest on the margin loan © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 19 The margin agreement gives the dealer member the right to take action if the client does not maintain proper margin in the account. The firm can also use the client’s securities as collateral against the amount it has loaned to the client. The firm may take the following actions, among others: Pledge the client’s securities to raise money to fund the client’s loan Realize on the client’s securities and other assets to cover the purchase of short securities Use a security in the client account to make a delivery on a short sale Liquidate client securities and other assets to cover any amount that the client owes The client usually has an opportunity to fully margin the account before the dealer member takes action. If an account becomes under‑margined, the firm issues a margin call, which is a request for sufficient funds to bring the account up to full margin. Some firms send margin calls in writing but, because of time constraints, margin calls can also be made by telephone, courier, fax, or email. If a margin call is made by telephone, the firm should maintain a written record of the time and content of the call, in case of a subsequent dispute. Dealer members should also have policies addressing which staff member is responsible for making the margin call and the deadline for clients to meet the call. The margin agreement specifies that the firm can sell out or buy in all or part of a client’s margined securities without notice, if dramatic and adverse price fluctuations make this necessary. EXAMPLE Courts have questioned the application of the margin agreement in cases where a dealer member has allowed clients latitude in the past. The courts generally expect firms to be consistent in their practice. For example, if a firm usually gives a client three days to meet a margin call, it may be inappropriate for the firm to sell out the client’s account within a day of the client not meeting a call. A client who usually meets margin calls might also be given more latitude than a client with a poor history of promptly meeting margin calls. FACTORS AFFECTING MARGIN RATES CIRO may change regulatory margin rates as conditions warrant, and dealer members can choose to have more stringent margin rates than those prescribed by regulation. They cannot, however, have rates that are less stringent. As shown in Table 9.1, various different factors can affect the regulatory margin rates or the rates set by firms. Table 9.1 | Factors Affecting Margin Rates Factor Description Price Volatility The more the price is likely to fluctuate, the greater the potential losses on holdings of those stocks or bonds. Issuer The more creditworthy the security’s issuer, the more money a firm is willing to lend to the purchaser. Term to Maturity The longer a security’s life, the more volatile the price may be. Default The riskier a security, the more margin clients will need to put up to purchase it. MANAGING MARGIN ACCOUNTS It should be clear who will ultimately make the decision to sell out a client’s account, and the advisor responsible should clearly understand his or her responsibility. When there is an unsecured debit balance, the dealer member’s claim against the client may be met by a counterclaim based on the firm’s action or inaction. Effective credit policies and practices can prevent such issues from arising. © CANADIAN SECURITIES INSTITUTE 9 20 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 Effective communication between the credit department and business location supervisors is also helpful, with links to advisors, the compliance department, and senior management. Minor credit problems can result in unsecured accounts when a credit department bypasses business location supervisors and tries to address the credit problem directly with the advisor. Business location supervisors are generally responsible for that location’s business, including credit and credit losses. It is therefore essential that business location supervisors receive daily credit reports, including detailed margin call information. Dealer members should encourage their clients (and advisors) to avoid maintaining minimal margin. Additional funds or securities with loan value provide a cushion of protection and prevent the possibility of frequent margin calls resulting from minor stock price fluctuations. CIRO produces a quarterly list of securities eligible for reduced margin, which includes only those securities that demonstrate both sufficiently high liquidity and low price volatility based on specific risk measures. The financing arrangements in a client’s margin accounts are based on loan value (i.e., the amount of money that the dealer member is willing to put up). Securities in a client’s account may have a loan value that is the complement of the margin rate prescribed by regulation. For example, if the margin rate on a security is 2%, its loan value is 98% of its market value. In some cases, a firm can establish a more conservative loan value for certain securities than the regulations require; however, the concept is the same. Most dealer members have a credit policy that addresses both regulatory requirements and those unique to the firm. The policy usually outlines responsibilities and communication requirements involving credit decisions. For example, the extension of margin loans against concentrated security positions often involves a decision tree based on the potential size of the margin loan. Similarly, policy may dictate which staff members must be advised in the event of various credit issues. A detailed and effectively implemented credit policy can be very helpful to the CCO. RESTRICTIONS A client whose account is under‑margined may not withdraw funds or securities, nor are such withdrawals permitted if they would cause the account to become under‑margined. If an under‑margined account is not sufficiently covered within 20 business days, the account will be restricted to only those trades that will reduce the margin deficiency. In practice, however, it is unlikely that an under‑margined account would be allowed to remain delinquent for 20 days or more; rather, the firm would sell out the account. When supervising such accounts, responsibilities should be clearly defined. The most effective method has the advisor responsible for communicating the restriction to the client, with a business location supervisor aware of both the restriction and its responsibility to supervise it. Monitoring is least effective when communication occurs between only the credit department and the advisor and excludes a business location supervisor. CONCENTRATION Regulations prohibit the granting of margin on any security that is part of a block, which is defined as a sufficient number of shares to materially affect control of that issuer. Most dealer members also have specific policies limiting the amount of margin they will allow on a given security or group of securities of the same or related issuers. The regulators impose a securities concentration charge against dealer members that have a high exposure to a single security or group of related securities of the same issuer. This charge is designed to protect firms against substantial decreases in value in a short time. It is difficult to quickly liquidate large holdings of a single security without adversely affecting the marketplace. Also, in the event of major fluctuations in the marketplace, credit extended to holdings concentrated in a single security can adversely affect a firm’s capital. A major fluctuation might be a stock dropping in value to the point where it is no longer marginable, for example. Advisors should consult with their firms’ credit or compliance departments before putting on margin positions where large quantities, or few different securities, are contemplated. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 21 COMPLIANCE ISSUES WITH MARGIN ACCOUNTS Flaws in the trading system can cause illiquid securities to show higher values than might actually be realized. This can happen for many reasons, including a significant amount of time between trades in the security. A more serious situation arises where an advisor orchestrates a cross trade in a security at a higher‑than‑market price so as to artificially inflate the margin eligibility of the security. Credit reports setting out margin loans against concentrated security positions can help identify these problems. Another issue that can cause credit and compliance risk exposure is the absence of a real‑time account margining system. Current securities bookkeeping systems produce margin reports based on the previous day’s trading and do not account for real‑time trading activity. This gap does not affect most accounts that trade infrequently. However, it can affect the monitoring of accounts that have a high volume of trading on margin, particularly in fast‑moving markets. EXAMPLE A client trades high volumes of stock index options in a volatile market. In the absence of real‑time margining, this account requires dedicated and experienced staff to monitor trading and margining. Otherwise, the account requires significant deposits of excess margin to minimize potential exposure. The credit and compliance departments must communicate effectively. A very high percentage of compliance issues have their origin in credit or have credit implications. Litigation issues arising from unsecured client accounts often involve allegations regarding unsuitable trading, breach of contract or fiduciary duty, and negligence. An effective way to ensure ongoing communication with the credit department is to encourage the circulation of high‑level credit reports to compliance staff. These reports should disclose under‑margined and unsecured accounts above a certain dollar‑value threshold, accounts that use the highest amounts of margin, and accounts with concentrated securities positions securing margin loans. Some firms assign credit administrators to particular business locations or regions that correspond to a similar allocation of responsibilities within the compliance department. The flow of information between these individuals can address potential compliance and credit issues at an early stage. In many instances, an unsecured debit balance in a client account follows previous (and occasionally chronic) under- margin problems with the account. These accounts are often actively traded or involve margin against concentrated and illiquid security positions. FUNDS AND SECURITIES MOVEMENTS 5 | Discuss the importance of implementing transaction controls at a dealer member. CIRO rules mandate that controls be placed on transactions. Because some areas may be run by financial or operational staff who do not understand compliance issues, it is necessary to implement training, procedures, and red flag lists. The following non‑trading transactions require supervision and compliance controls: Deposits and withdrawals of funds Delivery‑in and transfer‑out of securities (including physical certificates) Journal entries between accounts Controls are necessary to prevent fraud and the misappropriation of funds or securities. In addition, certain laws and regulations must be considered in the context of non‑trading transactions. For example, controls relating to the deposit, withdrawal, and transfer of funds should address AML and terrorist financing regulations, as well as those related to market manipulation and insider trading. Tax laws may also be a consideration. © CANADIAN SECURITIES INSTITUTE 9 22 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 EXAMPLE A client’s account receives a large‑denomination stock certificate of a bulletin board OTC issuer. The stock is sold, and the proceeds are transferred out to a number of different parties with no apparent connection to the client. In this case, the dealer member should consider whether it is participating in an improper distribution of securities and whether money laundering is involved. Another consideration is whether this is a one‑off transaction or representative of the type of ongoing business that the client is conducting. Finally, given the potential delay that may be experienced in the settlement of proceeds relating to OTC sales, the dealer member should consider hold periods on accounts following these types of transactions. For all of these reasons, many dealers simply refuse this type of business. The department responsible for wire transfers should implement policies and procedures to ensure that potential problems are escalated and that third‑party fund transfers do not involve the misdirection of funds or fraud. The delivery‑in of securities, including physical securities, must also be subject to controls, particularly in the securities cage and account transfers department. Third‑party transfers also pose significant AML issues. Staff members in this area of the dealer member should be well versed in order to prevent this type of transaction from being used as a tool by money launderers. Journal entries among accounts raise similar concerns. Most dealer members require written instructions from clients for transfers of cash or securities to accounts with different beneficial ownership. The compliance department should also review journals between registrants and clients. Likewise, journals of securities between unrelated accounts should be pre‑approved because they may be subject to CIRO rules governing off‑floor trades. Clients may also request backdated journal entries for tax purposes. These should not be fulfilled unless they are requested within a few days of the initiating transaction to correct an obvious account allocation error. ACCOUNT TRANSFERS Delays in account transfers are a frequent source of client complaints. Although account transfers are usually the responsibility of operations departments, a CCO should be familiar with the process. The CCO can then handle specific complaints and monitor the process for any pattern of transfer problems. Problems often arise when an advisor moves to another firm and both the advisor and the firm attempt to retain the advisor’s clients. CIRO rules set out the method that dealer members must use when transferring client accounts from one dealer member to another. They establish an overall timeframe of 10 business days for completing an account transfer through the use of Account Transfer Online Notification (ATON), the electronic system for handling the account transfers at the CDS. In circumstances where certain proprietary products cannot be transferred through ATON, the delivering firm might explain to the client in advance that delays may occur. Alternatively, the firm might seek instructions to liquidate a security or account that cannot be transferred. Under the rules, the onus is on the receiving dealer member to obtain client authorization to make the transfer and indemnify the delivering dealer member for any errors that the receiving dealer member makes. An advisor’s interest in getting his or her accounts transferred quickly can result in shortcuts, such as the advisor signing the client’s name, with or without the client’s consent. Controls should be in place to check client signatures, to ensure that authorization has been received before accounts are transferred, and to ensure that proper authorization records are maintained. The competition to keep clients can also lead to excessive attempts to persuade clients to stay or leave the firm. For example, an advisor hoping to obtain the client’s business might claim that the client’s current holdings are unsuitable, whereas a firm not wanting to lose the client’s business might make slanderous statements about the departed advisor. Dealer members may wish to establish standards that define acceptable behaviour when an advisor or firm attempts to retain a client. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 23 Dealer members occasionally request CIRO approval for bulk transfers of client accounts (i.e., when all accounts are transferred at once without prior client authorization). Such transfers can be relatively easy in some cases; for example, when the accounts of both the old and new dealers are carried by the same carrying broker. However, client assets belong to the client and generally cannot be transferred without his or her specific authorization. CIRO permits bulk transfers only when the accounts cannot stay where they are. For example, a firm may make a bulk transfer when a new advisor is not available to handle the accounts of the original advisor who has resigned. In such cases, the accounts can be transferred in bulk with the agreement of both firms, subject to the following conditions: The clients must be given as much advance notice as possible. The clients must be given an opportunity for a set period to transfer their accounts elsewhere, either before or after the bulk transfer, at no cost to them. In such cases, the dealer members involved decide which firm pays the transfer costs. CAPITAL REQUIREMENTS 6 | Outline the capital rules of the securities industry, and describe the common reasons why dealer members become undercapitalized. CIRO, as sponsor of CIPF, requires that dealer members maintain a cushion of capital to ensure their solvency. CIRO has issued a detailed and uniform set of minimum capital requirements that reflect, among other things, the size, type, and volatility of a firm’s business. OVERDUE CASH ACCOUNTS The capital requirements for a Type 3 or Type 4 dealer member that carries overdue cash accounts effectively tie up portions of the dealer member’s capital, which then cannot be used in profitable areas of the business. Therefore, there is considerable financial pressure on firms to encourage clients to make normal settlement. If accounts become overdue, charges against the dealer member’s capital become increasingly onerous. Firms and their advisors respond by insisting that clients settle outstanding items immediately or close out the overdue accounts. DID YOU KNOW? Overdue cash for a Type 2 dealer must be carried by the carrying broker, although that broker may use the introducing broker’s comfort deposit for overdue amounts. Chief compliance officers are not normally involved in calculating a firm’s capital requirements. Nevertheless, they must understand clients’ payment obligations and how overdue accounts affect the firm. They must also understand the capital charges that a firm may face as a result of overdue accounts. They may even make a charge against an advisor’s commission if the member has to provide capital for delinquencies in the advisor’s client accounts. The purpose of a capital charge is to recognize and provide for risk related to cash accounts that do not settle on the prescribed basis and are not closed out. This risk has two measurements: The length of time that the transaction is overdue The quality of the securities in the account, which is reflected by the margin rates later imposed The cash account rule is most easily understood by reviewing the timing of transactions in an account because the timing is based on the aging of the transactions. The duration of deficiency in an account determines how the account will be treated and what funds must be put up. © CANADIAN SECURITIES INSTITUTE 9 24 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 There are two ways to deal with delinquent accounts, depending on whether the account is overdue for less than or more than six business days: For cash accounts that are overdue for one to five days, CIRO requires that securities in the account be given a weighted value and compared against the amount of the deficiency. The market value of the securities determines the amount available to support the cash account debit balance prior to the settlement date plus six business days. The weightings are used to ensure that the relative quality of any collateral held within the account is considered when establishing what credit may be extended. Market value alone is insufficient to determine collateral value. A cash account that is overdue for six or more business days after the settlement date is treated as a margin account, with any margin deficiency becoming a charge to the firm’s capital. This calculation is made beginning on the sixth business day after the settlement date. ACCEPTABLE INSTITUTIONS AND COUNTERPARTIES When determining a firm’s cushion of capital, charges to available capital include aggregated under‑margin amounts. Firms deal with certain so‑called acceptable counterparties (AC) and acceptable institutions (AI) that pose little or no risk to their capital. Acceptable counterparties are entities that a dealer member may deal with on a value‑for‑value basis, with mark‑to‑market imposed on outstanding transactions. Transactions with ACs do not require margin, and any negative capital impact of a transaction is merely the result of negative market fluctuations from the date of the transaction. Acceptable institutions are entities that a dealer member may deal with on an unsecured basis, without capital penalty. Both ACs and AIs are sophisticated and well‑capitalized corporate and government clients. A list of ACs and AIs can be found on CIRO’s website under the Member Resources tab. However, the list is not exhaustive and can change based on the dynamic financials of the members on the list. EXAMPLE Acceptable counterparties and institutions are usually “clients” of the institutional trading desks of dealer members. Clients that do not meet the definition of AC or AI should not be clients of institutional trading desks under the guise of being ACs or AIs. CAPITAL RULES The general purpose of CIRO’s capital rules is to establish a common framework governing the capital requirements of dealer members. The framework is intended to ensure that a firm has sufficient liquid assets to meet its obligations without prohibiting or severely restricting any particular type of transaction that is within the bounds of good business practice. Besides ensuring liquidity, the main purpose of the capital formula is to protect against insolvency resulting from liabilities exceeding the realizable value of assets. An integral part of the capital formula is an early warning system based on profitability, liquidity, and capital tests. The system provides advance warning to a dealer member that is encountering financial difficulties. The system does not detect all circumstances that may cause a firm to have subsequent capital shortages or liquidity problems. However, it anticipates some of those situations and encourages firms to build a capital cushion. The capital formula includes capital reserve requirements in its calculation to buffer against liquidity risk. Liquidity risk is the risk of a shortfall in the firm’s ability to quickly convert assets into cash (or equivalents) to meet its © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 25 obligations. Liquidity risk can accompany any of the risks described in Table 9.2, which are often interrelated, and once they arise, they can ultimately lead to insolvency. Table 9.2 | Types of Liquidity Risk Risk Description Market risk Market risk refers to the potential for losses arising from changes in the price or value of an asset based on fluctuations in interest rates, stock prices, or commodity prices. Credit risk Credit risk refers to the risk that a borrower will default on a loan or bond obligation. Operational risk Operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events. Operational risk includes reputational risk and legal or compliance‑related risks, but excludes strategic risk associated with business decisions. Dealer members are also exposed to the ongoing financial risks described in Table 9.3. Table 9.3 | Other Types of Ongoing Financial Risk Risk Description Counterparty risk Counterparty risk refers to the risk of loss due to a counterparty default or insolvency. Price risk Price risk refers to the risk of loss due to a price decline. Concentration risk Concentration risk refers to the risk of loss posed by a heightened exposure to any one particular issuer. Counterparty, liquidity, and price risk are addressed through margin requirements; concentration risk is addressed by the capital formula’s security concentration charge. INSURANCE REQUIREMENTS All dealer members must maintain insurance coverage within prescribed limits to protect their assets against losses arising from fraud, theft, or dishonest acts of its employees. This insurance is referred to as the firm’s financial institution bond. The limits, which reflect the clients’ net equity with the firm, range from $200,000, for some introducing brokers, to $25 million. THE CAPITAL FORMULA The capital formula defines what assets can be classified as liquid assets on the balance sheet. It deducts balance sheet liabilities and margin and capital charges to determine how much residual capital resources are available to address liquidity risk. © CANADIAN SECURITIES INSTITUTE 9 26 CHIEF COMPLIANCE OFFICERS QUALIFYING EXAMINATION      SECTION 4 The easiest and most effective method of explaining the uniform capital formula is to present it as a two‑step process, as detailed below. Step 1: Determine Net Allowable Assets (Total Financial Statement Capital − Non-allowable Assets = Net Allowable Assets) Notes Assets are classified as either allowable or non‑allowable. Allowable assets are conservatively valued and emphasize the liquidity necessary to operate in a short‑term trading environment. These assets are considered to be balances that are readily convertible into cash or equivalents and have no risk of non‑payment. Non-allowable assets cannot be disposed of quickly or do not have a readily known current realizable value. They include potentially uncollectible receivables. Items that are considered non‑allowable for capital purposes include investments in subsidiaries, fixed assets, inter‑company receivables, cash deposits at non‑acceptable locations, or non‑trading account receivables, such as commissions and fees from certain counterparties. They are considered to be balances that are not readily convertible into cash or equivalents. Net allowable assets are calculated as allowable assets net of all liabilities or capital employed (share capital, retained earnings, subordinated loans), net of all non-allowable assets. Step 2: Determine Risk-Adjusted Capital (Net Allowable Assets − Minimum Capital and Margin Required + Applicable Tax Recoveries − Securities Concentration Charge = Risk-Adjusted Capital) Notes Minimum capital required is the amount that cushions a firm against immeasurable risk that is not necessarily covered by other parts of the formula. The minimum capital required by carrying brokers and Types 2–4 introducing brokers is $250,000. The minimum for Type 1 introducing brokers is $75,000. Margin required is the margin needed on security positions held in the firm’s proprietary accounts. Tax recoveries are the known and quantifiable tax recoveries from tax paid in previous years. The add‑back is 75% of such recoveries. Securities concentration charge is a charge relating to a firm’s large holdings in a single security. Such concentrations can be difficult to liquidate, and the risks of holding a single security are greater than holding a diversified portfolio. The concentration charges are based on a formula tied to the firm’s RAC. Risk-adjusted capital should never be less than zero. A capital‑deficient firm has 24 hours to correct the problem or face suspension of its CIRO membership, which may lead to the appointment of a trustee in bankruptcy. THE EARLY WARNING SYSTEM CIRO has implemented an early warning system designed to provide advance warning of a dealer member encountering financial difficulties. The system measures the characteristics that can indicate financial trouble and imposes a series of restrictions and sanctions to reduce further deterioration. The sanctions are intended to get a firm out of early warning status and prevent a subsequent capital deficiency. Early warning measures include capital, liquidity, profitability, and frequency tests. © CANADIAN SECURITIES INSTITUTE  CHAPTER 9      OPENING AND MAINTAINING ACCOUNTS 9 27 Two levels of tests are used to designa