CSI Conduct and Practices Handbook Course PDF

LOGO Conduct and Practices Handbook Course Where leaders learn financial services. Conduct and Practices Handbook Course Prepared and published by CSI 121 King Street West 15th Floor Toronto, Ontario M5H 3T9 Phone 416.364.9130 Toll-free 1.866.866.2601 Fax 416.359.0486 Toll-free fax 1.866.866.2660 www.csi.ca Where leaders learn financial services Copies of this publication are for the personal use of only as a convenience and the inclusion of any properly registered students whose names are entered reference does not imply endorsement of the third on the course records of CSI Global Education Inc. party materials. (CSI)®. This publication may not be lent, borrowed or resold. Names of individual securities mentioned in this publication are for the purposes of comparison and illustration only and prices for those securities were approximate figures for the period when this publication was being prepared. 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ISBN # 1-894741-06-4 First Printing 1997 Revised and reprinted 2000, 2001, 2002, 2003, 2004, 2005, 2006 Copyright © 2005 by CSI Global Education Inc. CONTINUING EDUCATION INTRODUCTORY COURSES Canadian Funds Course Anti-Money Laundering Canadian Insurance Course Broker Liability Canadian Securities Course Conduct and Practices Handbook Course TM CSI Prep SeriesTM Investment Advisor Training Program Investment Representative Training New Entrants Course CE Compliance Course including CPH for Industry Professionals Charts and Formations CPH for Industry Professionals Corporate Governance (compliance) Covered Call Writing Estate Planning Ethics Module and Case Study, Institutional Version COMPLIANCE & TRADING Branch Managers Course Canadian Commodity Supervisors Exam Chief Financial Officers Qualifying Exam Options Supervisors Course Partners, Directors & Senior Officers Course Trader Training Course Ethics Module and Case Study, Retail Version Exchange Traded Funds Fixed Income Investing Hedge Fund Essentials for Today’s Financial Professional How Mutual Funds and Hedge Funds Use Derivatives Income Trusts Industry Trends Investor Confidence FINANCIAL PLANNING & WEALTH MANAGEMENT Canadian Securities Course Professional Financial Planning Course Wealth Management Techniques Portfolio Theory, Asset Allocation and Performance Measurement Practice Management Pre-Retirement Planning Principal-Protected Notes Quantitative Analysis Retirement Planning Segregated Funds INSURANCE Canadian Insurance Course Single Stock Futures Socially Responsible Investing Trust Structures Understanding Margin: Benefits and Risks PORTFOLIO MANAGEMENT Canadian Securities Course Investment Management TechniquesTM Portfolio Management TechniquesTM RISK MANAGEMENT & DERIVATIVES Derivatives Fundamentals Course DESIGNATIONS Financial Management Advisor (FMA) Canadian Investment Manager (CIM) Derivatives Market Specialist (DMS) Energy Markets Risk Management Course Financial Markets Risk Management Course Futures Licensing Course Options Licensing Course Options Strategies Course Technical Analysis Course Fellow of CSI (FCSI) Table of Contents Table of Contents Introduction................................................................................................................. 1 Coverage of Material................................................................................................ 1 SECTION I: THE REGULATORY ENVIRONMENT Chapter One – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Introduction.............................................................................................................. 3 Know Your Client and Suitability.............................................................................. 3 Fiduciary Duty.......................................................................................................... 5 I. Registrant Code of Ethics............................................................................. 5 II. Registrant Standards of Conduct................................................................. 6 Standard A – Duty of Care..................................................................... 8 Standard B – Trustworthiness, Honesty and Fairness......................... 11 Standard C – Professionalism.............................................................. 14 Standard D – Conduct in Accordance with Securities Acts.................. 21 Standard E – Confidentiality................................................................. 23 Personal Information Protection and Electronic Documents Act............................................................................... 24 III. Summary.................................................................................................... 26 Chapter Two – Regulation of the Securities Industry Introduction............................................................................................................ 27 I. General Principles of Securities Regulation............................................... 28 Disclosure............................................................................................. 29 Registration.......................................................................................... 30 Investigation and Prosecution.............................................................. 30 II. Key Players Involved in Securities Regulation........................................... 32 The Federal Government..................................................................... 32 Integrated Market Enforcement Teams (IMETs)............................ 32 The Provinces....................................................................................... 32 III. Self Regulatory Organizations (SROs)....................................................... 36 The Canadian SROs............................................................................ 38 The Investment Dealers Association (IDA)........................................... 38 The Exchanges (Marketplaces)............................................................ 40 Market Regulation Services Inc. (RS).................................................. 43 The Mutual Fund Dealers Association (MFDA).................................... 45 IV. Jurisdiction of the Provinces and SROs..................................................... 45 V. Dealing with Money Laundering and Terrorist Financing in the Securities Industry...................................................................................... 46 VI. Investor Protection Funds........................................................................... 56 Canadian Investor Protection Fund (CIPF).......................................... 56 Mutual Fund Dealers Association's Investor Protection Corporation (MFDA IPC)...................................................................... 60 © CSI Global Education Inc. (2005) i Table of Contents VII. Protection for Depositors............................................................................ 60 Canada Deposit Insurance Corporation (CDIC)................................... 60 Provincial Insurance Funds for Depositors........................................... 60 VIII. Summary.................................................................................................... 61 Chapter Three – Registration of Securities Industry Participants Introduction............................................................................................................ 63 I. Types of Registration.................................................................................. 64 II. Categories of Registration.......................................................................... 64 Dealers................................................................................................. 64 Introducing/Carrying Broker Arrangements.................................... 65 Advisors................................................................................................ 66 III. Exemptions from Registration.................................................................... 67 Advisors................................................................................................ 67 Banks and Other Financial Institutions................................................. 67 IV. Registration of an Individual as a Registered Representative.................... 68 Proficiency Requirements and Categories of Individual Registration.......................................................................................... 70 Investment Advisor (IA)........................................................................ 72 Investment Representative (IR)............................................................ 74 Mutual Fund Sales Representative (MFSR)......................................... 75 Restrictions on Unregistered Staff........................................................ 76 Dual Licensing for Securities and Life Insurance................................. 77 The National Registration System (NRS)............................................. 78 The National Registration Database (NRD)......................................... 79 Procedures for Individual Registration............................................ 81 Single and Multi-Jurisdiction Submission Types............................. 82 Renewal of Registration.................................................................. 82 Notice of Changes.......................................................................... 82 Termination of Registration............................................................. 83 Registration After an Absence........................................................ 84 Filing Requirements for Proficiency Exemption.............................. 84 Jurisdictional Registration Considerations............................................ 85 Dealing with Clients in Other Canadian Jurisdictions..................... 85 Dealing with U.S. Residents........................................................... 85 Special States................................................................................. 90 Blanket Exemption for TSX Listed Securities................................. 91 V. Summary.................................................................................................... 92 SECTION II : DEALING WITH CLIENT ACCOUNTS Chapter One – Account Opening Procedures Introduction............................................................................................................ 93 I. Opening Accounts...................................................................................... 93 The Cardinal Rule - Know Your Client.................................................. 93 Client Identification Requirements....................................................... 94 The New Account Application Form................................................... 107 Client Information............................................................................... 109 Account Opening Red Flags............................................................... 114 © CSI Global Education Inc. (2005) ii Table of Contents Account Information............................................................................ 115 Registrant Information....................................................................... 122 Regulatory Section............................................................................. 123 Banking Information............................................................................ 125 Documentation................................................................................... 126 General Documents...................................................................... 126 Trading Authorization Documents................................................ 128 Other Documents.......................................................................... 129 Recommendation and Comments...................................................... 130 Approval............................................................................................. 130 Separate NAAFs and Supporting Documents.................................... 130 Electronic Signatures.......................................................................... 131 II. Client Records.......................................................................................... 132 New Account Application Form.......................................................... 132 Portfolio Record.................................................................................. 132 Security Cross-Reference.................................................................. 133 Correspondence................................................................................. 133 Removal of Records........................................................................... 133 Consolidation of Back Office Activities.............................................. 133 Records of Orders.............................................................................. 133 III. Summary ……………………………………………………………………….134 Chapter Two – Sales and Trading Conduct Introduction.......................................................................................................... 135 I. Review of Basic Principles....................................................................... 135 Know Your Client................................................................................ 136 Recommendations.............................................................................. 139 II. Rules of Conduct...................................................................................... 141 Sales Practices Prohibited by the Securities Acts.............................. 141 Calling at or Telephoning Residences.......................................... 141 Sales Made from One Province to Another Province or Country...................................................................... 141 Sale of Unqualifed Securities........................................................ 142 Churning....................................................................................... 142 Illegal Representations to Effect a Trade...................................... 142 Improper Sales Practices................................................................... 144 Manipulative Trading Practices as Defined by SRO Rules................. 144 Discretionary Trading......................................................................... 145 Priority of Client Orders...................................................................... 145 III. Principal vs Agency Transactions............................................................. 146 Principal Transactions........................................................................ 146 Client Priority Rules...................................................................... 146 Off-Floor Rule............................................................................... 147 Agency Transactions.......................................................................... 147 IV. Concerns about Client Trading................................................................. 147 Deliveries and Payments.................................................................... 149 V. Account Activity and Money Laundering Red Flags................................. 149 VI. Dealing with Confidential Information....................................................... 150 © CSI Global Education Inc. (2005) iii Table of Contents Obligation to Maintain Confidentiality................................................. 151 Illegal Insider Trading And Tipping..................................................... 152 Who are Insiders?......................................................................... 153 What is Inside Information?.......................................................... 153 Prohibition of Insider Trading and Tipping.................................... 154 Information Barriers ("Chinese Walls")......................................... 156 Insider Reporting Requirements................................................... 157 The System for Electronic Disclosure by Insiders........................ 157 VII. Commissions and Other Compensation................................................... 158 Gifts to Clients.................................................................................... 159 Mutual Fund Incentives...................................................................... 159 National Instrument 81-105................................................................ 159 Disclosure..................................................................................... 160 Non-monetary Benefits................................................................. 161 Soft Dollar Arrangements................................................................... 161 Rebate of Commissions..................................................................... 162 VIII. Personal Financial Dealings..................................................................... 162 Carrying Accounts at Other Firms...................................................... 163 XI. Summary.................................................................................................. 163 Chapter Three – Placing Orders for Securities Introduction.......................................................................................................... 165 How Securities are Traded................................................................................... 165 Trading Units...................................................................................... 165 Minimum Quotation Spreads............................................................. 167 I. Placing an Order....................................................................................... 168 II. Types of Orders........................................................................................ 170 Orders Categorized by Duration......................................................... 170 Orders Categorized by Price.............................................................. 171 Orders Categorized by Special Instructions....................................... 172 Other Types of Orders........................................................................ 175 III. Settlement of Trades................................................................................ 176 The Clearing System.......................................................................... 176 Advantage with Securities Sold.......................................................... 177 Accrued Interest to Seller................................................................... 177 Trading Ex-Dividends and Ex-Rights.................................................. 177 Cash Trades................................................................................. 177 Exceptions.................................................................................... 178 Rights on Stock............................................................................. 178 Reducing Outstanding Orders When Shares Go Ex-Dividend, Ex-Rights etc........................................................... 178 Transfer of Securities......................................................................... 178 Simple Transfer............................................................................ 179 Transfer Involving Legal Documentation...................................... 179 Changes in Beneficial and Economic Ownership......................... 180 Failure to Deliver Listed Securities..................................................... 180 IV. Errors........................................................................................................ 181 V. Summary.................................................................................................. 182 © CSI Global Education Inc. (2005) iv Table of Contents Chapter Four – Cash and Margin Account Rules Introduction.......................................................................................................... 183 I. Accounting for Client Transactions........................................................... 183 II. Cash Accounts......................................................................................... 185 Purchases of Securities...................................................................... 186 Sale of Securities................................................................................ 187 Special Cash Accounts....................................................................... 188 Detailed Rules for Cash Accounts...................................................... 189 Dealing with Overdue Cash Accounts................................................ 190 Cash Accounts Overdue for Less Than Six Business Days.............................................................................. 191 Cash Accounts Overdue for Six or More Business Days.............................................................................. 193 Detailed Rules for DAP/COD Accounts........................................ 194 Overdue DAP/COD Accounts....................................................... 194 Exceptions to the Cash Account Rule.......................................... 195 III. Margin Accounts....................................................................................... 197 Margin Agreements............................................................................ 198 Long Margin Accounts........................................................................ 199 An Introduction to Margin Rates................................................... 199 Securities Eligible For Reduced Margin........................................ 200 Operating a Long Margin Account...................................................... 201 Loan Value.................................................................................... 202 Margin Position............................................................................. 203 Equity Position.............................................................................. 204 Long Margin Account - Case Study.............................................. 204 More about Margin Rates............................................................. 206 Margining Long Positions in Unlisted Equities.............................. 207 Sample Margin Account................................................................ 208 Short Margin....................................................................................... 210 Risk............................................................................................... 210 Credit Balances............................................................................ 210 Margin Required........................................................................... 210 Combination of Short and Long Positions in a Margin Account................................................................................... 213 Special Margin Situations................................................................... 213 Restrictions................................................................................... 213 Convertible Bonds/Debentures..................................................... 213 Hedge Positions............................................................................ 214 Guarantees................................................................................... 214 Concentration............................................................................... 214 Unlisted Securities Sold Short...................................................... 215 Options......................................................................................... 215 IV. Free Credit Balances................................................................................ 215 V. Summary.................................................................................................. 216 © CSI Global Education Inc. (2005) v Table of Contents Chapter Five – Communications with Clients Introduction.......................................................................................................... 217 I. General Regulations and Guidelines for Sales Literature........................ 218 II. Mutual Fund Sales Communications........................................................ 219 General Requirements....................................................................... 219 Use of Performance Data................................................................... 221 Warnings............................................................................................ 222 Standard Performance Data............................................................... 222 Other Required Disclosure – Mutual Funds....................................... 224 III. Electronic Communications...................................................................... 225 Issuer Disclosure and Delivery........................................................... 225 System for Electronic Document Analysis and Retrieval (SEDAR).............................................................................. 226 Company Websites............................................................................ 226 Internet Trading and Advising............................................................. 227 IV. General Disclosure Requirements............................................................ 228 Disclosure When Acting as Principal.................................................. 228 Disclosure When Selling Securities Short.......................................... 229 Disclosure of Conflicts of Interest....................................................... 229 Disclosure Relating to Products......................................................... 230 Leverage Disclosure........................................................................... 231 V. Communicating Trading Information to Customers.................................. 231 Confirmation of Trades....................................................................... 231 Account Statements........................................................................... 232 Margin Accounts........................................................................... 235 Other Information for Clients.............................................................. 238 Safekeeping, Segregation and Street Name................................ 238 Portfolio Reporting........................................................................ 239 Taxation........................................................................................ 239 VI. Handling Client Complaints...................................................................... 239 Disputes with Clients.......................................................................... 239 ComSet............................................................................................... 241 OSC Tipping Program........................................................................ 242 Arbitration........................................................................................... 242 Eligibility........................................................................................ 243 The Arbitration Process................................................................ 243 The Financial Services OmbudsNetwork (the OmbudsNetwork).......................................................................... 244 Client Communication................................................................... 245 VII. Summary.................................................................................................. 246 © CSI Global Education Inc. (2005) vi Table of Contents Section III: Special Transactions and Products Chapter One – Bringing New Issues to Market Introduction.......................................................................................................... 247 I. Bringing Securities to the Market.............................................................. 248 Securities Distributions....................................................................... 248 When a Prospectus is Required......................................................... 248 New Issues................................................................................... 248 Sale from a Control Position......................................................... 249 Preliminary or Red Herring Prospectus.............................................. 249 Permitted Activities During the Waiting Period................................... 250 Final Prospectus................................................................................. 250 Details of the Offering......................................................................... 251 Information on the Business and Affairs of the Issuer.................. 251 Factors Affecting an Investment Decision.................................... 252 Information on Promoters, Principal Security Holder and Interest of Management in Material Transactions.................. 252 Financial Information.................................................................... 252 Representations, Declarations and Certificates............................ 253 Market Out Clauses...................................................................... 254 Simplified or Short Form Prospectus and Shelf Prospectus............... 254 The Bought Deal................................................................................. 255 Use of U.S. Prospectuses.................................................................. 255 Securities Distributions through the Exchanges................................. 256 Distributions through the TSX....................................................... 256 Distributions through Bourse de Montréal.................................... 256 Distributions through the TSX Venture Exchange........................ 256 Exempt Issues.................................................................................... 257 Purchasers’ Statutory Rights.............................................................. 261 Right of Withdrawal....................................................................... 261 Right of Rescission....................................................................... 261 Right of Action for Damages......................................................... 262 Restrictions on Trading....................................................................... 262 Hot Issues........................................................................................... 263 Conflict of Interest Rules.................................................................... 263 II. Maintaining Publicly Trading Status......................................................... 264 Financial Disclosure........................................................................... 264 Press Releases and Material Change Filings..................................... 266 National Policy 51-201.................................................................. 266 SEDAR......................................................................................... 267 The System for Electronic Disclosure by Insiders (SEDI)........................................................................................... 268 Proxies and Proxy Solicitation............................................................ 268 Mandatory Proxy Solicitation........................................................ 268 Shareholder Communication Procedures..................................... 268 Voting by Dealers......................................................................... 270 III. Summary.................................................................................................. 271 © CSI Global Education Inc. (2005) vii Table of Contents Chapter Two – Takeover Bids, Insider Bids, and Issuer Bids Introduction.......................................................................................................... 273 I. Formal Takeover Bids.............................................................................. 273 What Is a Formal Takeover Bid?........................................................ 273 Early Warning Rules........................................................................... 274 Takeover Bid Rules............................................................................ 275 Takeover Bid Circular................................................................... 275 Directors’ Circular......................................................................... 275 Timing........................................................................................... 275 Withdrawal Rights......................................................................... 276 Fairness Rules.............................................................................. 276 Other Acquirers............................................................................. 276 II. Insider Bids............................................................................................... 277 III. Statutory Rights of Shareholders.............................................................. 277 Defenses To Unfriendly Takeover Bids.............................................. 278 IV. Exempted Takeover Bids......................................................................... 278 Stock Exchange Takeover Bids.......................................................... 279 Normal Course Issuer Bid............................................................. 279 Regulations on Substantial Takeover Bids Made on Stock Exchange.................................................................................. 280 Allotment Procedure and Competing Bids.......................................... 280 Conduct of Members in Tendering Shares and Short Tendering........................................................................................... 280 V. Issuer Bids................................................................................................ 281 VI. Exchange Issuer Bids............................................................................... 282 VII. Summary.................................................................................................. 282 Case Studies........................................................................................................... 283 Case #1 - Gemini Mutual Funds........................................................................... 285 Case #2 - Luke Picard.......................................................................................... 288 Case #3 - The Cheng Accounts........................................................................... 290 Glossary.................................................................................................................... 295 Appendix A – The CSA Numbering System for National Policies and National Instruments...................................................... 313 Appendix B – TSX Electronic Communications Disclosure Guidelines................................................................................... 315 © CSI Global Education Inc. (2005) viii Introduction The Conduct and Practices Handbook (CPH) Course Introduction The following Handbook identifies many of the requirements of provincial securities legislation and of the Self-Regulatory Organizations (SROs) that affect registrants in their dealings with clients. The Handbook results from careful consideration of the different elements that comprise the daily life of a registrant in the Canadian securities industry, and is organized into three major sections that reflect these areas: Section I: The Regulatory Environment Chapter 1: Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Chapter 2: Regulation of the Securities Industry Chapter 3: Registration of Securities Industry Participants Section II: Dealing with Client Accounts Chapter 1: Account Opening Procedures Chapter 2: Sales and Trading Conduct Chapter 3: Placing Orders for Securities Chapter 4: Cash and Margin Account Rules Chapter 5: Communications with Clients Section III: Special Transactions and Products Chapter 1: Bringing Issues to Market Chapter 2: Takeover Bids, Issuer Bids and Issuer Bids Ethics and compliance-related case studies, a glossary, and other supplementary resources have also been included for reference purposes. Coverage of Material This Handbook is intended as a guide to requirements (rules, regulations, policies, by-laws, etc.) of the Administrators and SROs. It should facilitate the study of these requirements but it is by no means exhaustive. The registrant should remember that the final authority is always provincial legislation and SRO rules and by-laws. It is the registrant’s duty to be fully familiar with the content of © CSI Global Education Inc. (2005) 1 Introduction all sections of this Handbook. In addition, registrants are responsible for knowing provincial legislation as it relates to their employment in provinces and/or territories where they are or will be licensed to sell securities. Some material included in this book should be known to students but will not be tested on the CPH exam. In such cases the material is highlighted and marked “For information only.” The registrant is still responsible for knowledge of this material apart from the actual CPH exam. This material should be viewed as reflecting minimum standards or policy guidelines for compliance with industry rules. In practice, internal procedures of securities houses will reflect their individual management techniques and controls and, as a result, may be stricter than those presented here. The Handbook does not specifically deal with futures and options matters. The registrant who is qualified to deal with the public in futures and options is subject to the various Securities Acts and Commodity Futures Acts, as applicable in these areas. Additional courses are required for licensing to deal in these products. Major provisions of Canadian securities legislation of particular concern to investment professionals are summarized in the material that follows in this Handbook. Descriptions are based largely on the present Securities Act (Ontario), as this was the model used for most other provinces. Any significant differences in provincial legislation are noted. Where possible, the Handbook also provides highlights of proposed changes to requirements. Referencing of some of the relevant legislation has been included in the textbook. © CSI Global Education Inc. (2005) 2 Section I: The Regulatory Environment SECTION I : THE REGULATORY ENVIRONMENT Chapter 1 Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Introduction The securities industry is a business of trust and confidence. As a consequence, even in an environment that already has many complex rules and regulations, a Code of Ethics is warranted. It should be understood that there is a difference between compliance and ethics. Compliance is, basically, following the rules, whether those rules are legal requirements or firm policies. Ethics involve not only complying with the letter of the law but also complying with the spirit of the law. Therefore, ethics go beyond prescribed behaviour, and address situations where rules are not clear or are contradictory. It is possible to take an action that is unethical, even though one is complying strictly with the rules. Learning Objectives After reading this section, you should understand: the importance of the Know Your Client rule and suitability in the registrant’s dealings with clients the importance of ethics in the securities industry the Code of Ethics and Standards of Conduct for the securities industry how to apply the Code and Standards to various situations Know Your Client and Suitability A way of integrating ethics into the rules is through ensuring suitability of investment recommendations. The focus of the registrant’s daily business hinges on this all-important matter. Suitability means ensuring that all recommendations © CSI Global Education Inc. (2005) 3 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct take into account the client’s unique situation and investment objectives. It also means that recommendations are based on a personal and financial knowledge of the client and knowledge of the investment products being recommended. In April 2000, the Canadian Securities Administrators (CSA) ruled that discount brokers who do not provide investment advice may submit applications for an exemption from suitability requirements. Exemptions were to be granted under certain conditions, including: The dealer must operate as a separate legal entity or business unit that limits activities so that no advice or recommendations will be given regarding the purchase or sale of any security; The separate legal entity or business unit must, at a minimum, have separate letterhead, accounts, registered persons and account documentation; The dealer must not compensate individuals on the basis of transactional values; and The dealer must receive a client’s written acknowledgement that no advice or recommendations will be given and that no determination of suitability will be provided for any purchase or sale of a security through the legal entity or business unit. In September 2001, the IDA implemented revisions to its know-your-client regulations that incorporate the April 2000 CSA ruling and expand it to give full service dealers the opportunity to accept non-recommended trades without a suitability obligation. The changes included revisions to IDA Regulation 1300 and the introduction of Policy 9. Policy 9A applies to dealers or branches offering order-execution services only and contains the same provisions as the CSA ruling. The CSA exemptions, which were granted to dealers individually, generally required that members operating under a CSA exemption are required to obtain Policy 9A exemptions from suitability within a year of the implementation of the IDA rule. When applying for relief under Policy 9A, dealers must submit new account forms, letterhead, account statements and confirmations that clearly differ in format from those used by any full service branch, and that clearly label the accounts as “order execution only” accounts or some variant thereof. Policy 9B is applicable to full service dealers who want to be able to execute client orders that do not result from any advice or recommendation from the dealers and without incurring a suitability obligation. Those trades would be affected through the same accounts as trades that did result from advice or a recommendation. In order to obtain relief under Policy 9B, a dealer must establish record keeping and supervisory systems acceptable to the IDA, capable of distinguishing between recommended and non-recommended trades. The dealer must also supervise the © CSI Global Education Inc. (2005) 4 Section I: The Regulatory Environment marking of trades to ensure that there is no practice of marking recommended trades as non-recommended in order to avoid suitability obligations. Policy 9B also requires disclosure to and agreement by clients whose nonrecommended trades will not be subject to a suitability review. A concerted effort must be made to know the client – to understand the financial and personal status and aspirations of the client. Thus, the Investment Advisor (IA) will make recommendations for the client to invest his or her funds in securities that reflect, to the best knowledge of the IA, these considerations. The IA, having provided sound advice, will therefore be above reproach for potentially unsuitable purchases and sales of securities for a client if the client does not heed the IA’s advice. Fiduciary Duty When disputes between dealers and clients are resolved through civil litigation, the courts will generally hold that the IA owes a fiduciary duty to the client if the IA provides investment advice and recommendations to the client, and the client relies on such advice. The existence of such a fiduciary duty imposes a higher standard of care upon the IA than would be the case if the IA merely executed the client’s orders without providing any advice. A fiduciary relationship requires the IA to act carefully, honestly, and in good faith in dealings with the client, and not to take advantage in any way of the trust the client has placed in the IA. I. Registrant Code of Ethics This Code of Ethics establishes norms that incorporate, but are not limited to, strict compliance with “the letter of the law” but also foster compliance with the “spirit of the law.” These norms are based upon ethical principles of trust, integrity, justice, fairness and honesty. The Code distills industry rules and regulations into five primary values. A. B. C. D. Registrants must use proper care and exercise independent professional judgement. Registrants must conduct themselves with trustworthiness and integrity, and act in an honest and fair manner in all dealings with the public, clients, employers and colleagues. Registrants must, and should encourage others to, conduct business in a professional manner that will reflect positively on themselves, their firms and their profession. Registrants should also strive to maintain and improve their professional knowledge and that of others in the profession. Registrants must act in accordance with the Securities Act(s) of the province or provinces in which registration is held and the requirements of all Self- © CSI Global Education Inc. (2005) 5 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct E. II. Regulatory Organizations (SROs) of which the firm is a member must be observed. Registrants must hold client information in the strictest confidence. Registrant Standards of Conduct The Standards of Conduct on the following page amplify the Code of Ethics and set out certain specifics of required behaviour. These requirements are based in large part on the provincial Securities Acts and the SRO rules. © CSI Global Education Inc. (2005) 6 Section I: The Regulatory Environment Exhibit 1 Canadian Securities Industry Standards of Conduct (Summary) Standard A: Duty of Care θ Know Your Client θ Due Diligence θ Unsolicited Orders Standard B: Trustworthiness, Honesty and Fairness θ Priority of Client Interests θ Protection of Client Assets θ Complete and Accurate Information θ Disclosure Standard C: Professionalism θ Client Business Client Orders Trades by Registered and Approved Individuals Approved Securities θ Personal Business Personal Financial Dealing with Clients Personal Trading Activity Other Personal Endeavours θ Continuous Education Standard D: Conduct in Accordance with Securities Acts θ Compliance with Securities Acts and SRO Rules Inside Information Standard E: Confidentiality θ Client Information θ Use of Confidential Information © CSI Global Education Inc. (2005) 7 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Standard A – Duty of Care While a duty of care encompasses a wide number of obligations towards parties, the obligation to know the client is of paramount importance in order to ensure the priority of clients’ interests. Along with this obligation, the three other major components of duty of care are: Know Your Client: The Know Your Client (KYC) rule is paramount for the industry. All registrants, except those granted the exemption from the suitability requirement, must make a diligent and business-like effort to learn the essential financial and personal circumstances and the investment objectives of each client. Client account documentation should reflect all material information about the client’s current status, and should be updated to reflect any material changes to the client’s status in order to assure suitability of investment recommendations. Due Diligence: Registrants must make all recommendations based on a careful analysis of both information about the client and information related to the particular transaction. Unsolicited Orders: Registrants who give advice to clients must provide appropriate cautionary advice with respect to unsolicited orders that appear unsuitable based on client information. The registrant must be aware of the objectives and strategies behind each order accepted on behalf of his or her clients, whether it is solicited or not. Registrants should take appropriate safeguarding measures when clients insist on proceeding with unsolicited, unsuitable orders. Example A: Jane Morgan is an IA. The New Account Application Form (NAAF) for one of her clients, Bruno Mannheimer, indicates that he has a moderate income, moderate net worth and conservative investment objectives. Mannheimer has recently come into a substantial inheritance. He calls Morgan, telling her about his inheritance. Based on Mannheimer’s new net worth, Morgan recommends the purchase of several growth and speculative stocks, the total of which comes to over $200,000. When Morgan’s branch manager sees these orders the next day, she checks the client’s New Account Application Form. It shows a net worth of $100,000, annual income of $50,000 and objectives of 50% income and 50% safety. Immediately concerned, the branch manager calls Morgan into her office and requests an explanation of whether the client can pay for these securities and whether the securities are appropriate for the client. Comment The IA in this example was fortunate that her branch manager was alert. Either the orders were well beyond the client’s apparent ability to pay, or the client has experienced a major change in his financial situation. The client documentation did not show the financial resources to support acceptance of such an order. © CSI Global Education Inc. (2005) 8 Section I: The Regulatory Environment It is not clear in this case whether Morgan discussed any change in objectives that might have accompanied the change in financial circumstances. Taking into account Mannheimer’s age, occupation, plans for retirement, and any change of attitude on the client’s part, Morgan should consider the continuing applicability of the objectives on the client’s NAAF. In order to justify the suitability of the recent purchases in Mannheimer’s account, Morgan must update the client’s New Account Application Form. It is not always sufficient to “Know Your Client” - the registrant must also be able to prove that he or she does. Otherwise, if the securities did not perform well and the client complained, Morgan could be faced with the problem of justifying these orders. In fact, if the client claimed to be unsophisticated and conservative, and had the investment history to support these claims, a complaint by the client might result in sanctioning of the IA for giving unsuitable advice. Procedures for Compliance Registrants must document any material changes to their clients’ situations. This includes changes to net worth, income, employment, investment objectives and marital status. The firm should ensure that any transactions that appear unsuitable based on a client’s NAAF are flagged and investigated. Example B: An IA, Stanley Kowalski, receives a phone call from one of his clients, Doris Green, who is interested in speculating on the proposed takeover of a national auto parts manufacturer. After a lengthy discussion, Green concludes that the speculation is worthwhile and instructs the IA to invest her excess margin in shares of the company. After checking the account’s margin balance, Kowalski buys 2,500 shares of the company’s Class B shares. Two weeks later, the takeover is finalized. At that time, the IA learns that the takeover has been directed at the company’s voting shares only. A quick review of a research source shows that the company’s class A shares carry one vote per share. However, Class B shares are non-voting. As a result, Green does not profit from the takeover, and in fact, actually takes a small loss on her trade. Comment The IA appears to have been negligent in not having taken enough care to learn the essential details surrounding the company in question and its proposed takeover. Through his negligence, Kowalski failed to act in the client’s best interests. It is likely that the IA could be held responsible for the client’s losses as well as missed profit opportunity. © CSI Global Education Inc. (2005) 9 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Procedures for Compliance Registrants must have a thorough level of product knowledge and understanding. Many firms offer the facilities of a research department to assist registrants in locating up to date information on various companies and products. Firms often offer training for registrants in the areas of specialized products and trading strategies. A wide variety of financial and news publications are available to help registrants keep up on the latest developments in the investment industry. Example C: Kate Janeway, an IA, takes a call from a seventy-two year old retired client, Sam McMunny, whose NAAF states that his only income is from a pension, his net worth is $150,000 and his investment objective is 100% income. At the time of the call his account holds $130,000 in a combination of Canada Treasury Bills and long-term Government of Canada bonds. McMunny is calling to say that his sonin-law, who is a mining engineer, has given him a tip on a penny mining stock that is currently involved in explorations. The company is expected to announce drilling results in a few days. If the drilling results are favourable, the stock’s price could rise dramatically. McMunny instructs Janeway to liquidate all of his T-Bills (which make up about half of his portfolio) and use the proceeds to buy shares in the penny stock. Janeway promptly enters the orders as requested. Comment By accepting this order without question, the IA has violated the requirement for due care. It is her duty under Standard A to ascertain that this client is aware of the risk associated in buying speculative stock. He must also be made aware that this type of trade does not conform to the investment objectives that he specified when his account was opened. If his objectives have changed, the NAAF must be updated to reflect this. If the objectives of the client have not really changed, but the client continues to insist on the trade, the IA must clear it with her branch manager or compliance department. If the firm agrees to accept the order, it should be marked “unsolicited” and the circumstances of the trade should be documented in the client’s file. Procedures for Compliance Clients must be warned when transactions seem unsuitable based on their NAAF. NAAFs should be updated if investment objectives have changed. Client orders entered against the advice of the IA should be marked “unsolicited” and the circumstances of the transaction documented. © CSI Global Education Inc. (2005) 10 Section I: The Regulatory Environment If IAs are unable to dissuade clients from making apparently unsuitable trades, they should clear such orders with the branch manager or compliance department before putting them through. Firms may refuse to accept unsuitable orders. Policies may be put in place or they may be dealt with on a case-by-case basis. Standard B – Trustworthiness, Honesty and Fairness Registrants must display absolute trustworthiness since the client’s interests must be the foremost consideration in all business dealings. This requires that registrants observe the following: Priority of Client’s Interest: The client’s interest must be the foremost consideration in all business dealings. In situations where the registrant may have an interest that competes with that of the client, the client’s interest must be given priority. Respect for Client’s Assets: The client’s assets are the property solely of the client and are to be used only for the client’s purposes. Registrants shall not utilize client funds or securities in any way. Complete and Accurate Information Relayed to Client: Registrants must take reasonable steps to ensure that all information given to the client regarding his or her existing portfolio is complete and accurate. While the onus is on the investment firm to provide each client with written confirmations of all purchases and sales, as well as monthly account statements, the individual registrant must accurately represent the details of each clients’ investments to the client. The registrant must be familiar with the client’s investment holdings and must not misrepresent the facts to the client in order to create a more favourable view of the portfolio. Disclosure: Registrants must disclose all real and potential conflicts of interest in order to ensure fair, objective dealings with clients. Example A: A fairly new IA, Kyle Toshiba, has a small group of clients. To increase his and his firm’s income, he favours an active trading approach with his clients. Toshiba’s branch manager notices that several of the IA’s accounts show very high levels of trading activity, many times without significant differences in the types of securities traded. Quite often, shares that had been sold from an account were bought back for the same account a few days later. In one case, a client whose investment knowledge was indicated as “fair” had 24 trades in his account over a two-month period, with no significant changes over that period in the type or performance of securities traded. © CSI Global Education Inc. (2005) 11 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Comment While registrants have an interest in executing transactions in order to earn commission revenue, they should do so only if the transactions are in the best interests of the clients. In this case, the number of trades in the IA’s client accounts does not seem to be in the clients’ best interests. Toshiba appears to be churning, or generating trades simply for the commission he will earn. Churning is a prohibited sales practice as it implies trading that is unnecessary and unsuitable for the client. Churning is trading which does not benefit the client and deprives the client of the money being paid in commission. Procedures for Compliance Recommendations for trades should be made only when necessary and when it is to the benefit of the client. Branch managers must be aware of and question any trading that appears excessive. Example B: Jack Chopra, an IA, has a long-time client named Igor Sazonoff. One day, Chopra notices that Sazonoff’s account shows a small margin deficiency. Chopra knows that his branch manager will ask him to clear up this deficiency. Chopra also knows that Sazonoff is on vacation and will certainly be bringing the account up to date within the week. Another client of Chopra’s, Monica Mintz, has a large cash balance sitting idle in her account. Chopra moves some money from Mintz’s account into Sazonoff’s to cover the margin deficiency. Within the week, Sazonoff has returned from vacation and deposited enough money to bring his account up to date. Chopra then replaces the borrowed money into the Mintz account. Comment Chopra has used Mintz’s assets for the benefit of another client, Sazonoff. A client’s assets must be used solely for the benefit of that client. Mintz may have wished to convert her cash into securities while some of her cash was still in Sazonoff’s account. Her cash would have been at risk in Sazonoff’s account if Sazonoff had not repaid the balance owed. However, no matter whether Mintz wished to access her money or not, an unauthorized transfer such as this is not permitted. Using client assets for the benefit of the registrant or another client is not permitted and reflects badly on the registrant, the firm and the industry. This violates the trust inherent in the registrant-client relationship and may constitute criminal behaviour. © CSI Global Education Inc. (2005) 12 Section I: The Regulatory Environment Procedures for Compliance Firms should have policies in place to ensure that any movement of assets between client accounts is appropriately authorized and monitored. Example C: A retired client, Fredella Bingleby, holds a portfolio of preferred stocks, primarily for the dividend income they provide. Higher interest rates have caused the value of the portfolio to decrease, causing her some concern. She calls her IA, Philip de Groot, and asks if her money might be more safely invested in GICs at a local trust company. The IA explains that the higher interest rates are only a short-term problem, and that everything will be all right eventually. To help ease Bingleby’s concern, he volunteers to do a portfolio evaluation for her. After de Groot has completed the evaluation, he realizes that the client’s total return on investment does not look favourable in light of current interest rates. So, not wanting to lose Bingleby’s business, de Groot re-calculates the portfolio’s yield using current market values rather than the purchase price of the various preferred shares. This method of calculation shows a higher income return on the shares and ignores the capital loss on the principal amount of the shares. Satisfied with the results, he sends the evaluation to the client, who is reassured by what she reads. Several weeks later, Bingleby’s tax accountant reviews the evaluation and realizes what has occurred. Angry at having been misled by the IA, the client complains to the branch manager and transfers her account to another firm. Comment By providing the client with inaccurate information regarding her portfolio holdings, the IA has deliberately misled the client. He has taken advantage of Bingleby’s lack of understanding of yield calculation to create the impression that the client’s portfolio was performing better than it really is. In so doing, the IA has attempted to deceive his client. The branch manager must also approve all such communication before it goes to clients. Procedures for Compliance Rather than making an effort to disguise an apparent weakness in Bingleby’s portfolio, de Groot should appraise the portfolio constructively, perhaps suggesting some changes such as alternative securities which are suitable for the client and will increase her return. The member firm should have procedures in place to ensure that the branch manager or a director of the firm review any portfolio evaluations prepared by IAs in order to ensure that the enclosed information is accurate and complete. © CSI Global Education Inc. (2005) 13 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Example D: Jeff Doe, an IA, also sits on the board of directors of a small software company (Tekwax) owned by his cousin. Doe thinks that Tekwax is a promising investment, and has been recommending that clients purchase its stock on the over-the-counter market, telling them only that Tekwax is a promising new company in the technology sector. Doe does not think it necessary to inform his clients or employer that he is a director of Tekwax. Comment Doe must disclose his directorship to both his employer and his clients. His position with Tekwax may bias his investment recommendations to clients and cause him to overlook more suitable or advantageous investments. Procedures for Compliance The IA must disclose his directorship to his employer and obtain written approval from the employer. The IA must tell his clients that he is a director of Tekwax when he makes any recommendations for the stock. Standard C – Professionalism It is generally accepted that professionals, by having specialized knowledge, need to protect their clients, who usually do not have the same degree of specialized knowledge, and must continually strive to put the interests of their clients ahead of their own. Registrants must also make a continuous effort to maintain a high standard of professional knowledge. Client Business: All methods of soliciting and conducting business must be such as to merit public respect and confidence. Client Orders: Every client order must be entered only at the client’s direction unless the account has been properly constituted as a discretionary or managed account pursuant to the applicable regulatory requirements. Trades by Registered and Approved Individuals: All trades and all acts in furtherance of trades, whether with existing or potential clients, must be effected only by individuals who are registered and approved in accordance with applicable legislation and the rules of the SROs. Approved Securities: Only securities approved for distribution by the appropriate regulatory authority and partner, director or officer of the firm should be distributed, and all such transactions should be recorded in the normal way on the books and records of the firm. © CSI Global Education Inc. (2005) 14 Section I: The Regulatory Environment Personal Business: All personal business affairs must be conducted in a professional and responsible manner, so as to reflect credit on the individual registrant, the securities firm, and the profession. Personal Financial Dealings with Clients: Registrants should avoid personal financial dealings with clients, including the lending of money to or the borrowing of money from them, paying clients’ losses out of personal funds, and sharing a financial interest in an account with a client. Any personal financial or business dealings with any clients must be conducted in such a way as to avoid any real or apparent conflict of interest and be disclosed to the firm, in order that the firm may monitor the situation. Personal Trading Activity: Personal trading activity should be kept to reasonable levels. If a registrant is trading his or her own account very actively on a daily basis, it is doubtful that the registrant will have enough time to properly service his or her clients. Excessive trading losses by a registrant will also present a negative image of the registrant as a responsible financial professional. Other Personal Endeavours: Each registrant must take care to ensure that any other publicly visible activity in which he or she participates (such as politics, social organizations or public speaking) is conducted responsibly and moderately so as not to present an unfavourable public image. Continuous Education: It is the responsibility of each registrant to have an understanding of factors that influence the investment industry in order to maintain a level of competence in dealing with his or her clientele. A registrant must continually upgrade his or her levels of technical and general knowledge to ensure the accuracy and responsibility of his or her recommendations and advice. Example A: Mario Fellini, an IA, opens a margin account for a surgeon who wishes to speculate in growth stocks. Fellini suggests several trades to the client over a six-month period. Most of the trades are quite profitable. However, on a few occasions, the IA is unable to contact his client when he is tied up in surgery for several hours. As a result of these delays, some potential profits are reduced due to adverse market moves before Fellini is able to contact his client. Frustrated, but still pleased by the consistent success of the IA’s recommendations, the client tells the IA that if he is unable to reach him at any time in the future, the IA should go ahead and use his own initiative to take profits on existing positions, or to take on new positions as long as there is enough margin available in the account. Fellini agrees to do this on a “when necessary” basis. © CSI Global Education Inc. (2005) 15 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Comment Regardless of the client’s willingness to have the IA make certain decisions regarding the trading of his or her account, this arrangement contravenes the rules for two reasons: The registrant does not have the authority to accept a discretionary account on behalf of his or her firm. This can only be done by a partner or director of the firm (or his or her alternate) who has been designated to supervise account openings and activities (the “designated person”). The client must supply discretionary authority in writing. Verbal authority is not acceptable. Unauthorized discretionary trading is one of the most common reasons for disciplinary action being taken against registrants. The nature of the business is such that, due to rapidly changing markets, it may be difficult for registrants to obtain specific orders from a client on short notice. Thus, the perception of a need to trade on a discretionary basis can become a serious temptation. However, penalties can be quite severe, and in most member firms unauthorized discretionary trading may be grounds for termination. Procedures for Compliance The IA must have the client complete a discretionary agreement (assuming that the firm allows discretionary accounts), update the New Client Application Form to indicate that the account has become discretionary, and submit these documents to the firm’s designated person for approval. If the IA is not a person authorized to place discretionary orders, he or she would have to ensure that all discretionary orders for the account are approved by the appropriate person before they are entered. The onus is on each member firm to ensure that all representatives are familiar with the by-law regarding discretionary trading. In most member firms, unauthorized discretionary trading is grounds for termination. Since it is very difficult for supervisory personnel to detect unauthorized discretionary trading in the absence of a client complaint to that effect, it is necessary for the firm to initiate procedures to assist in this area. For example, all IAs who transfer in from other member firms should be asked if they maintain any discretionary accounts. The entire sales staff should be surveyed at least on an annual basis in order to verify what accounts are being traded on the basis of discretionary authority. Clients must reauthorize discretionary authority no less frequently than annually. The firm’s new account staff should be instructed to contact the compliance department whenever they see a new account that appears to be discretionary (e.g. an account over which an IA holds a Power of Attorney or a Trading Authorization). © CSI Global Education Inc. (2005) 16 Section I: The Regulatory Environment Example B: An established IA, Ramesh Issar, with a sizeable client base decides that strip bonds have become very attractive investments. He hopes to use Government of Canada strip bonds as a prospecting tool for new accounts, so he plans a monthlong solicitation campaign. Because of the magnitude of the campaign and the fact that he will be spending a lot of time out of the office visiting prospects, he is worried that he will not have enough time to service his existing clientele. So, he instructs his unregistered sales assistant, who has taken the Canadian Securities Course and is now enrolled in the CPH, to take all of his incoming calls, and to place any orders that his clients may give. He also tells the sales assistant to convince his clients to take profits in their common stocks, as he expects prices to generally go lower for the next several months. Comment The IA (and the firm) is in violation of the rules. An unregistered individual must not be allowed to accept orders or solicit business from clients except in “exempt securities” (e.g. T-Bills, CSBs, etc.). Note that even if the assistant had completed the courses required for registration, the individual must be registered and acknowledged as such by the SRO. The firm could also be found guilty of failing to properly supervise the IA and the sales assistant. Procedures for Compliance In a case such as this, the registrant must make arrangements with another IA in the firm to have the other IA handle existing clientele. In fact, some firms encourage their IAs to develop this type of buddy system to provide mutual back up when they are out of the office. Firms usually require their sales assistants to be registered to assist with order-taking duties. Each member firm should have policies in place to ensure that unlicensed employees are not taking orders from clients. Example C: An accomplished IA, Eric Jacobson, has a client, Antoinette Lagarde, who controls a number of small companies involved in various types of business. One of the more successful businesses is Toyco Inc., an import/export operation which has the exclusive right to distribute in Canada a line of interactive stuffed toys. Sales are growing quickly, and Lagarde needs additional capital to finance her inventory. Not wanting to borrow, she approaches a number of people, including Jacobson, to solicit interest in making an equity investment in the company. The IA is impressed by the profit potential of the business and agrees to invest $10,000 of his own money, for which he receives 10,000 common shares of Toyco Inc. © CSI Global Education Inc. (2005) 17 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Jacobson mentions this investment to a number of other clients, five of whom express an interest in investing in Toyco as well. Jacobson relays this information to Lagarde, who says she would be willing to issue additional shares to the IA’s other clients on the same terms. The IA obtains cheques from the five clients, payable to Toyco Inc., and in return receives share certificates registered in the clients’ names, which he subsequently delivers to them. As Jacobson feels that this is a private arrangement between Toyco and the clients, he does not see any necessity to advise his branch manager of the transactions. Comment Although Jacobson may believe the transactions are a private arrangement, the clients may view him as acting as a representative of the firm in facilitating the investment. Dealings in securities outside of the normal business of the firm, sometimes referred to as selling away or outside deals may expose clients to unknown risks and expose registrants and firms to civil liability. Such activities done without the knowledge of the firm also prevents effective supervision of the handling of client accounts, which is a requirement placed upon firms by the SROs. Firms may be exposed to liability for the actions of their employees in effecting such trades, even though the firm is unaware of the activities. Procedures for Compliance The firm must have knowledge of and give written consent to any business dealings outside of normal business. The IA should have taken Lagarde’s proposal to the appropriate official of the firm. The IA should have placed the securities with clients only if the firm agreed to participate in the distribution of the securities, perform the necessary due diligence with respect to the proposed distribution, and ensure compliance with securities legislation. Any trades must be recorded in a normal way with trade confirmations issued and monthly statements sent to the clients. Example D: An experienced IA, Edgar Brown, has a client, Michelle Green, with whom he has dealt for the past six years. Although Brown did not know Green prior to her becoming a client, since then they have socialized to some extent and might be considered friends. About a year ago, Brown needed $20,000 for renovations to his house. As the house was already heavily mortgaged and Brown knew he would have difficulty obtaining financing, he approached Green and asked if she would lend him the $20,000. Brown knew that Green could well afford to lend the funds as her account was worth over $100,000, much of which was liquid. The client agreed to lend the funds, and received from Brown a promissory note providing for payment within six months, with interest at the prime rate. © CSI Global Education Inc. (2005) 18 Section I: The Regulatory Environment When the six months had passed, the client inquired about repayment. Brown replied that he would have difficulty paying the debt at this time, and asked for more time, to which the client reluctantly agreed. It has now been six months since the note came due and Brown has not yet been able to pay it. Green has grown increasingly upset with Brown’s stalling and has now complained directly to the firm’s management about the unpaid debt. Comment The purpose of this standard is to prevent the creation of conflicts of interest that may arise when the registrant enters into financial dealings with clients on a personal level, aside from normal business dealings conducted through the firm. The IA in this example has entered into a transaction that creates a fundamental conflict of interest. He is now both a borrower from, and an advisor to, the client. In addition, Brown took advantage of his knowledge of Green’s financial circumstances, gained through his professional relationship with the client, thereby using their professional relationship for his personal benefit. By borrowing the funds from Green, Brown has also prevented the client from taking advantage of any superior investment opportunities that might have arisen. The standard is not stated as an absolute prohibition, as it is recognized that there are some circumstances where such dealings may not be objectionable. There may be grey areas in compliance with the standard. For example, where there is a close, pre-existing relationship, or family relationship, between the registrant and the client, such dealings might not be objectionable, depending on the circumstances. However, any such dealing should not be entered into without the knowledge and approval of the firm, and the firm should ensure that the client’s interests are fully protected. Procedures for Compliance Personal financial dealings with clients are to be avoided. Any proposed financial relationship with a client should be reviewed with an appropriate official of the firm, such as the head of compliance. The firm must give approval to the relationship and monitor the situation. Any such financial relationship must be conducted so as to avoid any real or apparent conflict of interest. In the event that a client is to be compensated for losses (for example, for trading errors or losses resulting from unsuitable recommendations), such compensation should only be paid through the proper channels of the firm, even if the loss is ultimately charged back to the registrant. © CSI Global Education Inc. (2005) 19 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Example E: Elaine van Nostrand, an IA, has used her increasing knowledge of investments to build up her own portfolio, as well as those of her clients. She is planning to buy a house next year, and is counting on profits from her portfolio to provide a large down payment. The stock market has been rather volatile lately, and van Nostrand finds that she has to keep monitoring her own holdings in order to prevent losses. On two consecutive days, van Nostrand spends at least one quarter of her time at the office buying and selling for her own account, both to protect her potential profit and because she sees many stock bargains. Comment Van Nostrand obviously is not serving her clients at the level they should expect. While trading for one’s own account is allowed, it should not be done to the point where clients’ accounts are in any way neglected or compromised. The reason that the IA in this example is spending a large amount of her time on her own account is given as the volatility of the stock market. If markets are volatile, clients’ accounts should be monitored even more closely than normally. Procedures for Compliance Trading for a registrant’s personal account(s) should not be excessive, and should not affect the level of service given to clients. Firms should monitor trading in personal accounts by employees. Registrants should avoid taking excessive risk that may lead to large losses. Example F: An IA, Walter Garcia, participates in a political organization. This organization recently held a protest, which Garcia attended. An opposing group showed up and shouting matches ensued. The TV news that night featured Garcia, among others, speaking out against the opposing group. Both Garcia’s occupation and his firm were identified. The next day, several clients called Garcia’s firm, wondering if the firm supported Garcia’s organization. Comment This is an example of the type of situation that could present an unfavourable and unprofessional public image. This negative publicity reflects badly on the IA, the IA’s firm and on others in the industry, as it contributes to the public perception of the investment professional. © CSI Global Education Inc. (2005) 20 Section I: The Regulatory Environment Procedures for Compliance Garcia should have ensured that his participation in organizations outside of the firm’s business did not result in negative publicity being reflected on the firm, or in any implication of the firm’s support of his personal activities. Firms should make their employees aware that they have an interest in any personal activities of the employee, as these activities may reflect badly on the firm and on the investment profession. Standard D – Conduct in Accordance with Securities Acts Registrants must ensure that their conduct is in accordance with the Securities Acts and the applicable SRO rules and regulations. Compliance with Securities Acts and SRO Rules: Registrants must ensure that their conduct is in accordance with the Securities Acts of the province or provinces in which registration is held. The requirements of all SROs of which a registrant’s firm is a member must be observed by the registrant. Note that if two rules apply, the registrant must adhere to the rule which is the most stringent. The registrant shall not knowingly participate in, nor assist in, any act in violation of any applicable law, rule or regulation of any government, governmental agency or regulatory organization governing his or her professional, financial or business activities, nor any act which would violate any provision of the industry Code of Ethics and Standards of Conduct. Inside Information: If a registrant acquires non-public, material information the information must neither be communicated (outside of the relationship) nor acted upon. Employees of a firm’s trading, corporate finance or research departments must be aware of the need to safeguard non-public, confidential, material information received in the normal course of business. Example A: Phyllis Erdo, an IA, is married to the treasurer of a publicly-traded pharmaceutical company, Feelgood Inc. Like many other employees of Feelgood Inc., Erdo’s husband holds a sizeable position in the company’s stock. Feelgood Inc. stock has recently enjoyed a 30 per cent increase in value due to rumours of an impending merger with a larger, U.S.-based company. One day, Erdo receives a phone call from her husband, informing her that the merger has fallen through. The husband wants to unload a large portion of his Feelgood stock before news of the failed merger becomes public. Erdo enters her husband’s order to sell 10,000 shares. She then calls her sister, who is also a client. Erdo tells her sister that the merger has fallen through and suggests that her sister make a quick profit by short selling Feelgood shares. When news of the failed merger becomes public, the price of the shares should quickly drop back to its previous level. The sister agrees and sells 1,000 shares short. © CSI Global Education Inc. (2005) 21 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Comment The IA in this example has actually violated two rules regarding insider trading. First of all, she accepted a sell order from a client (her husband) who was obviously acting on inside information as a result of his special relationship with the issuer. A special relationship denotes a relationship in which confidential information is obtained about an issuer by virtue of employment or the employment of a close relative or cohabitant. This includes insiders of the issuer as well as those working in certain capacities for or with the issuer (see Section II, Chapter 1 for a more extensive definition of insiders and special relationships). Therefore, Erdo herself could be considered to have a special relationship with the issuer through her husband. Provincial securities legislation states that no person or company in a special relationship with a reporting issuer shall purchase or sell securities of the reporting issuer with the knowledge of a material fact or material change with respect to the reporting issuer that has not been generally disclosed. The IA then passed along this information to her sister. This act of tipping is also contrary to provincial securities legislation. Regulation states that no person or company in a special relationship with a reporting issuer shall inform another person or company of a material fact or material change with respect to the reporting issuer before the material fact or material change has been generally disclosed. Procedures for Compliance Erdo knew that her husband was an insider of Feelgood Inc. She should not have accepted the order. She should not have divulged the confidential information to (tipped) her sister. Example B: While using a fax machine in close proximity to her firm’s Corporate Finance Department, an IA, Margaret Peterson, notices an incoming fax message addressed to someone in Corporate Finance. The fax discusses the purchase of a large trust company by a competitor. Peterson’s firm is apparently assisting with the financing of this purchase. When she returns to her desk, Peterson proceeds to call several of her clients, suggesting that they purchase shares in the trust company. She tells the clients that they can expect to hear an announcement soon detailing the terms of the competitor’s purchase offer. Naturally, such an announcement could be expected to have a positive effect on the value of the trust company. Comment Although the registrant in this example is not directly involved in a special relationship with the trust company (although her firm appears to be), she has nonetheless come into possession of confidential, non-public information. By reading the fax message that was intended for her firm's corporate finance © CSI Global Education Inc. (2005) 22 Section I: The Regulatory Environment department, Peterson has misappropriated this information. As well, by passing the information on to her clients and attempting to solicit trades based on the information, she has breached the Code of Ethics and Standards of Conduct. Procedures for Compliance In this example, the registrant’s best course of action would have been to deliver the fax to the corporate finance department immediately. As well, the IA should have understood that she was in possession of confidential information, and that use of such information is not allowed. If she had any doubt as to her ability to use this information to solicit trades from her clients, the registrant should have discussed the matter with her firm’s corporate finance and compliance departments. The firm should assess its practices with regard to the protection of confidential information. Firms should implement effective “Chinese Walls” policies, by which persons within a firm who make investment decisions are physically separated from persons within the firm who are privy to undisclosed material information which may influence those decisions. For instance, there should be separate fax and photocopy machines for corporate finance departments and sales departments, in order to avoid the potential problem of leaving confidential documents in places where they may be intercepted. Standard E – Confidentiality All information concerning the client's transactions and his or her accounts must be considered confidential and must not be disclosed except with the client’s permission, for supervisory purposes or by order of the proper authority. Client Information: Registrants must maintain the confidentiality of identities and the personal and financial circumstances of their clients. Registrants must refrain from discussing this information with anyone outside their firm, and must also ensure that the firm’s client lists and other confidential records are not left out where they can be taken or observed by visitors to the office. Use of Confidential Information: Information regarding clients’ personal and financial circumstances and trading activity must be kept confidential and may not be used in any way to effect trades in personal and/or proprietary accounts or in the accounts of other clients. Not only must registrants refrain from trading in their own accounts based on knowledge of clients’ pending orders, but they must also refrain from using it as a basis for recommendations to other clients or passing this information along to any other parties. Personal information is identifiable data about an individual and includes information contained in New Account Application Forms, account statements, trade confirmations and cheques and financial records in relation to the trading in securities. Clients from whom personal information is collected must be notified of © CSI Global Education Inc. (2005) 23 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct the purposes of the collection, use and disclosure of personal information, including its disclosure to SROs and its use and disclosure by SROs for regulatory purposes. It is important to note that Regulated Persons must decline to accept or administer an account in respect of which an individual does not consent to such intended collection, use or disclosure of their personal information. Any organization, including any Regulated Person, may be subject to disciplinary proceedings by an applicable SRO if it: Fails to provide notification to individuals from whom it collects personal information sufficient to ensure that the Regulated Person can comply with its obligations to produce or make available for inspection documents and information to SROs for regulatory purposes, or Accepts or administers an account in respect of which the Regulated Person is unable to comply with its obligations to produce or make available for inspection documents and information to SROs for regulatory purposes, including circumstances in which the client of such Regulated Person does not consent to the disclosure of personal information to SROs and the use and disclosure of that information by SROs. Effective November 2002, amendments to section 153 of the Ontario Securities Act dealing with the exchange of information between the OSC and those entities that provide services to the Commission became effective. The OSC now has greater flexibility in sharing information obtained in an investigation with other securities or financial regulatory authorities, stock exchanges and self-regulatory bodies. PERSONAL INFORMATION PROTECTION AND ELECTRONIC DOCUMENTS ACT Beginning January 1, 2004, the final stage of the Personal Information Protection and Electronic Documents Act (PIPEDA) came into force. The Act governs each firm’s information gathering processes and regulates what firms can do with the personal information that is collected, used and disclosed in the course of doing business. The final stage of the Act covers all businesses and organizations in Canada, both federally and provincially regulated, that collect, use or disclose personal information, except those in provinces where the government has enacted privacy legislation that is “substantially similar” to the PIPEDA. To date, British Columbia, Alberta and Quebec are the only provinces to do so, and firms should already be aware of this legislation and be complying with it. However, even where substantially similar provincial legislation exists, the PIPEDA will continue to apply to personal information transferred across provincial borders. Fines for violations of the Act can range from up to $10,000 for a summary conviction or up to $100,000 for an indictable offence. It is also an offence under the Act to destroy personal information that a client has requested, or dismiss or harass an employee that has complained to the Privacy Commission, or obstruct a complaint investigation or audit. © CSI Global Education Inc. (2005) 24 Section I: The Regulatory Environment The Nova Scotia Securities Commission issued Policy 11-601 to provide individuals with access to certain categories of records without having to submit a Freedom of Information and Protection of Privacy Act Application in that province. The policy allows for improved accessibility to certain records and to provide greater certainty of access for those requesting information. Example A: Phoebe Goldman, an IA, has a technical analyst as a client. Noting the successful track record of this analyst, Goldman calls several other clients and tells them of these successes. These clients agree to adopt the same trading strategies as the analyst. Comment Not only has the registrant violated the client’s confidentiality by passing along his trading strategies to other clients, Goldman has also done so simply by telling the other clients that she maintained an account for the analyst. This registrant may be vulnerable to regulatory penalties and possibly a civil lawsuit brought by the analyst. Procedures for Compliance The confidentiality of each client must be protected. The firm must ensure that each of its representatives is aware of his or her responsibilities with regard to client confidentiality. Example B: Maria Oliveira, an IA at a large investment firm, has a client that is the pension fund of a local university. The pension fund has a sizeable holding in a national pharmaceutical company that has recently been developing a drug used in the treatment of allergies. Preliminary experimental results have been successful, so the stock has enjoyed a substantial rise in value in the past several months. However, potential patenting problems and pending legal action by a competitor have caused the stock’s price to decline from its recent highs. The director of the pension fund tells Oliveira that if the stock price falls below a technical support level of $30, the fund will take profits by liquidating its entire position in the stock. Two days later, the IA notices that the stock has opened at $29.75. Aware of the impact that a large sell order could have on an already weakening market, Oliveira quickly sells short 1,000 shares in her own account. She then calls the director of the pension fund to report that the stock has opened below $30. As expected, the client instructs her to sell the entire position. By the end of the day, the stock has closed at $28.25, creating a nice profit in Oliveira’s short position. © CSI Global Education Inc. (2005) 25 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct Comment By using her confidential knowledge of the client’s impending trade, Oliveira has taken advantage of her relationship with that client. Not only has she profited by trading on material, non-public information, she has also possibly cost her client a better fill price by not putting her client’s order ahead of her own. Thus, the registrant has not upheld her regulatory responsibility to that client. The IA is also guilty of frontrunning (entering an order for her own account ahead of a similar client order). Had she called the client first and entered the client's order before her own, she would not be guilty of frontrunning, but she would still have been guilty of using confidential information for her own benefit. From the point of view of the member firm employing the IA, a simple review of the next day's commission run would almost certainly have brought attention to the trade and the obvious example of frontrunning, which would have left Oliveira susceptible to discipline by her firm. Procedures for Compliance Confidential information may not be used either for the benefit of the IA or as the basis of recommendations to others. Firms should have policies in place regarding the use of confidential information. If registrants feel that their own trading activity may be such that it would cause an appearance of frontrunning, they must defer their own trades in the interest of protecting the integrity of the investment industry. III. Summary Ethical conduct is vital to ensuring the integrity and stability of the capital markets. Registrants should therefore be familiar with the Code of Ethics and Standards of Conduct and should be able t

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