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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...

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 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 4 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 Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 5 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. Registrants must use proper care and exercise independent professional judgement. B. 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. C. 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. D. 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 SelfChapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 6 Regulatory Organizations (SROs) of which the firm is a member must be observed. E. Registrants must hold client information in the strictest confidence. II. 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. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 7 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 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 8 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. 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. 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. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 15 􀂉 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. 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. 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 Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 24 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. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 25 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. 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 to apply these standards to everyday situations. The Code and Standards incorporate the basic concepts of duty of care and suitability with the aim of protecting the interests of the investing public. The basic concepts of the Code and Standards underlie much of the regulatory material presented in this text. The cardinal rule in making investment recommendations is that of Know Your Client. Investment recommendations must take into account all relevant factors regarding the client’s financial and personal situations, objectives and constraints. Registrants may be found to have a fiduciary duty to their clients if the client relies heavily upon their advice; this may have legal implications for the registrant and the firm. Ethical conduct entails that registrants concern themselves not only with the actual rules as written, but also with the spirit and intent of the rules. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 27 SECTION I : THE REGULATORY ENVIRONMENT Chapter 2 Regulation of the Securities Industry Introduction The securities industry is a regulated industry. Various governmental and industry organizations impose rules and restrictions on participants in the securities marketplace to promote market integrity and to protect investors. For example: An issuer of securities may not sell new securities into the public marketplace without meeting certain requirements to provide information to potential purchasers as specified in the securities acts and regulations. Secondary trading in securities may not occur in public markets unless ongoing compliance with securities disclosure requirements takes place. This ensures that the public will continue to be adequately informed as to the nature of the securities and the associated risks so that an informed decision to purchase or sell the securities can be made. Distributors of securities (securities dealer firms and individuals) must also abide by rules governing their conduct. For example, securities regulation specifies the responsibilities which securities salespersons have to their clients when making recommendations for clients to buy and sell securities and when providing information to clients. Firms are required to supervise their employees’ conduct and to use care when handling assets of the clients. These rules, among others, promote a fair and efficient securities marketplace. The following chapter discusses the basic principles of securities regulation and the functioning of provincial securities legislation and the rules, regulations, by-laws, policies, guidelines etc. of the Self-Regulatory Organizations (SROs). Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 28 Learning Objectives After reading this module, you should understand: the structure of Canadian securities industry regulation principles of securities regulation the role of the SROs and provincial regulators the role of the CIPF and limits of CIPF coverage penalties that can be applied by regulators for contravention of rules I. General Principles of Securities Regulation The mandates of each of the securities regulators are first and foremost to promote the integrity of financial markets and ensure investor protection. An example of these mandates is expressed in the B.C. Securities Commission Mission Statement: “The mission of the British Columbia Securities Commission is to protect and promote the public interest by regulating trading in securities 1) to ensure the securities market is fair and efficient and warrants public confidence and 2) to foster a dynamic and competitive securities industry in British Columbia that provides investment opportunities and access to capital.” and in the mandate of the Ontario Securities Commission: “The Ontario Securities Commission’s mandate is to protect investors from unfair, improper or fraudulent practices and to foster fair and efficient capital markets and confidence in their integrity.” These statements and similar statements of other securities commissions and SROs have broad, extensive implications for the behaviour of participants in the securities industry. Securities legislation and SRO rules and regulations are crafted to incorporate these values. Securities Acts have been passed by each province to regulate the primary and secondary distribution of securities and to protect buyers and sellers of securities. The term Act will be used to refer to the Securities Act of each province. In most provinces, a securities commission administers the Acts. In provinces where there is not a separate commission, an administrator, registrar or other official handles securities administration. The term Administrator will be used here to describe the securities regulatory authority of a province, whether it be a commission, registrar, administrator or other official. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 29 Generally, the Acts are based on three broad principles of regulation: (i) Disclosure of facts necessary to make reasoned investment decisions; (ii) Registration of securities dealers and advisors; and (iii) Enforcement of securities laws and administrative policies. Disclosure The underlying principle of securities regulation in Canada is full, true and plain disclosure. Every person or corporation that sells, or offers to sell, to the public securities which have not previously been publicly distributed is required to file with the Administrator, and deliver to the purchaser, a prospectus containing full, true and plain disclosure of all material facts relating to the securities offered for sale. Until disclosure has been made to the satisfaction of the Administrator concerned, it is illegal to offer securities for public sale. Such disclosure is normally made in a prospectus issued by the company and its underwriter and accepted for filing by the Administrator of the province or provinces in which the offering will be made. In most provinces, a sale from a control position – where the holder of the securities exercises significant influence over the issuer of the securities – is subject to the same disclosure requirement. As the security moves beyond the primary distribution, it may be further bought and sold by investors, often through the facilities of a stock exchange. This trading is called secondary trading and is done subject to the issuer meeting the requirements of the Securities Act (s) and the exchange(s) upon which the securities are traded. These rules require, among other things, periodic filing of financial statements and filing of information concerning material changes to the company. Examples of the emphasis on continued disclosure are seen in material to be covered later in this Handbook, such as: the regulatory requirements covering insider trading reports where persons connected to the company disclose their market activities; the information circular required in proxy solicitation; regular corporate financial reports, including management’s discussion and analysis; annual information forms; timely disclosure of material changes in the affairs of issuers; and other shareholder communication. The purpose of this disclosure is to ensure efficient communication of material information from issuers to the public and investment professionals. Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 30 Registration Every firm that underwrites or sells securities must be registered with the Administrator in the province in which the securities are sold. All partners, directors, officers and salespersons employed by securities firms must also be registered with the Administrator of the appropriate province. The Administrators have the responsibility for registering persons and companies that are engaged in direct selling of securities to the public or engage in the business of advising others on the buying or selling of securities. This process allows the Administrators to impose proficiency requirements upon those that apply for or hold registration. The Administrators have the power to suspend or cancel registrations when they consider such action to be in the public interest. Investigation and Prosecution The Administrators are empowered to make investigations, to undertake prosecutions for violations against their respective Acts, to ensure that the laws are obeyed and to take administrative action - i.e., impose sanctions for breaches of the Acts - with respect to conduct that is contrary to the public interest. They also have authority to compel the attendance of witnesses at a hearing, take evidence under oath, seize documents for examination, freeze funds or securities on deposit with or under the control of any person and, in fact, have many of the powers of a court. Although an Administrator, with the exception of the Manitoba Securities Commission, has no power to compel restitution of monies paid, nor to interfere in the internal disputes of shareholders of companies, registration can be suspended, cancelled or revoked, fines can be levied, trading in a security can be ordered to cease, and the right to trade securities in the province can be denied. Cancellation of registration can have serious consequences to a person in the industry who can lose the ability to earn a living. If securities of an issuer cease trading, the issuer will be less able to raise financing. In certain provinces the Administrators have broader powers, such as preventing individuals from being directors or officers of public companies, giving public reprimands and levying fines. In all provinces, any person who considers himself aggrieved by a ruling of the Administrator may make an appeal to the courts. In addition, should the Administrators find that any provisions of their respective Acts have been violated, they may recommend that a charge be laid against the offending party. This may result in a guilty party suffering a fine or imprisonment or both. With the passing of Bill 198 in December 2002, the maximum penalties for offences under the Ontario Securities Act have been increased from a fine of $1,000,000 and imprisonment for two years to a fine of $5,000,000 and Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 31 imprisonment for a term of not more than five years less a day. Also, Bill 198 gives the OSC the power to order the payment of an administrative penalty of up to $1,000,000 and to order the disgorgement of monies obtained as a result of noncompliance if a person or company fails to comply with Ontario securities law. The amendments prohibit engaging in acts that a person or company knows, or reasonably ought to know, perpetrates a fraud or results in a misleading appearance of trading activity in, or an artificial price for, a security. The amendments also contain a general prohibition on making statements that a person or company ought to know are misleading or untrue and significantly affect, or would reasonably be expected to have a significant effect on, the market price or value of a security. In February 2003, amendments to the Manitoba Securities Act gave the Manitoba Securities Commission the power to order repayment when investors lose money because of the improper or illegal conduct of others, including investment advisers. If an investor chooses to make a claim, the commission can now order repayment of up to $100,000 from an individual who is registered to sell securities as well as that individual's employer. Someone who is not registered but who is acting in the capacity of a trader or adviser on investment products can also be ordered to repay the investor. Following a hearing, if the commission finds that there has been improper or illegal conduct, a commission panel can order penalties, including reprimands, fines, suspensions or cancellation of registration to prevent further securities trading. The order may also include compensation for financial loss. It is interesting to note that in the first quarter of 2003 the British Columbia Securities Commission began providing a feature on its website that provides investors with information about individuals who have faced disciplinary action since 1987. The Disciplined Persons List is an alphabetically organized list of individuals who have been sanctioned for trading bans or monetary penalties by the Commission for securities market misconduct. This initiative is similar to the Public Disclosure Program available on the NASD (National Association of Securities Dealers) website for investors in the United States. Even the most determined public officials and the most exhaustive legislation cannot guarantee that persons who purchase or sell securities will not suffer financial loss. Securities with widely varying risk characteristics may be made available in the public markets. Although it is very difficult to completely restrict the activities of unscrupulous promoters without impeding the efforts of legitimate entrepreneurs, the laws are designed to prevent, as far as possible, blatant fraud and deceit as well as to protect the investor from his or her possible lack of investment sophistication. However, no legislation supplants the need for investors and their advisors to evaluate an investment both before initial purchase and periodically while the investment is held. Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 32 II. Key Players Involved in Securities Regulation Regulation of the securities industry in Canada occurs to a greater or lesser degree at three levels: the federal, provincial and industry levels. The Federal Government No formal federal securities regulatory body exists in Canada, in contrast to the United States, where the Securities and Exchange Commission (SEC) has exerted considerable regulatory authority on a national level since the early 1930s. Canadian federal officials have suggested from time to time that some type of federal securities authority should be established, but at the time of writing, no Canadian federal securities regulatory body has yet been formed. Nonetheless, certain securities activities are influenced by federal legislation. For example, the Canada Business Corporations Act (CBCA) regulates proxy solicitations and insider trading for federally incorporated companies. There is also an indirect federal government interest as banks are federally regulated and banks own many large securities dealers in Canada. However, any securities activity takes place in provincially regulated subsidiaries of the banks is subject to provincial securities regulation. Securities dealers are also subject to the federal Proceeds of Crime (Money Laundering) and Terrorism Financing Act, and the Personal Information Protection and Electronic Documents Act. Integrated Market Enforcement Teams (IMETs) Integrated Market Enforcement Teams (IMETs) were launched in November 2003 as an initiative of the Royal Canadian Mounted Police (RCMP) and the federal government with the goal of strengthening the law enforcement community’s ability to detect, investigate and deter capital markets fraud. To meet this obligation, the RCMP will focus its resources on the investigation and prosecution of the most serious market-related crimes by creating integrated enforcement teams composed of police, lawyers and other investigative experts through branches in Toronto, Vancouver, Montreal and Calgary. The teams are jointly managed by the RCMP and Justice Canada and work closely with securities regulators, such as the IDA, MFDA and RS, as well as other federal and provincial authorities. The Provinces Each province regulates securities activities within its borders. Since 1966, there have been efforts to make legislation in most of the provinces compatible. Ontario was the first to adopt a new Securities Act in 1979. Quebec’s new Securities Act came into force in 1983 and is generally compatible with Ontario’s Act. Alberta, British Columbia, Nova Scotia, Newfoundland and Labrador and Saskatchewan Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 33 have all adopted extensive amendments to their legislation in the area of takeover bids and insider trading in a uniform manner. In Canada, there are three types of securities policies/instruments. (i) National Policies/Instruments – apply in all Canadian jurisdictions. (Note that the primary difference between a National Instrument and a National Policy is that the National Instrument has the force of a binding rule, whereas the National Policy does not. The National Policy may be considered more akin to a guideline as it informs market participants of the manner in which the securities commission may exercise its statutory discretionary authority.) (ii) Uniform Act Policies – apply in Ontario and the four Western Provinces. (The Acts and regulations now incorporate many Uniform Act Policies). (iii) Provincial Policies – reflect local differences in legislation, regulation and procedure, even within this latter group of policies there is substantial agreement between the jurisdictions in many areas. As of February 1, 2004, the Autorité des marchés financiers (Financial Services Authority) (AMF) became the regulatory body that administers the regulatory framework surrounding the following areas of Québec's financial sector: the securities sector, the distribution of financial products and services sector, the financial institutions sector and the compensation sector. The AMF is intended to be a single window for consumer information and complaint processing. Furthermore, it is intended to streamline the regulatory framework governing the financial sector and thus simplify the administrative procedures of individuals and businesses practicing in the sector. The AMF oversees or administers: the securities sector which covers the operations related to supervising the Québec securities market to ensure that it operates properly, to provide investor protection, and to regulate the information that companies make public. Prior to the establishment of the AMF, the former Quebec Securities Commission provided the regulatory framework for this sector. the distribution of financial products and services in all operations related to authorization of the right to practice in the eight following sector classes: insurance of persons, group insurance of persons, damage insurance, claims adjustment, financial planning, group savings brokerage (mutual funds), investment contract brokerage, and scholarship plan brokerage. financial institutions, other than banks, that conduct their activities in Québec. This refers primarily to regulation of insurance companies, financial service cooperatives, trust companies, and savings companies. the "financial services compensation fund", which compensates victims of fraud, fraudulent tactics, or embezzlement that occur during the distribution of financial products and services. This protects consumers of financial products and users of financial services when they do business with the authorized Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 34 persons and groups subject to certain provisions respecting the distribution of financial products and services in the eight sector classes listed above. This also includes protecting depositors, under certain conditions, to a limit of $60,000 per person per registered institution in the case of an insolvent financial institution. Exhibit 2 lists the governing securities legislation and administrative organizations in each of the provinces. Despite the fact that there is no federal regulatory body in Canada responsible for securities regulation, the securities regulators from 10 provinces and 3 territories have formed a joint panel, referred to as the Canadian Securities Administrators (CSA), to coordinate and harmonize regulation of the Canadian capital markets. The CSA operates as an informal body through regular meetings of the commissions’ Chairs on issues of shared concerns or matters that are to be pursued jointly. By collaborating on rules, regulations and other initiatives on a national level, the CSA helps avoid duplication of efforts and streamlines the regulatory process for companies seeking to raise capital and others working in the securities industry. The CSA is also responsible for maintaining the public electronic databases SEDAR (the System for Electronic Document Analysis and Retrieval) and SEDI (the System for Electronic Disclosure by Insiders) on the Internet. SEDAR is a centralized database where public records of all publicly traded companies in Canada are pooled together, while SEDI is a database containing reports on securities holdings and trading for insiders of Canadian public companies. In 1971 the CSA commenced issuing National Policy (NP) statements. It is now reformulating many of these policies as National Instruments (NIs), which are enforceable rules once the provinces have incorporated them into their legislation. Once the CSA has formulated a National Policy or Instrument, it is reviewed by the provinces and amended if necessary. Once approved by an Administrator, the NP/NI is then formally incorporated into its legislation. As the 1980s ushered in an era of international securities markets, the need for cooperation among international securities regulators became obvious. In 1988, for example, the SEC and the Administrators in Ontario, Quebec and British Columbia entered into a formal Memorandum of Understanding (MOU) to cooperate in the enforcement of their respective securities regulations by providing each other with the fullest mutual assistance possible. A number of other MOUs have since been entered into between Administrators and the securities regulatory authorities of other jurisdictions, including Mexico, Australia, Italy, France, and Hong Kong. In March 2003, the Ontario Securities Commission along with the British Columbia, Quebec and Alberta Securities Commissions entered into a MOU with the China Securities Regulatory Commission to promote the integrity of the securities markets by establishing a framework for cooperation for the purpose of increasing mutual understanding and for the exchange of regulatory and technical information. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 35 These MOUs are statements of intent that, while not legally binding, facilitate the exchange of information and foster regulatory cooperation in the global capital markets. Exhibit 2 III. Self-Regulatory Organizations (SROs) Self-Regulatory Organizations (SROs) are industry organizations that have the privilege of regulating their own members, whether as officially recognized “SROs” or under the “stock exchange” portions of their provincial Acts. SROs are responsible for enforcement of their members’ conformity with securities legislation and have the power to prescribe their own rules of conduct and financial requirements for their members. Since December 2000, the OSC has made it mandatory for all securities dealers and mutual fund dealers to become members of the Investment Dealers Association of Canada (IDA) or the Mutual Fund Dealers Association of Canada (MFDA). Self-regulation is a privilege, not a right. SROs are delegated regulatory functions by the Administrators, and SRO by-laws policies and rules are designed to uphold the principles of securities legislation. The commissions monitor the conduct of the SROs and review the rules of the SROs in the province to ensure that the SRO rules do not conflict with securities legislation and are in the public’s best interest. SRO regulation can be divided between member regulation and market regulation. The IDA and MFDA deal with member regulation while RS and the exchanges are the SROs that deal with market regulation. The four main areas of member regulation are: Financial Compliance: Firms are required to maintain a minimum amount of capital if they want to conduct business in Canada. Financial compliance includes controlling the minimum capital and financial requirements of members and monitoring this through regular examinations. Sales Compliance: Sales compliance revolves around maintaining high industry standards of broker and member business conduct. Registration: Responsibility for overseeing professional standards and educational programs designed to maintain the competence of industry employees. All investment advisors employed by member firms are initially screened and have successfully completed the required educational courses. Enforcement: This department investigates complaints received against a member firm or a registered employee. The IDA has the authority to prosecute individuals and firms suspected of wrongdoing and to impose penalties in the form of reprimands, fines, suspensions, and expulsion from the industry. Market regulation, on the other hand, focuses on three main areas – market surveillance, investigation & enforcement, and regulatory/market policy. Market regulation responsibilities in Canada are handled by the exchanges and RS and involves:. Market Surveillance: Market surveillance involves the review of real time trading, historical trading and press releases, as well as brokers’ sales practices. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 37 Investigation & Enforcement: These activities usually begin after a complaint has been filed or when market surveillance finds that the rules have been broken. If an infraction has been committed, prosecution proceedings may begin. Regulatory/Market Policy: As the name implies, the SROs are also responsible for developing rules and policies that promote more efficient markets. SRO rules must set a standard equal to or higher than those imposed by the provinces and they address: The issuing and trading of securities listed on exchanges, including: (i) the quality of disclosure required of companies who wish to list their securities on an exchange; (ii) the type of continuing disclosure required of companies which are traded on an exchange; and (iii) promoting of securities and investor relations. The affairs of member firms, include: (i) selecting those member firms which are permitted to use the trading facilities of an exchange and therefore act as intermediaries between the exchange trading function and the public; (ii) prescribing rules for the conduct of persons at the member firms who deal with the public; and (iii) establishing rules for financial conduct and the maintenance of adequate capital in member firms’ business. Among other things the financial rules of the SROs prescribe: the frequency and format for financial reports which are submitted to the SROs; the method of calculation of regulatory capital which is a measure of the financial capacity of the member; the requirement to have an audit and some specific procedures to be carried out by member firm auditors; proper books, records and procedures to be put in place to safeguard clients’ assets; the necessity to have fully paid client securities held in trust for the client. These securities are to be segregated and not to be used by the member broker; and the requirement to maintain sufficient insurance coverage against potential losses, and that insurable losses are identified and claimed on a timely basis. Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 38 The Canadian SROs (i) The Investment Dealers Association of Canada (ii) The Exchanges (iii) Market Regulation Services Inc. (iv) The Mutual Fund Dealers Association of Canada The Investment Dealers Association (IDA) The Investment Dealers Association of Canada (IDA) is the national self-regulatory organization of the Canadian securities industry. The IDA is an organization comprised of member firms governed by its Constitution, by-laws, regulations and policies. Effective December 1, 2000, all securities dealers and brokers must be members of the IDA (for details refer to the OSC Rule 31-507 SRO Membership- Securities Dealers and Brokers). As of July 2005, 201 firms were registered as members of the IDA and they employed 37,512 people. The IDA is empowered by its by-laws to conduct examinations and investigations in response to complaints and other relevant information received, and to initiate disciplinary action against any individual registrant or member firm where appropriate. Typically, investigations are initiated either as the result of complaints because of questionable situations identified in the course of compliance examinations, or because of information received from a member in a Notice of Termination. Once an investigation is opened, a staff investigator will gather documents, interview witnesses and perform any analysis required to determine whether there has been a violation of IDA rules. Members and individuals subject to investigation may be required to submit a report in writing with regard to the matter under investigation; produce for inspection and provide copies of books, records and accounts; and attend and give information respecting the matter under investigation. IDA disciplinary proceedings are brought before the applicable IDA District Council in the particular case. There are ten District Councils in all, representing different provinces or regions of the country. The Councils are normally made up of officers, directors or branch managers of member firms. Disciplinary hearings are normally conducted before a panel of two industry members and one “public member.” A member of the public, who is legally trained, resident in the District and not associated with any member, chairs the disciplinary hearing. Each District Council may appoint a roster of qualified public members and may add to or delete from the roster as required. The disciplinary powers of the District Councils are set out in the IDA By-laws, and include the power to impose any one or more of the following penalties where Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 39 a registrant or member is found to have violated IDA rules or to have engaged in unbecoming conduct: a reprimand. a fine of up to the greater of $1,000,000 per offence or three times (four times in Quebec) the gain accrued from the commission of the violation. suspension of registration approval or membership. prohibition against approval for any period of time. revocation of approval or termination or expulsion from membership. conditions of approval or continued approval. In addition, costs of the investigation are usually assessed against any respondent found guilty of a violation. Commonly imposed conditions of approval or continued approval include the requirement to rewrite industry examinations and the requirement to disgorge commissions. It should be noted that registrants are still subject to IDA disciplinary actions for up to five years after leaving the industry, but the IDA on its own cannot force individuals who no longer work in the industry to pay fines. However, unlike in the other provincial securities Acts, the Alberta Securities Act permits approved self-regulatory organizations (such as the IDA) to file disciplinary decisions with the Alberta Court of Queen’s Bench to seek a civil execution order to ensure that fines, disgorgements and costs are collected. Registrants who choose to act in ways that threaten the integrity of the capital markets must have the expectation that they will be held accountable through enforcement action by the regulators. Sanctions should be based on the circumstances of the particular misconduct with an aim at general deterrence, therefore, on January 29, 2003, the IDA released “Disciplinary Sanction Guidelines” that recommend penalties to an IDA disciplinary panel for various offences. The guidelines may also be taken into account when determining the appropriate sanction to be imposed as part of a Settlement Agreement or at the end of a disciplinary proceeding. Since sanctions should be tailored to address the misconduct involved in a particular case, a penalty must be proportionate to the gravity of the misconduct and the relative degree of responsibility of a respondent. To properly assess the gravity of specific misconduct, a number of factors should be looked at, including: harm to clients, employer and/or the securities market; blameworthiness (distinctions should be drawn between conduct that was unintentional or negligent, and conduct that involves manipulative, fraudulent or deceptive conduct); the degree of participation (this is what is meant by “degree of responsibility”); Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 40 the extent to which the respondent was enriched by the misconduct (whether it is appropriate to require that any profits, commissions, fees, or any other compensation earned be disgorged); prior disciplinary record; acceptance of responsibilities, acknowledgement of misconduct and remorse; credit for cooperation during the investigation; voluntary rehabilitative efforts (showing both recognition of the misconduct and a commitment to remedy it); reliance on the expertise of others; planning and organization (if there is evidence of planning and pre-meditation); vulnerability of the victim; and the significance of the economic loss to the client or firm. In 2004, the IDA received approximately 1,200 complaints compared with 1,500 complaints received in 2003. The four most frequent complaints were unauthorized and discretionary trading (311), service issues (211), suitability issues (203) and misrepresentations (114). The Exchanges (Marketplaces) Presently, the exchange SROs in Canada are the Toronto Stock Exchange (TSX – formerly known as the TSE), the Montreal Exchange (ME), the TSX Venture Exchange (TSX V – formerly CDNX) and the Winnipeg Commodity Exchange (WCE). (Note: in Quebec, the Montreal Exchange is called Bourse de Montréal.) Since the split of regulatory responsibilities into member and market regulation, the IDA has the power to govern and regulate the business conduct of its members and their employees and to impose tough penalties for breaching any of the SRO requirements. The IDA also conducts financial and sales compliance examinations of its member firms to ensure compliance. The TSX and TSX V have retained Market Regulation Services Inc. (RS) as their regulatory services provider. RS’s mandate is to monitor trading activities and initiate investigations of potential breaches of Universal Market Integrity Rules (UMIR) or exchange rules, as well as take disciplinary proceedings against those responsible for the infractions. Note that UMIR is a standard set of market integrity rules that generally apply to equity trading on all Canadian marketplaces in order to promote fair and orderly markets. The exchanges have retained some market regulation responsibilities, which pertain mostly to rules that are specific to their individual business niches. Bourse de Montréal is unique among the SROs in that its by-laws grant it the power to order the restitution of funds to any person who has suffered a loss as a result of the misconduct of a person under its jurisdiction. Additionally, costs of the Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 41 investigation are typically assessed against respondents who have been found guilty of a violation. The SRO system changed dramatically in November 1999 as the TSX, the Alberta Stock Exchange (ASE), the Vancouver Stock Exchange (VSE), the ME and the Canadian Dealing Network (CDN) reached a restructuring agreement, which basically resulted in the creation of three distinct, streamlined exchanges: The fully automated TSX took over all trading of senior Canadian equities including all senior equities that previously traded on the ME. The ASE and the VSE consolidated to form the Canadian Venture Exchange (CDNX), which trades all junior equities. CDN and the Winnipeg Stock Exchange (WSE) joined CDNX in October 2000 and November 2000, respectively. Bourse de Montréal exclusively deals in all “non-agricultural” options and futures in Canada, including all options that previously traded on the TSX and all futures products that previously traded on the Toronto Futures Exchange (TFE). The WCE continues to deal in agricultural derivatives. Also under the agreement, Bourse maintained a market, as well as provided listing and regulatory services, to approximately 117 junior companies in Quebec. Beginning in October of 2001, the ME ceased to provide listings of these 117 companies and were invited to list on the TSX V. Effective February 1, 1997, the TSX transferred its member regulation responsibilities to the IDA so it could concentrate on market regulation. In 1998, the WCE also transferred its member regulation responsibilities to the IDA, as did TSX V on January 1, 2000. In addition, as of January 1, 2005, the ME transferred all of its member regulation functions to the IDA. The TSX, WCE, TSX V Exchange, the ME and RS remain responsible for market regulation, which involves monitoring and regulating members’ trading activities on the exchanges. On July 31, 2001 the TSX received approvals from the Alberta, British Columbia and Ontario securities commissions allowing it to acquire TSX V (then called CDNX). The benefits expected from the transaction ranged from cost efficiencies realized through combining certain services to a more streamlined approach to graduate listed companies from TSX V to the senior TSX market. The acquisition was intended to enhance the attractiveness of the TSX and TSX V as the exchanges for issuers seeking new listings. The two exchanges remained distinct with the senior market being operated by the TSX and the public venture market continuing to be operated by TSX Venture Exchange. In April 2002, the Toronto Stock Exchange announced that, as a result of “rebranding”, its abbreviated form has changed from the TSE to TSX and that CDNX has been renamed the TSX Venture Exchange (TSX V). The CDNX logo was also replaced with the new “TSX” logo that is shared with the TSX. These changes were part of a re-branding initiative as the TSX and its subsidiaries prepare Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 42 to go public. Under the re-branding program, the TSX, TSX V and TSX Markets Inc. (the arm of the TSX that sells market information and trading services) are collectively known as the TSX group of companies. On August 18, 2003, the NEX board became available for companies that had fallen below the TSX V’s ongoing listing standards. Before NEX was created, companies that fell below these standards were designated "inactive" and given 18 months to meet the standards or be delisted. Only companies that were formerly listed on the Toronto Stock Exchange or TSX Venture Exchange and that failed to meet TSX V ongoing listing standards are eligible to list on NEX. This includes Capital Pool Companies that have failed to complete a Qualifying Transaction in accordance with TSX V’s requirements. Companies that have not been listed on TSX or TSX V and companies that have been delisted from TSX and/or TSX V are not eligible for listing on NEX. A company listed on NEX may continue to have its securities listed for an indefinite period of time provided that it meets NEX listing requirements. In the event that a listed company does not comply with NEX Policies, fails to comply with applicable securities laws, completes a Reverse Takeover ("RTO"), conducts transactions or activities such that it meets applicable TSX V listing standards, or if NEX determines that it is in its best interest, NEX may delist the company. NEX companies are subject to the same disclosure standards as all Canadian public companies and must maintain good standing with all relevant Canadian securities commissions. In addition, surveillance standards of NEX companies remain unchanged and they will continue to be overseen by RS. In 2003, the Canadian Trading and Quotation System Inc. (CNQ) opened as a quotation and trade reporting system and in 2004 it gained recognition as an exchange by the Ontario Securities Commission. In July 2005, the British Columbia Securities Commission granted CNQ an exemption order allowing it to carry on business as a stock exchange in B.C. without having to apply and be recognized by the provincial regulator. The intent of CNQ is to provide an alternative market to the TSX V for emerging companies. CNQ focuses on micro and small-cap issues (it will not accept shell company listings), has a flat fee structure and a unique disclosure model.. Listed companies can directly post information for investors about its operations and public material transactions on CNQ’s website (www.cnq.ca) without having to wait for exchange permission. CNQ is based on a combination of auction and dealer markets and liquidity is enhanced on a security by security basis via market makers. Dealers accessing this marketplace are required to be members of the IDA and must comply with CNQ’s trading and sales practice rules as well as RS’s Universal Market Integrity Rules. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 43 RS also provides market surveillance and regulatory oversight as it does for the TSX and TSX V exchanges. Market Regulation Services Inc. (RS) The CSA’s on-going initiative to create a harmonized framework for the competitive operation of all Canadian marketplaces resulted in a creation of two National Instruments: NI 21-101 Marketplace Operation and NI 23-101 Trading Rules. These instruments require an independent “regulation services provider” to regulate trading in all Canadian marketplaces. Because of the conflicts of interest in having the TSX act as the regulation services provider with authority over its competitors, Market Regulation Services Inc. (RS), a new regulation services provider, was created. RS is an independent, not for profit organization that is jointly owned by the TSX and the IDA and whose mandate is to monitor, administer and police trading on all Canadian markets. In February 2002, RS was recognized as an SRO in the provinces of Alberta, British Columbia, Ontario and Quebec, and on March 1, 2002, it officially started providing independent regulation services to Canadian marketplaces including traditional exchanges, quotation and trade reporting systems (QTRSs), and alternative trading systems (ATSs). If retained, RS administers, monitors and enforces the Universal Market Integrity Rules (UMIR) that were approved as the standard set of trading rules on April 1, 2002. To ensure compliance with UMIR, RS is authorized to monitor real-time trading operations and market-related activities, to investigate alleged rule violations, and to administer any settlements and hearings that may arise in respect of such violations. RS’s Investigations and Enforcement Division investigates: manipulative or deceptive trading; illegal insider trading, defined as unreported trading done by insiders of a listed company who trade while in possession of material and non-public information that could reasonably be expected to have a significant affect the market price or value of a security; the failure of a registrant to ensure that the best possible market price was obtained for a client; the failure of a registrant to give a client order priority over all other similar principal and non-client orders existing at the same time; a registrant trading ahead of a known client order (frontrunning) in an attempt to take advantage of the market impact such a pending trade might have; all technical rules violations such as restrictions on short sales and order marking; pre-marketing activities by an issuer and/or its representatives/underwriters before a distribution of stock; Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 44 background checks with respect to directors and officers of companies which have applied for listing. Whenever a registrant, or another officer, director or employee of the registrant contravenes any UMIR or exchange requirement, RS may issue or impose one or more of the following penalties or remedies: a reprimand; a fine not to exceed the greater of: i. $1,000,000; and ii. an amount equal to triple the financial benefit that resulted from the contravention; the restriction or suspension of access to a marketplace for a period of time that RS finds warranted by the circumstances; the revocation of access to a marketplace; and any other remedy deemed as appropriate under the circumstances. There are factors involved in every infraction that need to be assessed when determining a penalty. RS has set out a formal process governing penalties imposed upon persons who have violated UMIR and exchange requirements. The guidelines take into account the seriousness of the violation, whether or not the violation was intentional or inadvertent, and whether the violation was isolated or one of a series of similar violations which may indicate a lack of care or a lack of regard for the rules. Effective March 11, 2005, the Alberta Securities Commission, British Columbia Securities Commission, Manitoba Securities Commission, Ontario Securities Commission and, in Quebec, the Autorité des marchés financiers (the “Recognizing Regulators”) approved amendments to the Universal Market Integrity Rules (“UMIR”) to: specifically provide that it is an offence to impede or obstruct a Market Regulator in an investigation, proceeding or the exercise of a power; provide that a person who is subject to the jurisdiction of UMIR (“Regulated Person”) shall respond to a request by a Market Regulator forthwith or not later than the date permitted by the Market Regulator as specified in its written request; and adopt a definition of “document” and clarify that records which must be provided by a Regulated Person during an investigation are not limited to “records” as contemplated by the audit trail and retention requirements. As mentioned above, RS may be retained as a regulation services provider not only by the traditional exchanges, but also by ATSs and QTRSs. Alternative trading systems (ATSs) compete with recognized exchanges by providing trade matching and execution services. Although ATSs may register as either exchanges or Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 45 dealers, they cannot engage in certain exchange-typical activities, such as providing listing services to issuers. Quotation and trade reporting systems (QTRSs) may also register as exchanges or dealers that operate facilities authorized to disseminate price quotations and report completed transactions to the applicable securities commissions, thus assuming the role formerly carried out by the Canadian Dealing Network (CDN) for over-the-counter (OTC) stocks. The Mutual Fund Dealers Association (MFDA) The mutual fund industry is currently managing over $400 billion in assets for Canadian investors who are now more invested in mutual funds than in savings accounts and GICs. As of August 2005, the Mutual Fund Dealers Association of Canada (MFDA) had 181 members, which employed approximately 70,000 registrants. Consequently, the provincial securities commissions had taken steps to ensure that an SRO is created for these people. As a result of these recommendations, the MFDA was created in November of 1997. On February 6, 2001, the Ontario Securities Commission recognized the MFDA as an SRO, as did the British Columbia Securities Commission on February 9, 2001, the Saskatchewan Securities Commission on February 13, 2001, and the Alberta Securities Commission on April 10, 2001. The MFDA is the mutual fund industry’s SRO responsible for regulating all sales of mutual funds by its members in Canada. The MFDA does not regulate the mutual funds themselves, as this responsibility has remained with the securities commissions. Effective April 23, 2001, all mutual fund dealers must be members of the MFDA (for details refer to the OSC Rule 31-506 SRO Membership – Mutual Fund Dealers). In Québec, the mutual find industry is regulated by the Autorité des marchés financiers (AMF). An agreement has been signed between the AMF and the MFDA to avoid regulatory duplication for mutual fund firms operating both in Québec and elsewhere in Canada. The Chambre de la sécurité financière (CHAMBRE) is Québec’s self-regulatory organization of the mutual fund and insurance industry. The CHAMBRE is responsible for setting and monitoring continuing education requirements and for enforcing a code of ethics of the licensed representatives. IV. Jurisdiction of the Provinces and SROs The IDA, the exchanges and Market Regulation Services (the SROs) have extensive powers to investigate possible violations of their by-laws, regulations, rules and policies and to take disciplinary action in the event of alleged violations by member firms and their employees. As mentioned above, provincial securities commissions also have extensive enforcement powers. The SROs and/or the securities commissions may discipline IAs, depending on the circumstances. Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 46 Sanctions for less serious offences may include fines, strict supervision and rewriting qualifying exams. Serious offences may result in loss of registration and substantial fines. V. Dealing with Money Laundering and Terrorist Financing in the Securities Industry Money laundering is a process in which the proceeds of crime are converted into legitimate funds using complex transactions, usually through financial institutions. By obscuring the origin of the money, criminals can use the funds without raising any suspicion about its legitimacy. When a criminal activity generates substantial profits, the individual or the group involved must find a way to control the funds without attracting attention to the underlying activity or to the persons involved. This is done by disguising the sources, changing the form, or moving the funds to a place where they are less likely to attract attention. The International Monetary Fund (IMF) has stated that the aggregate size of money laundering in the world could be somewhere between two and five percent of the world’s GDP. Based on 2002 statistics, this would equate to a range between US$980 billion and US$2.45 trillion. To put this into perspective, the lower figure is roughly equivalent to the total GDP of the combined economies of Canada and Sweden in the year 2002. Securities dealers are in an ideal position to assist in curbing criminal and terrorist activities. Identifying clients and transactions that raise red flags or fail the “smell test” and reporting this information to the appropriate authorities can limit access to what has traditionally been a major piece in the money laundering puzzle. The Three Stages of Money Laundering There are three basic stages of money laundering – placement, layering and integration, which can also be thought of as the “wash cycle”, the “spin cycle” and the “dry cycle”. Placement involves the physical disposal or deposit of cash proceeds derived from an illegal activity within the legitimate financial system. There are several methods of placing the proceeds of crime into the financial system, including: structured deposits, also called “smurfing”, involves breaking up large amounts of cash into smaller, less conspicuous sums that are subsequently deposited directly into bank accounts, always in amounts lower than cash deposit reporting levels; mingling criminal proceeds with deposits from legitimate cash businesses such as stores and restaurants; Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 47 bribery of bank or other financial institution personnel to accept deposits without reporting them; smuggling of cash to countries lacking anti-money laundering requirements for deposit in their financial institutions; and purchasing a series of monetary instruments (e.g., certified cheques, money orders) that are then collected and deposited into accounts at another location. The investment business is generally not cash-based, so it is at less risk from the initial placement of criminally derived funds than mainstream banking operations. Most payments to brokerage accounts are made by way of cheques or transfers from other financial institutions, so the first stage of money laundering has already been successfully achieved by the time the funds reach the firm. However, the bribery or persuasion of dealer personnel to accept cash deposits beyond firm limits is always possible. Layering involves separating illicit proceeds from their source by creating complex layers of financial transactions designed to obscure an audit trail and the original source and thereby providing anonymity. This frequently involves moving funds across borders to make tracing the source more difficult for law enforcement. The securities industry is more at risk in this stage as funds can easily change form into entirely different assets and launderers can engage in a series of conversions and movements of the funds to distance them from their source. The origin of the funds may be concealed by executing numerous buy and sell transactions of various investment instruments or the launderer may simply wire the funds through a series of accounts at various banks across the globe. Securities transactions are very attractive because funds are easily converted into highly liquid assets and investment portfolios containing both lawful and illicit proceeds that can be quickly sold. Certificated securities can also be moved easily across borders. Integration involves the provision of apparent legitimacy to criminally derived wealth. If the layering process has succeeded, integration schemes place the laundered proceeds back into the economy in such a way that they re-enter the financial system with the appearance of normal business funds. Frequent techniques include the use of corporate entities controlled by the launderers to make loans to themselves – the repayment of which is, of course, unnecessary – or to purchase high value items by such as businesses or real estate that can be used by the launderers without charge, either for personal use or to generate additional, seemingly legitimate income. Money Laundering Mechanisms Involving the Securities Industry When viewed on a global scale, the securities industry can be characterized by its diversity, the ease with which trading can take place and the ability to perform transactions in markets with little regard to national borders. Besides making securities markets attractive to ordinary investors, these same characteristics also Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 48 make the industry a potentially inviting mechanism for the laundering of funds from criminal sources. Proceeds of crime laundered through the capital markets can be generated by illegal activities both from outside and from within the securities industry. For illegal funds generated outside of the industry, securities transactions are used for concealing the source of these funds and obscuring an audit trail. For illegal activities carried out within the securities markets (e.g., insider trading and securities fraud), securities transactions or manipulation generates illegal funds that must be laundered. In both cases, the industry offers launderers the potential for a double advantage by allowing illegal funds to be laundered and by making an additional profit from the related investments. Illicit funds are often laundered through the purchase and sale of liquid securities. The audit trail of the proceeds of crime can be blurred through several buy and sell transactions involving numerous entities, accounts and types of securities. Securities can also be purchased in another name, such as that of a shell company (a business without substance or commercial purpose and incorporated to conceal the true beneficial ownership of business accounts and assets owned) located in tax or bank secrecy havens where local laws protect the anonymity of the owners and local professionals such as lawyers, accountants or “company formation agents” are in the business of setting up and operating such companies. Some money launderers open accounts at two different brokerage firms and enter offsetting transactions with each broker. For example, at one firm the person would take long positions in Eurodollar futures contracts while being short the exact same contracts at another firm. The two transactions would basically offset each other, as the one side of the trade would report a capital gain while the other side reports a loss. The cost of doing this would primarily be the two commissions, but the proceeds of the profitable side have the appearance of legitimacy, while the losses on the other side are concealed. Another money laundering method utilizing the securities industry involves establishing a publicly traded company to serve as a front for a money laundering operation. In this case, a criminal organization creates a company for an apparently legitimate commercial purpose and then commingles illegal funds with funds generated by the legal commercial activity. This usually requires the use of fraudulent accounting practices. There is also an advantage of using a publicly traded company for such a scheme because the owners could profit twice from the mechanism - by creating a successful means of laundering criminal funds and in selling shares in the business to unwitting investors. Another variation of this scheme would be to invest in a private company first, and then “go public” with a share purchase offer on the equities market. The earnings from the sale of shares creates the illusion that the funds are legitimate earnings on securities investments. The entire arena of online brokerage accounts is raising some major concerns for law enforcement agencies. How can regulators stop money launderers who trade Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 49 securities through shell companies that may actually be nothing more than a brass plate on an office door in an offshore secrecy haven? These investment accounts also offer an unprecedented level of anonymity because there is no requirement for a “face-to-face” meeting between the beneficial owner of the account and the entity executing the transactions. Is it going to be possible to prevent the flow of the proceeds of crime from further infecting our financial markets through these unregulated accounts? Terrorism and Terrorist Financing The primary objective of terrorism is “to intimidate a population, or to compel a government or an international organization to do or abstain from doing any act”. In contrast, the motivating factor behind most other types of criminal activity is financial gain. While this difference certainly exists between these groups, terrorist organizations still require financial support to achieve their goals. A successful terrorist group, like a criminal organization, is one that is able to build and maintain an effective financial infrastructure through various sources of funding. As of July 2005, over 1,600 individuals, entities and organizations have been designated as supporters of terrorism. This includes over 800 individuals ranging from organizational leaders such as Osama bin Laden and his key operatives as well as over 800 terrorist organizations, companies, charitable organizations, or entities who support and/or finance terrorism. Over 165 countries and jurisdictions have issued blocking orders against the assets of terrorists and US$112 million in terrorist assets have been frozen worldwide in over 500 accounts. For terrorist funds that are derived from legitimate sources, such as charities, there are very few indicators that would make individual, or multiple, financial transactions stand out as being linked to terrorists. Terrorist financing is also more difficult to detect because the size and nature of the transactions needed to mount a terrorist attack do not always require large sums of money and the associated transactions are usually not complex. In fact, it is almost like trying to “find a needle in a haystack”. Anti-Money Laundering and Anti-Terrorist Financing Regulations The original Proceeds of Crime (Money Laundering) Act, passed in 1991, stipulated that financial institutions must retain a number of records including a signature card for each account holder, a deposit slip for every deposit made to an account and a record or copy of every cleared cheque. In addition, every cash deposit, or series of deposits over a 24-hour period that involved an amount of $10,000 or more for the same beneficial owner had to be documented via a Declaration of Funds form to be retained by the financial institution receiving the deposit. Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 50 As a result of this requirement, money launderers employ armies of “smurfs” to make deposits in lesser amounts. Splitting up large amounts of money into smaller amounts to conceal a trail and escape laws governing notification of transactions involving $10,000 or more in cash is also known as “structuring” deposits. The funds are then transferred by cheque or wire transfer to central collection accounts. These regulations also made it mandatory to verify, within six months of opening a brokerage account, the identity of account holders via physical verification, cheque verification or a bank reference check. With limited exceptions, firms were required to verify the identity of all persons authorized to give instructions on an account, including giving instructions for accounts of corporations and other entities (i.e., accounts with third party authority). According to the Guide to Record Retention Requirements for IDA Members, these records are to be retained for seven years, which is in excess of the federal regulations requiring records to be retained for five years. Anyone contravening or failing to comply is guilty of an offence and liable for fines of up to $500,000 or imprisonment for a term not exceeding five years, or to both. Firms will generally accept the following identification: passport, driver’s license, citizenship card, birth certificate (for applicants under the age of 21), a personal cheque drawn and cleared from a Canadian financial institution (requires banking information) and verification from a Canadian deposit-taking institution that the applicant has an account in his or her name (requires banking information). Photocopies or notarized copies are not acceptable, which generally means that the client and IA must meet face-to-face. It should be noted that it is necessary to record the number of a financial entity account in the name of the person who is authorized to give instructions for the account where that person's identity is verified by confirming that a cheque drawn by that person on an account has been cleared, or by confirming that the person holds an account in that name with a financial entity. It is not necessary to record an account number where the person's identity is verified by reference to an acceptable identity document. The Proceeds of Crime (Money Laundering) and Terrorist Financing Act requires securities dealers to maintain a signature card, account operating agreement or account application containing the number of an account at a financial entity (such as a bank account) in the name of anyone having authority over the account. However, this provision is intended to apply only when the person’s identity is verified by confirming that the person has an account in his or her name at a financial entity, either through clearing a cheque drawn on the account or by other means. When an account is opened in person and the accountholder’s identity is verified by an acceptable government-issued document, such as a passport or driver’s license, the dealer is not required under the Regulations to obtain financial entity account information. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 51 Significant amendments to the Proceeds of Crime (Money Laundering) Act in 2001 added mandatory suspicious transaction reporting requirements on a wide range of financial institutions and other businesses that may be deemed vulnerable to money laundering activities. They also changed the requirements regarding cash deposits in excess of $10,000 from a record keeping to a reporting requirement. The 2001 amendments also created the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) to collect, analyze, assess and disclose information to assist in the detection, prevention, and deterrence of money laundering and terrorist financing. It is authorized to provide key identifying information on suspicious transactions to law enforcement agencies if there are reasonable grounds to suspect that the information would be relevant to investigating or prosecuting a money laundering offence. This information could also be provided to the Canada Revenue Agency (CRA), the Canadian Security Intelligence Service (CSIS) and Immigration Canada if there was reason to suspect tax evasion or a threat to national security. The Centre also has the primary responsibility of monitoring the compliance of financial intermediaries with record keeping, Know Your Client and mandatory suspicious transaction reporting requirements. Once it has been determined that there are reasonable grounds to suspect that a transaction is related to the commission of a money laundering offence, a suspicious transaction report must be sent to FINTRAC within 30 days. If done in good faith, member firms and their employees that are required to report suspicious transactions to FINTRAC are protected from criminal and civil legal proceedings for doing so. There is no monetary threshold for making a report on a suspicious transaction and an employee cannot be convicted of failing to report if a suspicious transaction is reported to his or her superior or supervisor. In 2004, FINTRAC made 142 case disclosures to law enforcement or the Canadian Security Intelligence Service (CSIS) covering transactions with a total dollar value of just over $2 billion, close to triple the total in 2003. In addition, the total value of case disclosures of suspected terrorist activity financing and other threats to the security of Canada was approximately $180 million, a two and a half fold increase over 2003. Of these 142 case disclosures: 110 were for suspected money laundering, 24 were for suspected terrorist activity financing and/or threats to the security of Canada, and 8 involved both suspected money laundering and terrorist activity financing and/or threats to the security of Canada. IAs are not allowed to inform (or tip) anyone, including the client, about the contents of a suspicious transaction report or even that a report has been made Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 52 because such notification could harm or impair a criminal investigation. Failure to comply with the reporting requirements can lead to criminal charges against a member firm and/or an individual employee. Depending on the facts surrounding a “tip”, an IA could be liable to a Criminal Code prosecution for a myriad of potential offences, including counselling an offence, accessory after the fact, breach of trust by a public officer, obstructing a peace officer, obstructing justice and public mischief. “Wilful blindness” (a situation that arises when people are aware that a situation should be investigated but fail to follow through usually because they do not want to jeopardize a business deal or business relationship) that leads to the failure to report a suspicious transaction is punishable by a fine of up to $2 million and/or imprisonment for up to five years. Furthermore, the line between wilful blindness and knowing involvement in money laundering, which carries higher penalties (could be punishable by up to ten years in prison), may not be easy to define, putting anyone ignoring signs of money laundering or terrorist financing activity at higher risk. If a transaction is not completed, there is no requirement for it to be reported. However, the indicators detected during an aborted transaction should be considered in subsequent dealings with the client if additional suspicious activity occurs. There is no requirement to close a client’s account when a suspicious transaction has been reported or is about to be reported - this is entirely up to the firm’s business practices. On January 6, 2003, Cross-Border Currency and Monetary Instruments Reporting Regulations came into effect. These regulations require all persons and entities to report the importing and exporting of currency and monetary instruments of $10,000 or more, or the equivalent in a foreign currency to the CRA. There are however no restrictions on the amount of currency or monetary instruments that may be imported into or exported from Canada, simply that they must be reported. It includes any movement across the border, including by mail, courier or other conveyance, unless the currency or monetary instruments are being transported without leaving controlled areas. IDA Member Regulation 188A clarifies the definition of monetary instruments to include those that are in bearer form only, or another form if title to them passes on at delivery. These include stocks, bonds, debentures and treasury bills, negotiable instruments such as bank drafts, cheques, promissory notes, traveler’s cheques and money orders. Instruments specified as belonging to a named individual or entity, such as cheques made out to a specific person or company and not endorsed and fully registered securities that have not been signed off are not required to be reported. These regulations give customs officers with the Canada Border Services Agency (CBSA) the authority to seize unreported cash or monetary instruments above the threshold at border crossings. Written currency reports must be signed and given to a customs officer. The failure to report currency and monetary instruments may result in their seizure. While the owners of seized cash and monetary instruments Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 53 can recover them if it is found that the seized assets are not linked to money laundering or terrorist financing, they may be subject to the assessment of a penalty ranging from $250 to $5,000 depending on circumstances such as whether this is a first time event and whether there is any effort to conceal the assets. The Act also sets out a maximum fine of $500,000 and a maximum jail term of five years for failing to co-operate with CBSA when a submitting a report. To combat terrorism and terrorist financing activities, Canada implemented the Anti-Terrorism Act, on December 24, 2001. The Act contains legislative measures aimed at identifying, deterring, prosecuting and punishing terrorist groups as well as providing new investigative tools for law enforcement agencies. Due to its comprehensive nature, the Anti-Terrorism Act also amended a number of other federal acts including the Criminal Code, the Official Secrets Act (which is now the Security of Information Act), the Canada Evidence Act, the Income Tax Act and the Charities Registration (Security Information) Act. It also amended several sections of the existing anti-money laundering legislation to include terrorist financing in its objectives. To assist in the detection of terrorist activities, the Office of the Superintendent of Financial Institutions (OSFI) publishes a list of individuals and organizations that are suspected of engaging in terrorist activities. Regulations require that Canadian securities dealers determine on a continuing basis whether they are in possession of property owned or controlled by, or on behalf of, anyone on the list. The list of names is compiled according to the Regulations Establishing a List of Entities made under subsection 83.05(1) of the Criminal Code or the United Nations Suppression of Terrorism Regulations (UNSTR). The Canadian list is developed by the Department of Foreign Affairs and International Trade and modified by the Department of the Solicitor General. The OSFI list is published monthly and is accessible via its website. Property of those whose names are published on this list must be frozen and transactions related to that property are prohibited. Canadian securities dealers must report monthly to their principal supervisory or regulatory body concerning the possession or control of any property described above. IDA members report to the IDA, federally regulated financial institutions to OSFI and non-IDA securities dealers such as mutual fund dealers to the provincial securities administrators. Furthermore, these regulations require anyone in Canada, as well as Canadians outside Canada, to disclose to FINTRAC, the RCMP and CSIS the existence of any property in their possession or control that they believe is owned or controlled by, or on behalf of, anyone on this list. This includes information about any transaction or proposed transaction relating to that property. Since November 8, 2001, securities dealers have had to report transactions if there are reasonable grounds to suspect that the transactions are related to the commission of a money laundering offence. Effective June 12, 2002, it is a requirement to report transactions to FINTRAC if there are reasonable grounds to suspect that the Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 54 transactions are related to the commission of a terrorist activity financing offence. There are also other offences associated with terrorist activities that are not specifically related to terrorist financing, such as participating in, or facilitating, terrorist activities, or instructing and harbouring terrorists. Under the new regulations, even a suspicion that a transaction is related to a terrorist activity financing offence triggers a requirement to report the suspicious transaction to FINTRAC. In May 2005, FINTRAC and the IDA announced the signing of a memorandum of understanding (MOU) to exchange information related to money laundering and terrorist financing. The agreement is intended to minimize potential overlap between the organizations in carrying out compliance examinations within the investment sector, thereby reducing the administrative and regulatory impact for individual investment dealers in Canada. Under the agreement, FINTRAC will provide information to the IDA to facilitate its risk assessment of investment dealers subject to the Proceeds of Crime (Money Laundering) and Terrorist Financing Act. In turn the IDA will provide FINTRAC with information regarding Member firm’s adherence to and compliance with the Act. In July 2004, OSFI and FINTRAC also signed an MOU under the authority of the Public Safety Act for exchanging information regarding money laundering and terrorist financing. This MOU will minimize potential overlap of work and reduce the impact of administrative requirements on federally regulated financial institutions. In addition, in September 2005, the Financial Institutions Commission of British Columbia (FICOM) and FINTRAC entered into an MOU to exchange compliance information in their joint fight against money laundering and terrorist financing. FICOM, which is responsible for the administration of the Financial Institutions Act, the Credit Union Incorporation Act and the Insurance Act, will provide FINTRAC with the results of its assessments of compliance with anti-money laundering and anti-terrorist financing measures. In return FINTRAC will provide information to help facilitate FICOM’s risk assessment within its regulated sectors. The agreement will facilitate the exchange of compliance information and it will also minimize the potential overlap of work. This MOU was also signed under the authority of the Public Safety Act, 2002. Money Laundering Record Retention Guidelines In June 2005, FINTRAC released an updated version of their guidelines relating to “Record Keeping and Client Identification for Securities Dealers”. According to the guidelines, records must be kept for every account that a firm opens. Firms are required to keep a signature card, an account operating agreement or an account application that shows the signature of individuals authorized to give instructions Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 55 for an account, as well as an account number of any financial entity account that is in the individual’s name, or that the individual is authorized to give instructions for. For an individual’s account, firms must retain new account applications, confirmations of purchase or sale, guarantees, trade authorizations, powers of attorney, joint account agreements and all correspondence about the operation of the account. Firms must also retain a copy of every statement sent to clients. For corporate accounts, a copy of official corporate records identifying individuals authorized to sign on behalf of the corporation must be retained. If there are subsequent changes to this information, a board resolution stating the changes must be included in the records. To open corporate accounts, firms are also required to identify all individuals who beneficially own more than 10% of that corporation, whether directly or indirectly. This involves obtaining the name, address, citizenship, occupation and employer of each beneficial own