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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. Example A: Jane Morgan is an IA. The New Account Application Form (NAAF) for one of her clients, Bruno Mannheimer, indicates that he has a moderate income, moderate net worth and conservative investment objectives. Mannheimer has recently come into a substantial inheritance. He calls Morgan, telling her about his inheritance. Based on Mannheimer’s new net worth, Morgan recommends the purchase of several growth and speculative stocks, the total of which comes to over $200,000. When Morgan’s branch manager sees these orders the next day, she checks the client’s New Account Application Form. It shows a net worth of $100,000, annual income of $50,000 and objectives of 50% income and 50% safety. Immediately concerned, the branch manager calls Morgan into her office and requests an explanation of whether the client can pay for these securities and whether the securities are appropriate for the client. Comment The IA in this example was fortunate that her branch manager was alert. Either the orders were well beyond the client’s apparent ability to pay, or the client has experienced a major change in his financial situation. The client documentation did not show the financial resources to support acceptance of such an order. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 9 It is not clear in this case whether Morgan discussed any change in objectives that might have accompanied the change in financial circumstances. Taking into account Mannheimer’s age, occupation, plans for retirement, and any change of attitude on the client’s part, Morgan should consider the continuing applicability of the objectives on the client’s NAAF. In order to justify the suitability of the recent purchases in Mannheimer’s account, Morgan must update the client’s New Account Application Form. It is not always sufficient to “Know Your Client” - the registrant must also be able to prove that he or she does. Otherwise, if the securities did not perform well and the client complained, Morgan could be faced with the problem of justifying these orders. In fact, if the client claimed to be unsophisticated and conservative, and had the investment history to support these claims, a complaint by the client might result in sanctioning of the IA for giving unsuitable advice. Procedures for Compliance Registrants must document any material changes to their clients’ situations. This includes changes to net worth, income, employment, investment objectives and marital status. The firm should ensure that any transactions that appear unsuitable based on a client’s NAAF are flagged and investigated. Example B: An IA, Stanley Kowalski, receives a phone call from one of his clients, Doris Green, who is interested in speculating on the proposed takeover of a national auto parts manufacturer. After a lengthy discussion, Green concludes that the speculation is worthwhile and instructs the IA to invest her excess margin in shares of the company. After checking the account’s margin balance, Kowalski buys 2,500 shares of the company’s Class B shares. Two weeks later, the takeover is finalized. At that time, the IA learns that the takeover has been directed at the company’s voting shares only. A quick review of a research source shows that the company’s class A shares carry one vote per share. However, Class B shares are non-voting. As a result, Green does not profit from the takeover, and in fact, actually takes a small loss on her trade. Comment The IA appears to have been negligent in not having taken enough care to learn the essential details surrounding the company in question and its proposed takeover. Through his negligence, Kowalski failed to act in the client’s best interests. It is likely that the IA could be held responsible for the client’s losses as well as missed profit opportunity. Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 10 Procedures for Compliance Registrants must have a thorough level of product knowledge and understanding. Many firms offer the facilities of a research department to assist registrants in locating up to date information on various companies and products. Firms often offer training for registrants in the areas of specialized products and trading strategies. A wide variety of financial and news publications are available to help registrants keep up on the latest developments in the investment industry. Example C: Kate Janeway, an IA, takes a call from a seventy-two year old retired client, Sam McMunny, whose NAAF states that his only income is from a pension, his net worth is $150,000 and his investment objective is 100% income. At the time of the call his account holds $130,000 in a combination of Canada Treasury Bills and long-term Government of Canada bonds. McMunny is calling to say that his sonin- law, who is a mining engineer, has given him a tip on a penny mining stock that is currently involved in explorations. The company is expected to announce drilling results in a few days. If the drilling results are favourable, the stock’s price could rise dramatically. McMunny instructs Janeway to liquidate all of his T-Bills (which make up about half of his portfolio) and use the proceeds to buy shares in the penny stock. Janeway promptly enters the orders as requested. Comment By accepting this order without question, the IA has violated the requirement for due care. It is her duty under Standard A to ascertain that this client is aware of the risk associated in buying speculative stock. He must also be made aware that this type of trade does not conform to the investment objectives that he specified when his account was opened. If his objectives have changed, the NAAF must be updated to reflect this. If the objectives of the client have not really changed, but the client continues to insist on the trade, the IA must clear it with her branch manager or compliance department. If the firm agrees to accept the order, it should be marked “unsolicited” and the circumstances of the trade should be documented in the client’s file. Procedures for Compliance Clients must be warned when transactions seem unsuitable based on their NAAF. NAAFs should be updated if investment objectives have changed. Client orders entered against the advice of the IA should be marked “unsolicited” and the circumstances of the transaction documented. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 11 If IAs are unable to dissuade clients from making apparently unsuitable trades, they should clear such orders with the branch manager or compliance department before putting them through. Firms may refuse to accept unsuitable orders. Policies may be put in place or they may be dealt with on a case-by-case basis. Standard B – Trustworthiness, Honesty and Fairness Registrants must display absolute trustworthiness since the client’s interests must be the foremost consideration in all business dealings. This requires that registrants observe the following: 􀂉 Priority of Client’s Interest: The client’s interest must be the foremost consideration in all business dealings. In situations where the registrant may have an interest that competes with that of the client, the client’s interest must be given priority. 􀂉 Respect for Client’s Assets: The client’s assets are the property solely of the client and are to be used only for the client’s purposes. Registrants shall not utilize client funds or securities in any way. 􀂉 Complete and Accurate Information Relayed to Client: Registrants must take reasonable steps to ensure that all information given to the client regarding his or her existing portfolio is complete and accurate. While the onus is on the investment firm to provide each client with written confirmations of all purchases and sales, as well as monthly account statements, the individual registrant must accurately represent the details of each clients’ investments to the client. The registrant must be familiar with the client’s investment holdings and must not misrepresent the facts to the client in order to create a more favourable view of the portfolio. 􀂉 Disclosure: Registrants must disclose all real and potential conflicts of interest in order to ensure fair, objective dealings with clients. Example A: A fairly new IA, Kyle Toshiba, has a small group of clients. To increase his and his firm’s income, he favours an active trading approach with his clients. Toshiba’s branch manager notices that several of the IA’s accounts show very high levels of trading activity, many times without significant differences in the types of securities traded. Quite often, shares that had been sold from an account were bought back for the same account a few days later. In one case, a client whose investment knowledge was indicated as “fair” had 24 trades in his account over a two-month period, with no significant changes over that period in the type or performance of securities traded. Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 12 Comment While registrants have an interest in executing transactions in order to earn commission revenue, they should do so only if the transactions are in the best interests of the clients. In this case, the number of trades in the IA’s client accounts does not seem to be in the clients’ best interests. Toshiba appears to be churning, or generating trades simply for the commission he will earn. Churning is a prohibited sales practice as it implies trading that is unnecessary and unsuitable for the client. Churning is trading which does not benefit the client and deprives the client of the money being paid in commission. Procedures for Compliance Recommendations for trades should be made only when necessary and when it is to the benefit of the client. Branch managers must be aware of and question any trading that appears excessive. Example B: Jack Chopra, an IA, has a long-time client named Igor Sazonoff. One day, Chopra notices that Sazonoff’s account shows a small margin deficiency. Chopra knows that his branch manager will ask him to clear up this deficiency. Chopra also knows that Sazonoff is on vacation and will certainly be bringing the account up to date within the week. Another client of Chopra’s, Monica Mintz, has a large cash balance sitting idle in her account. Chopra moves some money from Mintz’s account into Sazonoff’s to cover the margin deficiency. Within the week, Sazonoff has returned from vacation and deposited enough money to bring his account up to date. Chopra then replaces the borrowed money into the Mintz account. Comment Chopra has used Mintz’s assets for the benefit of another client, Sazonoff. A client’s assets must be used solely for the benefit of that client. Mintz may have wished to convert her cash into securities while some of her cash was still in Sazonoff’s account. Her cash would have been at risk in Sazonoff’s account if Sazonoff had not repaid the balance owed. However, no matter whether Mintz wished to access her money or not, an unauthorized transfer such as this is not permitted. Using client assets for the benefit of the registrant or another client is not permitted and reflects badly on the registrant, the firm and the industry. This violates the trust inherent in the registrant-client relationship and may constitute criminal behaviour. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 13 Procedures for Compliance Firms should have policies in place to ensure that any movement of assets between client accounts is appropriately authorized and monitored. Example C: A retired client, Fredella Bingleby, holds a portfolio of preferred stocks, primarily for the dividend income they provide. Higher interest rates have caused the value of the portfolio to decrease, causing her some concern. She calls her IA, Philip de Groot, and asks if her money might be more safely invested in GICs at a local trust company. The IA explains that the higher interest rates are only a short-term problem, and that everything will be all right eventually. To help ease Bingleby’s concern, he volunteers to do a portfolio evaluation for her. After de Groot has completed the evaluation, he realizes that the client’s total return on investment does not look favourable in light of current interest rates. So, not wanting to lose Bingleby’s business, de Groot re-calculates the portfolio’s yield using current market values rather than the purchase price of the various preferred shares. This method of calculation shows a higher income return on the shares and ignores the capital loss on the principal amount of the shares. Satisfied with the results, he sends the evaluation to the client, who is reassured by what she reads. Several weeks later, Bingleby’s tax accountant reviews the evaluation and realizes what has occurred. Angry at having been misled by the IA, the client complains to the branch manager and transfers her account to another firm. Comment By providing the client with inaccurate information regarding her portfolio holdings, the IA has deliberately misled the client. He has taken advantage of Bingleby’s lack of understanding of yield calculation to create the impression that the client’s portfolio was performing better than it really is. In so doing, the IA has attempted to deceive his client. The branch manager must also approve all such communication before it goes to clients. Procedures for Compliance Rather than making an effort to disguise an apparent weakness in Bingleby’s portfolio, de Groot should appraise the portfolio constructively, perhaps suggesting some changes such as alternative securities which are suitable for the client and will increase her return. The member firm should have procedures in place to ensure that the branch manager or a director of the firm review any portfolio evaluations prepared by IAs in order to ensure that the enclosed information is accurate and complete. Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 14 Example D: Jeff Doe, an IA, also sits on the board of directors of a small software company (Tekwax) owned by his cousin. Doe thinks that Tekwax is a promising investment, and has been recommending that clients purchase its stock on the over-the-counter market, telling them only that Tekwax is a promising new company in the technology sector. Doe does not think it necessary to inform his clients or employer that he is a director of Tekwax. Comment Doe must disclose his directorship to both his employer and his clients. His position with Tekwax may bias his investment recommendations to clients and cause him to overlook more suitable or advantageous investments. Procedures for Compliance The IA must disclose his directorship to his employer and obtain written approval from the employer. The IA must tell his clients that he is a director of Tekwax when he makes any recommendations for the stock. Standard C – Professionalism It is generally accepted that professionals, by having specialized knowledge, need to protect their clients, who usually do not have the same degree of specialized knowledge, and must continually strive to put the interests of their clients ahead of their own. Registrants must also make a continuous effort to maintain a high standard of professional knowledge. 􀂉 Client Business: All methods of soliciting and conducting business must be such as to merit public respect and confidence. Client Orders: Every client order must be entered only at the client’s direction unless the account has been properly constituted as a discretionary or managed account pursuant to the applicable regulatory requirements. Trades by Registered and Approved Individuals: All trades and all acts in furtherance of trades, whether with existing or potential clients, must be effected only by individuals who are registered and approved in accordance with applicable legislation and the rules of the SROs. Approved Securities: Only securities approved for distribution by the appropriate regulatory authority and partner, director or officer of the firm should be distributed, and all such transactions should be recorded in the normal way on the books and records of the firm. 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. Example A: Mario Fellini, an IA, opens a margin account for a surgeon who wishes to speculate in growth stocks. Fellini suggests several trades to the client over a six-month period. Most of the trades are quite profitable. However, on a few occasions, the IA is unable to contact his client when he is tied up in surgery for several hours. As a result of these delays, some potential profits are reduced due to adverse market moves before Fellini is able to contact his client. Frustrated, but still pleased by the consistent success of the IA’s recommendations, the client tells the IA that if he is unable to reach him at any time in the future, the IA should go ahead and use his own initiative to take profits on existing positions, or to take on new positions as long as there is enough margin available in the account. Fellini agrees to do this on a “when necessary” basis. Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 16 Comment Regardless of the client’s willingness to have the IA make certain decisions regarding the trading of his or her account, this arrangement contravenes the rules for two reasons: The registrant does not have the authority to accept a discretionary account on behalf of his or her firm. This can only be done by a partner or director of the firm (or his or her alternate) who has been designated to supervise account openings and activities (the “designated person”). The client must supply discretionary authority in writing. Verbal authority is not acceptable. Unauthorized discretionary trading is one of the most common reasons for disciplinary action being taken against registrants. The nature of the business is such that, due to rapidly changing markets, it may be difficult for registrants to obtain specific orders from a client on short notice. Thus, the perception of a need to trade on a discretionary basis can become a serious temptation. However, penalties can be quite severe, and in most member firms unauthorized discretionary trading may be grounds for termination. Procedures for Compliance The IA must have the client complete a discretionary agreement (assuming that the firm allows discretionary accounts), update the New Client Application Form to indicate that the account has become discretionary, and submit these documents to the firm’s designated person for approval. If the IA is not a person authorized to place discretionary orders, he or she would have to ensure that all discretionary orders for the account are approved by the appropriate person before they are entered. The onus is on each member firm to ensure that all representatives are familiar with the by-law regarding discretionary trading. In most member firms, unauthorized discretionary trading is grounds for termination. Since it is very difficult for supervisory personnel to detect unauthorized discretionary trading in the absence of a client complaint to that effect, it is necessary for the firm to initiate procedures to assist in this area. For example, all IAs who transfer in from other member firms should be asked if they maintain any discretionary accounts. The entire sales staff should be surveyed at least on an annual basis in order to verify what accounts are being traded on the basis of discretionary authority. Clients must reauthorize discretionary authority no less frequently than annually. The firm’s new account staff should be instructed to contact the compliance department whenever they see a new account that appears to be discretionary (e.g. an account over which an IA holds a Power of Attorney or a Trading Authorization). Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 17 Example B: An established IA, Ramesh Issar, with a sizeable client base decides that strip bonds have become very attractive investments. He hopes to use Government of Canada strip bonds as a prospecting tool for new accounts, so he plans a monthlong solicitation campaign. Because of the magnitude of the campaign and the fact that he will be spending a lot of time out of the office visiting prospects, he is worried that he will not have enough time to service his existing clientele. So, he instructs his unregistered sales assistant, who has taken the Canadian Securities Course and is now enrolled in the CPH, to take all of his incoming calls, and to place any orders that his clients may give. He also tells the sales assistant to convince his clients to take profits in their common stocks, as he expects prices to generally go lower for the next several months. Comment The IA (and the firm) is in violation of the rules. An unregistered individual must not be allowed to accept orders or solicit business from clients except in “exempt securities” (e.g. T-Bills, CSBs, etc.). Note that even if the assistant had completed the courses required for registration, the individual must be registered and acknowledged as such by the SRO. The firm could also be found guilty of failing to properly supervise the IA and the sales assistant. Procedures for Compliance In a case such as this, the registrant must make arrangements with another IA in the firm to have the other IA handle existing clientele. In fact, some firms encourage their IAs to develop this type of buddy system to provide mutual back up when they are out of the office. Firms usually require their sales assistants to be registered to assist with order-taking duties. Each member firm should have policies in place to ensure that unlicensed employees are not taking orders from clients. Example C: An accomplished IA, Eric Jacobson, has a client, Antoinette Lagarde, who controls a number of small companies involved in various types of business. One of the more successful businesses is Toyco Inc., an import/export operation which has the exclusive right to distribute in Canada a line of interactive stuffed toys. Sales are growing quickly, and Lagarde needs additional capital to finance her inventory. Not wanting to borrow, she approaches a number of people, including Jacobson, to solicit interest in making an equity investment in the company. The IA is impressed by the profit potential of the business and agrees to invest $10,000 of his own money, for which he receives 10,000 common shares of Toyco Inc. Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 18 Jacobson mentions this investment to a number of other clients, five of whom express an interest in investing in Toyco as well. Jacobson relays this information to Lagarde, who says she would be willing to issue additional shares to the IA’s other clients on the same terms. The IA obtains cheques from the five clients, payable to Toyco Inc., and in return receives share certificates registered in the clients’ names, which he subsequently delivers to them. As Jacobson feels that this is a private arrangement between Toyco and the clients, he does not see any necessity to advise his branch manager of the transactions. Comment Although Jacobson may believe the transactions are a private arrangement, the clients may view him as acting as a representative of the firm in facilitating the investment. Dealings in securities outside of the normal business of the firm, sometimes referred to as selling away or outside deals may expose clients to unknown risks and expose registrants and firms to civil liability. Such activities done without the knowledge of the firm also prevents effective supervision of the handling of client accounts, which is a requirement placed upon firms by the SROs. Firms may be exposed to liability for the actions of their employees in effecting such trades, even though the firm is unaware of the activities. Procedures for Compliance The firm must have knowledge of and give written consent to any business dealings outside of normal business. The IA should have taken Lagarde’s proposal to the appropriate official of the firm. The IA should have placed the securities with clients only if the firm agreed to participate in the distribution of the securities, perform the necessary due diligence with respect to the proposed distribution, and ensure compliance with securities legislation. Any trades must be recorded in a normal way with trade confirmations issued and monthly statements sent to the clients. Example D: An experienced IA, Edgar Brown, has a client, Michelle Green, with whom he has dealt for the past six years. Although Brown did not know Green prior to her becoming a client, since then they have socialized to some extent and might be considered friends. About a year ago, Brown needed $20,000 for renovations to his house. As the house was already heavily mortgaged and Brown knew he would have difficulty obtaining financing, he approached Green and asked if she would lend him the $20,000. Brown knew that Green could well afford to lend the funds as her account was worth over $100,000, much of which was liquid. The client agreed to lend the funds, and received from Brown a promissory note providing for payment within six months, with interest at the prime rate. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 19 When the six months had passed, the client inquired about repayment. Brown replied that he would have difficulty paying the debt at this time, and asked for more time, to which the client reluctantly agreed. It has now been six months since the note came due and Brown has not yet been able to pay it. Green has grown increasingly upset with Brown’s stalling and has now complained directly to the firm’s management about the unpaid debt. Comment The purpose of this standard is to prevent the creation of conflicts of interest that may arise when the registrant enters into financial dealings with clients on a personal level, aside from normal business dealings conducted through the firm. The IA in this example has entered into a transaction that creates a fundamental conflict of interest. He is now both a borrower from, and an advisor to, the client. In addition, Brown took advantage of his knowledge of Green’s financial circumstances, gained through his professional relationship with the client, thereby using their professional relationship for his personal benefit. By borrowing the funds from Green, Brown has also prevented the client from taking advantage of any superior investment opportunities that might have arisen. The standard is not stated as an absolute prohibition, as it is recognized that there are some circumstances where such dealings may not be objectionable. There may be grey areas in compliance with the standard. For example, where there is a close, pre-existing relationship, or family relationship, between the registrant and the client, such dealings might not be objectionable, depending on the circumstances. However, any such dealing should not be entered into without the knowledge and approval of the firm, and the firm should ensure that the client’s interests are fully protected. Procedures for Compliance Personal financial dealings with clients are to be avoided. Any proposed financial relationship with a client should be reviewed with an appropriate official of the firm, such as the head of compliance. The firm must give approval to the relationship and monitor the situation. Any such financial relationship must be conducted so as to avoid any real or apparent conflict of interest. In the event that a client is to be compensated for losses (for example, for trading errors or losses resulting from unsuitable recommendations), such compensation should only be paid through the proper channels of the firm, even if the loss is ultimately charged back to the registrant. Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 20 Example E: Elaine van Nostrand, an IA, has used her increasing knowledge of investments to build up her own portfolio, as well as those of her clients. She is planning to buy a house next year, and is counting on profits from her portfolio to provide a large down payment. The stock market has been rather volatile lately, and van Nostrand finds that she has to keep monitoring her own holdings in order to prevent losses. On two consecutive days, van Nostrand spends at least one quarter of her time at the office buying and selling for her own account, both to protect her potential profit and because she sees many stock bargains. Comment Van Nostrand obviously is not serving her clients at the level they should expect. While trading for one’s own account is allowed, it should not be done to the point where clients’ accounts are in any way neglected or compromised. The reason that the IA in this example is spending a large amount of her time on her own account is given as the volatility of the stock market. If markets are volatile, clients’ accounts should be monitored even more closely than normally. Procedures for Compliance Trading for a registrant’s personal account(s) should not be excessive, and should not affect the level of service given to clients. Firms should monitor trading in personal accounts by employees. Registrants should avoid taking excessive risk that may lead to large losses. Example F: An IA, Walter Garcia, participates in a political organization. This organization recently held a protest, which Garcia attended. An opposing group showed up and shouting matches ensued. The TV news that night featured Garcia, among others, speaking out against the opposing group. Both Garcia’s occupation and his firm were identified. The next day, several clients called Garcia’s firm, wondering if the firm supported Garcia’s organization. Comment This is an example of the type of situation that could present an unfavourable and unprofessional public image. This negative publicity reflects badly on the IA, the IA’s firm and on others in the industry, as it contributes to the public perception of the investment professional. Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 21 Procedures for Compliance Garcia should have ensured that his participation in organizations outside of the firm’s business did not result in negative publicity being reflected on the firm, or in any implication of the firm’s support of his personal activities. Firms should make their employees aware that they have an interest in any personal activities of the employee, as these activities may reflect badly on the firm and on the investment profession. Standard D – Conduct in Accordance with Securities Acts Registrants must ensure that their conduct is in accordance with the Securities Acts and the applicable SRO rules and regulations. 􀂉 Compliance with Securities Acts and SRO Rules: Registrants must ensure that their conduct is in accordance with the Securities Acts of the province or provinces in which registration is held. The requirements of all SROs of which a registrant’s firm is a member must be observed by the registrant. Note that if two rules apply, the registrant must adhere to the rule which is the most stringent. The registrant shall not knowingly participate in, nor assist in, any act in violation of any applicable law, rule or regulation of any government, governmental agency or regulatory organization governing his or her professional, financial or business activities, nor any act which would violate any provision of the industry Code of Ethics and Standards of Conduct. Inside Information: If a registrant acquires non-public, material information the information must neither be communicated (outside of the relationship) nor acted upon. Employees of a firm’s trading, corporate finance or research departments must be aware of the need to safeguard non-public, confidential, material information received in the normal course of business. Example A: Phyllis Erdo, an IA, is married to the treasurer of a publicly-traded pharmaceutical company, Feelgood Inc. Like many other employees of Feelgood Inc., Erdo’s husband holds a sizeable position in the company’s stock. Feelgood Inc. stock has recently enjoyed a 30 per cent increase in value due to rumours of an impending merger with a larger, U.S.-based company. One day, Erdo receives a phone call from her husband, informing her that the merger has fallen through. The husband wants to unload a large portion of his Feelgood stock before news of the failed merger becomes public. Erdo enters her husband’s order to sell 10,000 shares. She then calls her sister, who is also a client. Erdo tells her sister that the merger has fallen through and suggests that her sister make a quick profit by short selling Feelgood shares. When news of the failed merger becomes public, the price of the shares should quickly drop back to its previous level. The sister agrees and sells 1,000 shares short. Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 22 Comment The IA in this example has actually violated two rules regarding insider trading. First of all, she accepted a sell order from a client (her husband) who was obviously acting on inside information as a result of his special relationship with the issuer. A special relationship denotes a relationship in which confidential information is obtained about an issuer by virtue of employment or the employment of a close relative or cohabitant. This includes insiders of the issuer as well as those working in certain capacities for or with the issuer (see Section II, Chapter 1 for a more extensive definition of insiders and special relationships). Therefore, Erdo herself could be considered to have a special relationship with the issuer through her husband. Provincial securities legislation states that no person or company in a special relationship with a reporting issuer shall purchase or sell securities of the reporting issuer with the knowledge of a material fact or material change with respect to the reporting issuer that has not been generally disclosed. The IA then passed along this information to her sister. This act of tipping is also contrary to provincial securities legislation. Regulation states that no person or company in a special relationship with a reporting issuer shall inform another person or company of a material fact or material change with respect to the reporting issuer before the material fact or material change has been generally disclosed. Procedures for Compliance Erdo knew that her husband was an insider of Feelgood Inc. She should not have accepted the order. She should not have divulged the confidential information to (tipped) her sister. Example B: While using a fax machine in close proximity to her firm’s Corporate Finance Department, an IA, Margaret Peterson, notices an incoming fax message addressed to someone in Corporate Finance. The fax discusses the purchase of a large trust company by a competitor. Peterson’s firm is apparently assisting with the financing of this purchase. When she returns to her desk, Peterson proceeds to call several of her clients, suggesting that they purchase shares in the trust company. She tells the clients that they can expect to hear an announcement soon detailing the terms of the competitor’s purchase offer. Naturally, such an announcement could be expected to have a positive effect on the value of the trust company. Comment Although the registrant in this example is not directly involved in a special relationship with the trust company (although her firm appears to be), she has nonetheless come into possession of confidential, non-public information. By reading the fax message that was intended for her firm's corporate finance Section I: The Regulatory Environment © CSI Global Education Inc. (2005) 23 department, Peterson has misappropriated this information. As well, by passing the information on to her clients and attempting to solicit trades based on the information, she has breached the Code of Ethics and Standards of Conduct. Procedures for Compliance In this example, the registrant’s best course of action would have been to deliver the fax to the corporate finance department immediately. As well, the IA should have understood that she was in possession of confidential information, and that use of such information is not allowed. If she had any doubt as to her ability to use this information to solicit trades from her clients, the registrant should have discussed the matter with her firm’s corporate finance and compliance departments. The firm should assess its practices with regard to the protection of confidential information. Firms should implement effective “Chinese Walls” policies, by which persons within a firm who make investment decisions are physically separated from persons within the firm who are privy to undisclosed material information which may influence those decisions. For instance, there should be separate fax and photocopy machines for corporate finance departments and sales departments, in order to avoid the potential problem of leaving confidential documents in places where they may be intercepted. Standard E – Confidentiality All information concerning the client's transactions and his or her accounts must be considered confidential and must not be disclosed except with the client’s permission, for supervisory purposes or by order of the proper authority. 􀂉 Client Information: Registrants must maintain the confidentiality of identities and the personal and financial circumstances of their clients. Registrants must refrain from discussing this information with anyone outside their firm, and must also ensure that the firm’s client lists and other confidential records are not left out where they can be taken or observed by visitors to the office. 􀂉 Use of Confidential Information: Information regarding clients’ personal and financial circumstances and trading activity must be kept confidential and may not be used in any way to effect trades in personal and/or proprietary accounts or in the accounts of other clients. Not only must registrants refrain from trading in their own accounts based on knowledge of clients’ pending orders, but they must also refrain from using it as a basis for recommendations to other clients or passing this information along to any other parties. Personal information is identifiable data about an individual and includes information contained in New Account Application Forms, account statements, trade confirmations and cheques and financial records in relation to the trading in securities. Clients from whom personal information is collected must be notified of 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. Example A: Phoebe Goldman, an IA, has a technical analyst as a client. Noting the successful track record of this analyst, Goldman calls several other clients and tells them of these successes. These clients agree to adopt the same trading strategies as the analyst. Comment Not only has the registrant violated the client’s confidentiality by passing along his trading strategies to other clients, Goldman has also done so simply by telling the other clients that she maintained an account for the analyst. This registrant may be vulnerable to regulatory penalties and possibly a civil lawsuit brought by the analyst. Procedures for Compliance The confidentiality of each client must be protected. The firm must ensure that each of its representatives is aware of his or her responsibilities with regard to client confidentiality. Example B: Maria Oliveira, an IA at a large investment firm, has a client that is the pension fund of a local university. The pension fund has a sizeable holding in a national pharmaceutical company that has recently been developing a drug used in the treatment of allergies. Preliminary experimental results have been successful, so the stock has enjoyed a substantial rise in value in the past several months. However, potential patenting problems and pending legal action by a competitor have caused the stock’s price to decline from its recent highs. The director of the pension fund tells Oliveira that if the stock price falls below a technical support level of $30, the fund will take profits by liquidating its entire position in the stock. Two days later, the IA notices that the stock has opened at $29.75. Aware of the impact that a large sell order could have on an already weakening market, Oliveira quickly sells short 1,000 shares in her own account. She then calls the director of the pension fund to report that the stock has opened below $30. As expected, the client instructs her to sell the entire position. By the end of the day, the stock has closed at $28.25, creating a nice profit in Oliveira’s short position. Chapter 1 – Canadian Securities Industry Registrant Code of Ethics and Standards of Conduct © CSI Global Education Inc. (2005) 26 Comment By using her confidential knowledge of the client’s impending trade, Oliveira has taken advantage of her relationship with that client. Not only has she profited by trading on material, non-public information, she has also possibly cost her client a better fill price by not putting her client’s order ahead of her own. Thus, the registrant has not upheld her regulatory responsibility to that client. The IA is also guilty of frontrunning (entering an order for her own account ahead of a similar client order). Had she called the client first and entered the client's order before her own, she would not be guilty of frontrunning, but she would still have been guilty of using confidential information for her own benefit. From the point of view of the member firm employing the IA, a simple review of the next day's commission run would almost certainly have brought attention to the trade and the obvious example of frontrunning, which would have left Oliveira susceptible to discipline by her firm. Procedures for Compliance Confidential information may not be used either for the benefit of the IA or as the basis of recommendations to others. Firms should have policies in place regarding the use of confidential information. If registrants feel that their own trading activity may be such that it would cause an appearance of frontrunning, they must defer their own trades in the interest of protecting the integrity of the investment industry. III. Summary Ethical conduct is vital to ensuring the integrity and stability of the capital markets. Registrants should therefore be familiar with the Code of Ethics and Standards of Conduct and should be able 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 For information only: Province Governing Legislation Administration Alberta Securities Act, S.A. 1981, c.S-6.1, as amended Commission, headed by a Chairman, possibly a Vice-Chairman, and other members. The Executive Director is responsible for the day-to-day administration. British Columbia Securities Act, R.S.B.C. 1996, c.418, as amended Commission headed by a Chairman, a Vice-Chairman, and up to seven other members. The Executive Director heads day-to-day administration. Manitoba The Securities Act, R.S.M. 1988, c.S50 , as amended Commission, headed by a Chairman, a Vice-Chairman and up to five other members. The Director heads dayto- day administration New Brunswick Security Frauds Prevention Act R.S.N.B. 1973, c.S-6, as amended The Minister of Justice. An Administrator heads day-to-day administration. Newfoundland and Labrador The Securities Act, R.S.N. 1990, c.S-13, as amended Commission headed by a Chairperson. The Director of Securities heads day-today administration. Nova Scotia Securities Act, R.S.N.S. 1989, c.418, as amended Commission, headed by a Chairman, a Vice-Chairman and up to four other members. The Director of Securities heads day-to-day administration. Ontario Securities Act, R.S.O. 1990, c.S.5, as amended Commission headed by a Chair, up to two Vice-Chairs and up to eight other members. The Executive Director heads day-to-day administration. Prince Edward Island Securities Act, R.S.P.E.I. 1988, c.S-3, as amended The Director of Corporations. The Registrar heads day-to-day administration. Quebec Securities Act, R.S.Q. 1982, c.V-1.1, as amended. The Autorité des marchés financiers is headed by a Chief Executive Officer and seven Directors who head day-to-day administration. Saskatchewan The Securities Act, S.S. 1988, c.S-422, as amended Commission headed by a Chairman and a Vice-Chairman and consisting of up to six members. The Director heads day-to-day administration. Northwest Territories The Securities Act, R.R.N.W.T. 1990, c.S-5, as amended The Minister of Justice. The Registrar heads day-to-day administration. Nunavut Securities Act, R.R.N.W.T. 1990, c. S-5, as amended The Minister of Justice. The Registrar heads day-to-day administration. Yukon Territory Securities Act, R.S.Y.T. 1986, c. 158, as amended The Act is administered by a Registrar, who performs similar functions to Commissions in other jurisdictions. Chapter 2 – Regulation of the Securities Industry © CSI Global Education Inc. (2005) 36 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 t