Compliance Pitfalls in a world of One Rule & 13 Referees
By: Phil Du Heaume
For many dealing and advising firms in Canada, the coming into force of National Instrument 31-103: Registration Requirements and Exemptions on September 28, 2009 was a regulatory wake-up call; a notice to the industry at large that provincial regulators were joining in concert to standardize the registration and proficiency requirements for dealers, advisors and fund managers from British Columbia to Newfoundland and everywhere in between.
From the perspective of investors, exempt market dealer registration was long overdue. Prior to National Instrument 31-103, dealers in some jurisdictions were subject to almost no regulation if the investments they sold qualified as prospectus exempt under National Instrument 45-106. These dealers weren’t required to disclose financial interests in the companies whose securities they peddled, and too often a subscription agreement wound up being the last piece of paper an investor saw until it came time to (hopefully) realize on their investment. It was an industry that longed for legitimacy.
According to the CBC, in 2008, Alberta companies alone raised more than $10 billion in the exempt market - more than double what was raised by Alberta companies on both the TSX and TSX-Venture combined. In 2010 this figure had risen to $12.0 billion and in 2011 the annual amount had climbed yet again to $12.8 billion, of which only $3.1 billion was contributed by Alberta residents. With so much money in the exempt market changing hands across provincial borders, securities regulators were in dire need of a way to peek into their neighbor’s backyard and work together to protect investors. The new exempt market dealer registration regime was born and the industry took its first steps inward from the fringes of Canada’s financial marketplace towards the mainstream.
Contrasting the move towards uniformity that was represented by the introduction of National Instrument 31-103, the provincial governments of Alberta and Quebec were busy posing reference questions to their respective appeal courts to determine the constitutionality of a federal securities regulator. It was a matter that came to a head on December 22, 2011 when the Supreme Court of Canada ruled in Reference Re: Securities Act that the federal government’s proposal to appoint a national regulator overseeing all securities matters across Canada had overstepped its constitutional bounds.
Although the introduction of National Instrument 31-103 and the opposition to appointment of a national regulator are independent of one another, viewed together they help illustrate the complex regulatory landscape that awaits exempt market dealers after registration. Although the provincial regulators have conceptually agreed to work together, at the end of the day there’s a functional dichotomy created by a world of one rule and thirteen referees. If the compliance team of an exempt market dealership fails to recognize this key aspect of the new regime, they haven’t been doing their job.
To be successful, a registrant firm has to perform its activities effectively, profitably and (most importantly) compliantly in all jurisdictions where trading and advising activities are being undertaken. Chief Compliance Officers need to ensure that they’ve empowered their firms with the information and professional guidance required to safely navigate the pitfalls of an industry where national instruments are jurisdictionally enforced. One of the most readily identifiable examples of this need is in the private mortgage industry.
The Canadian Securities Administrators have created the definition “Mortgage Investment Entity” to refer to a person or company whose purpose is to invest substantially all of its assets in mortgages and whose other assets are limited to bank deposits, cash, debt securities, (limited) real property and certain risk-hedging instruments. To most industry participants, this calls to mind Mortgage Investment Corporations (MICs) as defined under the Income Tax Act (Canada), which in the years leading up to National Instrument 31-103 often considered themselves to be in the business of lending rather than the business of buying and selling mortgage securities. These entities were the subject of a great deal of consternation during the introduction of the new regulatory framework, not least because of the impact of pre-existing provincial oversight bodies in the mortgage industry. While nearly all members of the Canadian Securities Administrators (the British Columbia Securities Commission being the exception) quickly agreed that dealer registration was a necessity, all thirteen recognized that investment fund manager and adviser registration requirements needed to be further assessed.
On February 25, 2011, the Canadian Securities Administrators published CSA Staff Notice 31-323 “Guidance Relating to the Registration Obligations of Mortgage Investment Entities”, which stands as a cogent example of the “one rule, thirteen referee” regime. The notice contains two headings under the “Investment Fund Manager Registration” topic on pooled Mortgage Investment Entities: “In jurisdictions other than Alberta” and “In Alberta”.
Without delving into gritty details, the regulators other than Alberta essentially determined that so long as a pooled Mortgage Investment Entity is operating a business that creates and manages mortgages, it isn’t an investment fund and does not require the services of a registered Investment Fund Manager. In Alberta, however, if a pooled Mortgage Investment Entity has the primary purpose of investing money provided by its security holders into other securities (such as mortgages), then it qualifies as an investment fund and does require the services of a registered Investment Fund Manager. The result is that a MIC in Alberta is likely an investment fund, and cannot operate without the proper registrations, however the same MIC in Saskatchewan, is not an investment fund and can get by with exempt market dealer registration only.
Why is this a concern? Market participants need to be aware that a national instrument is only as uniform as the jurisdictional legislation and regulatory policies used to interpret and enforce that instrument. The passport registration mechanisms afforded under the new regime have helped streamline the ability for regional issuers to raise national capital, but they haven’t changed the fact that organizations still need to comply with the specific laws of the jurisdictions where they carry on business. As specialized exempt market dealer brokerages begin growing based on their ability to raise large capital sums for securities issuers, this problem is only going to become compounded unless Chief Compliance Officers become informed of the jurisdictional differences and are able to ensure that dealers and issuers alike are aware of the secondary impacts of cross-jurisdictional trading.
There’s no denying that the new regulatory framework has helped facilitate the ability for registrants to conduct cross-border transactions under a single set of registration guidelines. However, even though the national instruments provide for a uniform set of rules on the proficiency requirements and responsibilities of the people and companies conducting these registerable activities, it doesn’t mean that those activities are going to be viewed the same in each province. In a world with one rule and thirteen referees, registrant compliance teams need to be sure at all times that they know which referee is calling the game so that they can respond accordingly and compliantly.