01 Clarity on CRM II

The Canadian Securities Regulators (CSA) recently answered 35 questions from advisors and fund managers about CRM II.

Here’s the highlight reel.

Question #1: When does someone cease to be a client, such that a registrant is no longer required to provide the statements and reports contemplated in the CRM II amendments?

CSA says no one answer applies to all scenarios.

“We expect firms to exercise reasonable professional judgement, erring in favour of providing client reporting where there is doubt as to whether there is still a client relationship.”

Question #3: Do disclosure and reporting requirements in the CRM II amendments apply to other investments that may not be securities, such as seg funds?

“Lots of people ask about this,” says Rebecca Cowdery, a partner at Borden Ladner Gervais in Toronto. CSA’s response is that CRM II does not apply to non-securities investments; but the regulator nonetheless encourages those who deal in them to meet CRM II’s standards. CSA adds that SROs may extend these rules to non-securities investments.

Cowdery says the regulators’ answer points to a longstanding industry issue: the bifurcation of regulation between securities and non-securities products.

“I’d like to see regulators take more initiative to ensure there’s more consistency across the industry. If we think as a society that [CRM II] is the right way to go vis-à-vis the client, shouldn’t we be working harder to ensure that clients get consistent experiences no matter what products they invest in?”

She adds that dealers offering securities and non-securities products, as well as firms that deal strictly in the latter, will be industry leaders if they voluntarily meet CRM II standards for non-securities reporting.

#11: Can registrants use the Fund Facts document to satisfy the requirements for pre-trade disclosure of charges?

Yes. “If a registrant delivers the Fund Facts document at the point of sale and explains the specific costs of the transaction to the client, then the registrant may use it further to satisfy the requirements of section 14.2.1 for the disclosure of charges related to the transaction,” says CSA.

“Since the management fee generally constitutes most of the MER of a mutual fund, we think this would be in line with the guidance in the C[ompanion] P[olicy].”

#12: Why use last bid/ask price instead of closing price? Is it not misleading sometimes: e.g., when there are large bid/ask deviations?

CSA says it chose last bid/ask price because some securities aren’t actively traded, and using old closing prices has been consistently problematic.

“That said,” the regulators add, “we recognize that no one measure will always work best, so the requirement is for the firm to report the amount it reasonably believes to be the market value, after making any adjustments it considers necessary.”

#25: If a client transfers out of the firm in the middle of the year, does the firm have to send that client an annual report on charges and other compensation?

No, but CSA “encourage[s] firms to provide departing clients with information on charges and other compensation received during the year-to-date.”

Cowdery agrees it would be a good thing to take this extra step, but she questions the timing. Dealers will have a hard enough time getting ready for CRM II by 2016, and she says regulators don’t appreciate the full weight of that burden.

Instead, firms should consider taking the extra step after they’re fully settled with CRM II’s requirements, Cowdery says. “They have to focus on getting the basics in place by the deadlines because [those] won’t be moved.”

#26: Does the requirement to disclose the dollar amount of trailing commissions mean separate disclosures for the amount paid to the firm, and the amount paid to the
registered representative?

In May 2013, Cowdery told Advisor’s Edge Report: “It’s what the firm receives—they’re not expecting detail on what the advisor gets paid.”

CSA says the same in the FAQ.

#32: Will the CSA publish an approved formula to calculate money-weighted rate of return?

No. Firms can use the formula they want as long as it’s “generally accepted in the securities industry.”

Beyond these FAQs, Cowdery says industry participants will have more questions as CRM II is implemented through 2016.

“I would like to see a continued openness of [CSA’s] staff to take questions and provide these FAQs to the industry. It’s going to be absolutely needed over the next couple years.”

02 More safeguards for wealthy clients

CSA is proposing amendments to NI 45-106 Prospectus and Registration Exemptions targeting the Accredited Investor (AI) and Minimum Amount (MA) Exemptions.

AI Exemption

“The thrust of the proposals,” says Susan Han, a lawyer at Miller Thomson in Toronto, “is to provide additional protection for individual accredited investors. There’s a feeling among regulators that people too often don’t understand what they’re purchasing under private placement exemptions.”

She notes stakeholders had discussed whether to change the income and other asset thresholds individual clients have to meet to qualify for the AI Exemption. They’ve stayed the same, but CSA now mandates a risk acknowledgement form. New wording includes:

WARNING TO INVESTORS at the head of the page

  • I acknowledge that this is a risky investment. I could lose all of the $__________ [insert amount being invested, including any amounts you have agreed to pay in the future] I invest.
  • I understand that I may never be able to sell these securities and I may not be provided with any ongoing information from the issuer I invest in.

Philippe Tardif, a partner at Borden Ladner Gervais in Toronto, notes, “If you’re dealing with a permitted client, you don’t need to complete the risk acknowledgement form.” Han says the proposals would also change Form 45-106F1. The form’s required when a distribution is made under the AI and other exemptions.

“The advisor will now be named on it.” The form is not publicly available—only the regulators will have it. “I imagine it’s going to assist regulators if they want to do a compliance review of any particular dealer or advisor. Those forms are [now] electronic, while previously they were in paper form, so no one [at the regulator] was going go through them to figure out who was filing which form,” Han says.

“It’ll probably be searchable: A clerk at the OSC will be able to type in [an advisor’s name] and see what comes up. Let’s say he’s done 40 private placements in the last year. They may take 10 and review them. They never used to be able to do that because they didn’t have the resources to go through the paper documents. Now they may just have to run a query through their electronic database.”

The aim, Han suggests, “is to put the fear of God into advisors because there’s a widespread perception among regulators—just read what the OSC is saying about EMDs in particular—that EMDs are not as compliant and observant about the private placement rules and accredited investors as they would like.”

End of the Ontario-only carve out

The proposal also takes aim at the much-bemoaned carve out for investment funds in Ontario’s accredited investor definition.

“[A] registered advisor acting on behalf of a fully managed account is qualified to purchase any securities for that managed account as an accredited investor in all Canadian jurisdictions…except Ontario. In Ontario, a registered advisor acting on behalf of a fully managed account does not qualify as an accredited investor when that managed account is acquiring investment fund securities,” explains a BLG bulletin authored by David Surat and Michael Taylor.

The proposal would bring Ontario’s rules into line with the rest of the country. “The fund,” Tardif explains, “will not have to look into the qualification of the ultimate holder; it will just have to confirm that the advisor is registered.”

MA Exemption for individuals on chopping block

Currently, the MA Exemption allows clients to invest without a prospectus as long as the transaction is $150,000 or more. It’s been useful for people who don’t qualify as accredited investors.

CSA wants to forbid individual investors from using the exemption. “[T]he threshold of $150,000 … may not be a proxy for sophistication or ability to withstand financial loss for individual investors and may encourage over-concentration in one investment,” says the proposal document.

If the changes are approved, Tardif explains, individual clients will have to meet accredited investor thresholds to invest without a prospectus.

“What I’m hearing,” says Han, “is that it’s unlikely these amendments will be republished.” In other words, expect them to go through.

Cover your bases

If clients want to make investments under the AI Exemption, make sure they qualify as accredited investors before you sign off, says Philippe Tardif, a partner at Borden Ladner Gervais in Toronto. You can’t just ask them if they’re accredited.

Instead, ask “a potential purchaser questions about their net income in the past two years and expectations of net income in the current year,” says CSA.

Tardif notes advisors should keep records of how they determine clients meet the requirements. “If the investor has $1 million with the advisor, there’s no need to look further.” But if there’s even the slightest doubt a client qualifies, the advisor should require him or her to provide income and other records.

“That will reduce the risk,” says Tardif, “of a regulatory complaint or of a claim by the client in the event the investment is not successful.”

Originally published in Advisor's Edge Report

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