Hopefully, it’s just an honest mistake—a $1.2-million-dollar mistake.

But as the OSC continues to investigate the record-keeping discrepancy of the principal protected notes (PPNs) distributed by Pro-Financial to several investment dealers, questions remain about what really happened.

And the inconsistency isn’t just an issue of administrative hoopla. For investors, it means the money held in trust to meet outstanding obligations for the nine series of PPNs issued by Société Générale Canada and BNP Paribas Canada is short by $1.2 million.

In December, regulators said they’d give Pro-Financial’s record-keeper, Investment Administration Solutions Inc. (IAS), access to Pro-Financial’s reconciliation report to help resolve the issue.

But the assets remain frozen, per the OSC’s directive. PPN unitholders are barred from making early redemptions, and can’t redeem the funds even at maturity.

Pro-Financial sold the nine series of PPNs from mid-2003 to early 2007, according to regulatory documents. The PPNs have maturity dates ranging from December 2010 to October 2016. Separately, Pro-Financial is also under regulatory scrutiny for its working capital deficiency of $724,746 as of October 31, 2013 (see “Capital deficiency dilemma”).

“[Investors] need to keep an eye on this and follow up to understand how the reconciliation process is going,” says Marsha Gerhart, counsel at the securities and investment management group of Toronto-based BLG.

While Pro-Financial may be the PPN distributor, the issuers are responsible for paying the outstanding obligations, says Gerhart. She advises affected investors to stay in touch with those banks to ensure they’re taking
appropriate steps.

The case of Pro-Financial isn’t isolated: in 2006, the OSC ceased trades of Juniper Fund Management for several regulatory breaches, including improper recordkeeping.

Pro-Financial issued its own reconciliation report to the OSC in November, but the report, along with testimonies and other documents, remains confidential.

The OSC’s rules of proceedings says documents filed in evidence in proceedings shall be available to the public, but parties involved can request confidentiality before regulators, or the OSC’s panel can restrict public access if it
deems appropriate.

Larry Boyce, senior vice president at regulatory consulting firm Sutton Boyce Gilkes and former business compliance official at IIROC, says it’s not unusual for regulators to maintain confidentiality until matters are resolved. He also said the resolution timeframe depends on the nature of the case, and legal officers usually handle more than one case at a time.

The OSC is still reviewing the reconciliation report submitted by Pro-Financial in November. At a January 21 hearing, regulators said selling the management contracts of Pro-Financial’s index funds would address the capital deficiency issue, but approval of that sale is pending. The regulators reviewing that transaction also want the potential buyer to have access to the confidential documents, or excerpts from them.

Next steps

It’s unknown whether the $1.2- million shortfall affected the protected or the yield component of the PPNs (see “How PPNs work”) that went missing. And the loss amount for investors is also unconfirmed. A spokesperson from BNP Paribas declined to comment on the issue, and a spokesperson from Société Générale did not return a call for comment.

Pro-Financial’s CFO, Samantha Pinto, says the company issued a notice to dealers regarding the notes in December 2013, but declined to comment further due to the regulators’ confidentiality order on the case.

“Pro’s number one goal has been to resolve the issues surrounding the notes so that investors, who have been very patient, can be paid as soon as possible,” Pinto says in an emailed statement. “We do not believe that IAS will be able to add any significant value to the reconciliation report.”

When asked how the company has been working on its capital deficiency, Pinto says it entered into a transaction to sell the management contracts of the Index Funds and separately managed accounts to a new entity.

She declined to elaborate about the deal. But in October 2013, Pro-Financial announced an agreement to sell management contracts of a slew of index funds to Kingship Capital Corporation for an undisclosed sum. Regulatory documents say the firm has not rectified its working capital deficiency to date, but Pinto stressed investors’ money in the funds remains intact and untouched. OSC has suspended the firm from acting as an exempt market dealer, and has also put certain restrictions on its role as a portfolio and
fund manager.

Registered securities firms must meet their working capital requirements to keep their registration in good standing, according to the OSC’s latest annual summary report for dealers, advisors and investment fund managers. Their excess working capital can’t be less than zero for two consecutive days, and if it does fall that low, regulators expect firms to fix the problem within 48 hours.

Firms may resolve the deficiency by injecting fresh capital into or subordinating any long-term related-party debt.

OSC doesn’t disclose the number of firms that have had capital deficiencies, but in its 2013 report, the regulator notes the problem as a key trend from its recent compliance review. OSC adds some registered firms do not always maintain sufficient working capital, and some do not notify the regulator when their excess working capital is less than zero.

Boyce of Sutton Boyce Gilkes says being capital deficient doesn’t necessarily mean there’s misuse of customer funds (although that’s one issue regulators will be looking at). But he adds a firm’s ability to keep going in the face of capital deficiency will be in question, particularly its ability to manage funds and keep up with its responsibility to investors. And if a firm is unable to correct the deficiency, normally immediate action would be taken.

Gerhart agrees. Capital deficiency may not mean the firm is in trouble, but it’s an indicator of potential risk. “It’s an early warning,” she says. The minimum working capital for an investment dealer is $50,000, so a capital deficiency of more than $726,000 is considered huge, Gerhart adds.

But even with Kingship Capital Corporation’s help in resolving Pro-Financial’s deficient capital, the PPN issue remains, she adds.

Evelyn Juan is a Toronto-based financial writer.

Originally published in Advisor's Edge Report

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