(September 12, 2005) As the Ontario Securities Commission prepares to audit regulatory compliance among the provincially registered limited market dealers, many of those facing inspections are wondering what to expect.
Since first being required to register in Ontario, LMDs have enjoyed exemptions from many of the regulatory rules governing retail mutual fund dealers, for example. But under the current — read post-Portus — environment, a registrant need not even technically breach regulations to find themselves in trouble, says Ronald Kosonic, partner at Borden Ladner Gervais.
“I think we all realize now that Portus is much more than a hedge fund scandal,” Kosonic told the audience at Strategy Institute’s Limited Market Dealers’ Audit-Readiness Strategies symposium in Toronto. “Portus represented a wholesale failure of the distribution network and the regulators in protecting investors’ money.”
As a result, he says the OSC has “battened down the hatches,” taking away discretionary authority from its staff which used to grant waivers from existing regulation.
“They now have limited market dealers in their sights,” he says. “They decided to implement this risk assessment model sort of as their triage of registrants.”
He calls the current regulatory survey a “fishing expedition” to allow the regulator to refer questionable responses to its enforcement arm. At the same time, the survey offers the dealer insight into what the OSC is likely to focus on.
Suitability and transparency appear to be of primary concern. The sudden attention comes on the heels of the Portus case. Referral arrangements appear to be an area of particular concern. Even informal referral arrangements will likely draw regulatory attention, Kosonic says. For example, a well-connected client who is paid a finder’s fee for directing their HNW friends to the LMD could very well be considered offside.
Prema Thiele, another partner at BLG says such a peer referral would likely be seen as “an act in furtherance of a trade” by a non-registered person — the client. At the very least, Kosonic says the LMD should inform the new client of who is getting paid — and what they are receiving — based on the new client’s business.
Kosonic says the OSC survey indicates that LMDs can easily find themselves in a position of conflict of interest when they are promoting a fund they are selling.
“I think a lot of LMDs are going to be surprised to find out that not only is the fund your client, but that the people you are selling the product to are also their client and you have obligations to them too,” he says. “Do you really understand the difference between a product you sell as an investment dealer and a product you sell as a limited market dealer?”
Due to the fact they deal with accredited investors, limited market dealers have enjoyed exemptions from many rules contained in the Securities Act. Even the rules that do apply to LMDs went largely un-enforced. Now, regulations that have been waived may soon be enforced through the back door.
For example, under OSC Rule 31-503, Part 3.1, LMDs have been exempt from filing financial statements. But Kosonic says this exemption could soon be lifted, or the OSC could deem the LMD’s lack of record keeping as making the firm unfit for registration, and deny their renewal when it comes due.
LMDs are also required to develop, maintain and enforce a written compliance manual, giving their compliance officer the teeth they need to keep the firm onside.
“Compliance officers have to keep your registration record current,” he says. “You have an obligation to conduct due diligence on information being submitted by employees if they are individually registered.”
Firms that are registered as both LMDs and with the MFDA could face a higher standard in terms of client care, as they may have to demonstrate that they have a system in place to ensure clients understand they are buying a product other than a retail mutual fund.
Limited market dealers must ensure that their business cards indicate they are LMDs and the signage at their office must also reflect this.
There is one tricky aspect to this, however. The LMD is not allowed to advertise that they are registered as such with the OSC, as the regulators fear the client may take that as some form of endorsement.
“It’s a fishing expedition and part of it is that because its been unregulated for so long, we don’t know what they’re going to find,” he says. “Of course, every time they go on a fishing expedition they find lots of ‘great’ stuff. Hopefully they won’t use it solely as an enforcement thing.”
Filed by Steven Lamb, Advisor.ca, email@example.com