IIROC'S restricted dealer member proposal
On July 12, 2012, the Investment Industry Regulatory Organization of Canada (IIROC) released a concept proposal to create a new "Restricted Dealer Member" category. The IIROC proposal follows a concern that registrants in the Exempt Market Dealer (EMD) category—in particular, broker-dealer firms registered in the United States (US)—were offering full brokerage services to Canadian investors without the regulatory apparatus and oversight provided by IIROC. This concern was raised in September, 2011 by the Canadian Securities Administrators (CSA) in Staff Notice 31-327 Broker-Dealer Registration in the Exempt Market Dealer Category.
Concurrently with the IIROC proposal, the CSA released a notice stating that they had asked IIROC to consider a framework of oversight for these brokerage services (see CSA Staff Notice 31-331 Follow-up to Broker-Dealer Registration in the Exempt Market Dealer Category).
In general, the EMDs offering these services are already regulated in the US by the Financial Industry Regulatory Authority (FINRA). FINRA sets capital requirements, insurance requirements and other investor protection with respect to investment dealers. The IIROC proposal aims to transition existing EMDs offering brokerage services into Restricted Dealer Members of IIROC in a manner that recognizes foreign regulation under FINRA. The IIROC proposal is predicated on co-operation and information sharing between IIROC and FINRA.
Most Canadian brokers are regulated and registered as "investment dealers" by IIROC. To be a member of this category one must be a Canadian firm that meets certain capital requirements. Members are fully regulated, but can generally deal in any type of security with any client. The "international dealer" exemption from the dealer registration requirement is open to foreign firms and allows them to deal with "Canadian permitted clients" in foreign securities in specified circumstances. The exemption is described in the CSA's National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103). The qualification to be a permitted client is quite limiting; for example, individuals need $5M in financial assets and corporate or other entities must have net assets of at least $25M. The restriction to dealing only in foreign securities generally prevents international dealers from participating in basket trades that include Canadian securities, which is a serious impediment to cross-border investment.
The EMD category was created in 2009 by NI 31-103 to regulate companies that deal with exempt investors (those investors who are not required to receive a prospectus under securities laws). An EMD firm can trade in any type of security with "accredited investors," as defined in National Instrument 45-106 Prospectus and Registration Exemptions (NI 45-106). This group is more expansive than persons who would qualify as "Canadian permitted clients." Accredited investors include individuals whose income exceeds $200K in each of the two most recent calendar years and who reasonably expect to exceed that level in the current year. EMDs are also subject to capital and insurance requirements, but are not subject to IIROC rules and may be incorporated/formed outside of Canada.
As both the IIROC proposal and CSA Staff Notice 31-327 point out, when you combine the fact that under NI 31-103 an EMD can trade in any security that is subject to a prospectus exemption with the fact that EMDs are applying to the CSA for, and in certain cases being granted, exemptive relief that increases the scope of the services that they can provide to accredited investors, you have a situation where EMDs can provide accredited investors with full brokerage services. The view of the CSA, however, is that the EMD category was not intended to allow EMDs to engage in brokerage activities, and is considering registering those who do as restricted dealers. According to the IIROC proposal, approximately 22 firms registered, or seeking registration, as EMDs or restricted dealers are offering brokerage services to accredited investors, and 11 of these firms have obtained a CSA exemption from Section 13.12 of NI 31-103 that allows them to lend money, extend credit or provide margin to a client. These firms are primarily registered in the US and are regulated by FINRA.
IIROC proposes to create a new class of IIROC dealer member, the Restricted Dealer Member. This new category will allow a firm currently acting as an EMD or a restricted dealer to become an IIROC dealer member. Broker dealer firms that are members of FINRA in the US will be able to seek cross-membership with IIROC. One issue that remains to be decided is whether entrance to the Restricted Dealer Member class will be limited to existing EMDs or will be open to new entrants as well.
In order to become an IIROC Restricted Dealer Member, firms must apply for investment dealer registration under provincial securities law, and they will no longer be permitted to be registered as an EMD or a restricted dealer. Restricted Dealer Members cannot otherwise be participating organizations in a Canadian marketplace overseen by IIROC. Also, Restricted Dealer Members will not be permitted to rely on the international dealer and similar international adviser exemptions in NI 31-103.
(a) limit on the type of client
Restricted Dealer Members will be limited in the type of "Retail Customers" with whom they are permitted to deal, but the precise scope of "Retail Customers" is a question on which IIROC is seeking comments from stakeholders. IIROC has indicated that the current threshold for EMD clients, "accredited investors," may be too permissive. The IIROC proposal seeks feedback on appropriate restrictions and has suggested three possible client groups: "accredited investors," "permitted clients," or retail clients with assets that have an aggregate realizable value—before taxes but net of related liabilities—that exceeds $10M. This third, more stringent, group is consistent with the definition of "high net worth individuals" in IIROC's definition of "Institutional Customer."
Restricted Dealer Members will be exempt from complying with some of IIROC's financial operations requirements; instead, they will be required to comply with applicable FINRA requirements that have comparable regulatory principles and outcomes. In particular, Restricted Dealer members would be exempt from certain requirements for financial reporting (IIROC Dealer Member Rule 16.2), minimum capital (IIROC Dealer Member Rule 17), and minimum insurance coverage and margin, provided that they comply with the comparable FINRA requirements. Restricted Dealer Members would be subject to all other IIROC rules and oversight, and must undertake to provide IIROC, upon demand, with complete copies of the books and records that the firms are required to maintain in accordance with their membership agreements with IIROC.
(c) qualification requirements
In order to qualify as a Restricted Member Dealer, a firm must be: (1) an entity formed under US federal or state law; (2) a member of FINRA; (3) a member of the Securities Investor Protection Corporation (SIPC);1 and (4) registered under US securities laws in a category of registration allowing it to carry on investment dealing activities in the US comparable to its investment dealing activities in Canada.
Furthermore, a Restricted Dealer Member: (1) would not be allowed to participate in the Canadian Investor Protection Fund (CIPF); (2) must explain to its Canadian clients the material differences between CIPF and SIPC coverage; (3) would be prohibited from acting as a carrying broker for a full Dealer Member;2 (4) must have its head office or principal place of business in the US; (5) must have more than 50% of its securities owned by foreign entities or residents; and (6) must conduct activities that are consistent with its membership agreement with FINRA.
(d) limit on the amount of Canadian business
The IIROC proposal requests feedback regarding a new threshold for maximum Canadian business activity. If the Restricted Dealer Member engages in more activity than what is permitted, the firm would be required to transition into a full IIROC Dealer Member. Whether such a threshold is appropriate and what measure is an appropriate basis for the threshold are questions for which IIROC is seeking comments from stakeholders. Three sample limits are included in the IIROC proposal: (1) a prescribed number of Canadian clients; (2) a prescribed percentage of gross revenue derived from investment dealer activities in Canada; or (3) a prescribed percentage of gross revenue from Canadian residents in respect of Canadian securities. An example percentage of 5% is given for the second and third prescribed limits.
(e) comparison to existing restricted dealer registrations
Some firms engaging in brokerage activities are currently "restricted dealers" with the CSA. These firms have two main restrictions imposed upon them that limit the type of clients they may have and the extent of their Canadian business activities. Under the current regime, restricted dealers are limited to "permitted clients" and to a threshold of 10% of gross revenue from Canadian resident clients in respect of Canadian securities. The example client limits for the new Restricted Dealer Member class span a range that includes a broader base of potential clients (e.g., "accredited investor") and a narrower base of potential clients (e.g., $10M net asset test). The example tests in the IIROC proposal include setting a limit of 5% of gross revenue derived from Canadian residents in respect of Canadian securities. This reduced limit may suggest an intention to further restrict the amount of Canadian activity US broker dealers undertake.
3. transitional matters
Existing EMDs that are regulated by FINRA would be transitioned in a staged fashion. Client-facing approved persons would be given one year to complete IIROC proficiency requirements, while other approved persons would generally be grandfathered. New applicants to the Restricted Dealer Member class would have to meet IIROC proficiency requirements as set forth in Dealer Member Rule 2900, one requirement of which is that client-facing persons pass the Canadian Securities Course. Exemptions may be sought on a case-by-case basis for individuals with previous experience or similar education.
4. next steps and comments
The Restricted Dealer Member class is an attempt to allow FINRA-regulated firms to participate in Canadian markets within a limited scope of business activity. Both the IIROC proposal and CSA Staff Notice 31-327 contain an acknowledgement that the previous attempt to allow foreign dealers to engage in limited Canadian activities led to disparate requirements between various categories of dealers. Both documents also suggest that IIROC is in the best position to provide an integrated regulatory scheme for firms already regulated by FINRA. Whether the "restricted dealer member class" is a stop-gap measure for existing EMDs or becomes open to new entrants remains to be seen. IIROC is accepting comments on the proposal until October 10, 2012.
by Shahen Mirakian and Paul Pereira
1 SIPC must insure against loss due to insolvency of any Canadian client assets held by a Restricted Dealer Member.
2 A Restricted Dealer Member would, however, be allowed to act as a carrying broker for another Restricted Dealer Member.
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a cautionary note
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
© McMillan LLP 2012