In the wake of a couple of high-profile blow-ups, regulators are taking a closer look at the murky exempt market. Different regulators, however, are taking very different approaches to revealing what they have found.

In late October, the Mutual Fund Dealers Association issued a notice to its members saying that its staff had “identified significant concerns” about referral arrangements between some MFDA members and Meridian Global Investors Inc. and Lake Shore Asset Management Inc.

Chicago-based Lake Shore, a commodity trading advisor, operates in Canada through its agent, Toronto-based Meridian, under an exemption granted by the Ontario Securities Commission in late 2003. Meridian is registered as a limited-market dealer and an investment counsel/portfolio manager.

The notice indicates the MFDA is concerned that fund dealers may be acting beyond the scope of their registration by referring clients to the two firms. The concern is that the referrals were for specific securities and, as such, the referring dealers could be considered to be acting in “furtherance of a trade” in securities they aren’t registered to sell.

“At the end of the day, the referral was for one product — units of a commodity pool,” says Karen McGuinness, vice president of compliance at the MFDA. “So, it’s really not a referral to an IC/PM for a managed account, in which the IC/PM would consider all sorts of products that the client would want to invest in and which it would manage on a discretionary basis. It was really only for the purpose of facilitating the sale of one product.”

Richard Kang, Meridian’s president, indicates that the MFDA notice is not indicative of any problem with the products or services offered by the firms; it is a reminder to fund dealers that their advisors may not enter referral arrangements that put them in the position of sending clients to buy specific securities that they aren’t registered to sell themselves.

The MFDA had issued a bulletin about single-securities referrals in the summer of 2005, warning that these arrangements may result in dealers and their reps giving advice beyond their registrations. The concern is that it is not clear where the responsibility to ensure suitability lies. The dealer could claim that, in making a referral, it is not involved in the trade, whereas the manager could claim that it is up to the dealer to assess suitability because the dealer has a more comprehensive picture of the client’s financial situation.

“In a situation in which the form of the arrangement is a referral but the substance isn’t — it’s the sale of a product — we advise members what our views are, right up front,” McGuinness says.

But the OSC’s views are not nearly as clear. In the same week in which the more recent MFDA notice was released, the OSC sent a report to Meridian outlining its concerns about the structure that Lake Shore and Meridian were using.

In response, the firms decided to shut down the arrangement and return any money that had been invested. In a statement to Investment Executive, Lake Shore explains that it operates in more than 45 countries, and “prides itself on having excellent relationships with the appropriate regulatory bodies in those countries. It is not Lake Shore’s policy to offer products or services that its regulators have problems with.”

It adds that, upon receiving the report from the OSC: “Lake Shore and Meridian concluded that a sensible course of action would be simply to discontinue the program and return investors’ money.”

A spokesman for Lake Shore declines to say how much money is involved, but says it is not significant in the context of Lake Shore’s total business.

That said, the spokesman adds, Lake Shore does not intend to pull out of Canada; it plans to do business in Canada in the future under whatever structure regulators deem appropriate for its products. It just wants to make sure that it understands what the regulators want and how to comply.

But divining what the OSC wants is not easy. The OSC — which has promised to improve investor communications and access to information in response to last year’s “investor town hall” — declines to elaborate on its concerns.

Understanding what the MFDA wants is fairly straightforward. “We are looking at other ones,” McGuinness says. “This isn’t the only one that has come across our desk about which we have concerns that it may be a product referral, vs a referral for a managed account. We are trying to communicate that to the industry, so that it is aware of what our interpretation is.”

@page_break@She stresses that it is up to dealers and product providers to ensure that their arrangements comply with both the spirit and the letter of the rules. In particular, when fund dealers refer clients to big, well-resourced firms — such as banks selling principal-protected notes — dealers may assume that the arrangement is in compliance with the rules. Dealers have to realize they cannot rely on anyone else to ensure compliance, she says.

Meridian’s Kang says the regulators are on the right track to look at the exempt market. In light of the growing popularity of hedge funds, PPNs and other products, regulators need to ensure that proper registration is being required.

“I work in the field, so it’s not nice for me to say that regulation should be increased. But something has to be done,” he says. Otherwise, he adds, the industry may face a bigger backlash.

Knowing that regulators are actively examining the field and may propose new rules, Kang will wait to see what they come up with. In the meantime, the regulatory environment remains murky. It would be helpful, he says, if the regulators reported what they have found so far, what they are looking at now and what their timeline is for getting new regulations in place.

Both the industry and investors would certainly benefit from that degree of transparency. But the OSC continues to maintain its veil of secrecy. IE