The echo from the implosion of Portus Alternative Asset Management Inc. will continue to be heard for some time.
Enforcement action against reps who sent it business is almost certain, and fundamental changes to the exempt market and referral business may be looming, too.

For the advisors who helped build Portus into a business with about $830-million in assets under management and 26,000 clients, there is certain to be some type of enforcement action. It’s unlikely that all of the reps or firms involved will face sanctions, but it’s almost certain that some will.
Regulators are looking at reps on at least three different grounds:

> whether they were carrying on securities-related business outside their dealer via referrals;

> whether some of the referrals to Portus constituted “acts in furtherance of a trade” and, therefore, to trading in products they weren’t otherwise registered to sell;

> and whether the products were suitable for the clients who ended up buying them.

Issues such as suitability and whether certain referrals constitute acts in furtherance of a trade are an open question, but it is clearly against the rules for advisors to carry on securities business outside their dealers. Indeed, that circumstance was the basis of the one enforcement case that has already been brought in connection with Portus by the Nova Scotia Securities Commission last August.

That case has yet to be heard, as the accused rep challenged the NSSC’s jurisdiction to enforce a by-law of a self-regulatory organization. Both the NSSC and the Supreme Court of Nova Scotia have struck down that challenge. The court issued written reasons in mid-June, essentially ruling that there’s nothing in securities legislation that bars the securities commission from exercising its enforcement power once it has delegated authority to an SRO, in this case, the Mutual Fund Dealers Association of Canada.

It remains to be seen whether the NSSC will
win that case. At this point, nothing has been proven. In the meantime, since the NSSC first brought seemingly innocuous allegations regarding an outside referral last August, the Portus affair has blown up into the biggest investigation of the MFDA’s relatively short history.

Much of Portus’s business — more than $500 million — came via referrals from mutual fund dealers. (The Investment Dealers Association of Canada has said only about $20 million was referred by its dealers.) The MFDA is investigating more than 60 dealers in connection with these referrals, and it’s looking at another 200 advisors who made referrals outside their dealers.

The investigation is still in its early stages, the MFDA says. Actual allegations are not likely until early 2006. And it’s far too early to determine how the cases might proceed.
For example, in the mutual fund market-timing case, the regulators divided up their actions neatly, with the MFDA and IDA going after the dealers, and the Ontario Securities Commission taking on the fund managers. All three got some Bay Street scalps for their office walls, and a healthy chunk of change back for investors. The Portus case may well be messier, as regulators try to sort out just who should be held accountable.

Take the question of suitability, for example. In the Portus case, it’s not clear who, if anyone, was responsible for checking suitability. As the IDA’s hedge fund report, released May 18, notes, the dealers may say they simply provided referrals and that it was up to Portus’s registered fund manager arm to ensure suitability. But Portus may claim it was the referring dealers’ responsibility because they had a full picture of clients’ finances and would refer only suitable clients.

Typically, the IDA report says, the firm taking the referral would review suitability. But in a case in which the firm making the referral is being paid for the referral, and the only purpose of the referral is to buy a specific product, the suitability obligation may fall on the referring dealer. “Otherwise, the client can easily conclude that both parties are ensuring suitability when neither may be,” it says.

The same question must be answered in determining whether the referrals constitute acts in furtherance of a trade. In an interview just before he left the commission at the end of June, OSC chairman David Brown said that the OSC is examining the whole business of referrals. “We need to understand whether referrals are part of the trade, or not,” he says.

@page_break@Brown suggested that the fees paid for referrals will be an important factor in determining whether a referral is considered part of a trade by regulators. “[In some cases], there are some fairly heavy fees being paid for the referral, and there are trailer fees being paid, so it’s hard not to think that there’s some service being provided, and that it’s not part of the distribution chain,” he noted.

The MFDA also appears to be following a similar train of thought. In early July, it issued a notice to its members stressing that regulators are coming to view referrals that are geared to specific securities as acts in furtherance of a trade. It notes that
although these arrangements are conceived as referrals, “it appears that they are not operating as such in practice. MFDA staff is of the view that when a referral is tied to a specific security rather than a general service, it is more likely to lead to acts in furtherance of a trade, and may serve as a means for members to sell a specific security through another party.”

Advisors who aren’t registered to sell the products they are referring to clients could be accused of acting beyond their registration. As a result, MFDA staff is cautioning members from entering into referral arrangements tied to specific securities, “as it will be difficult in such situations to monitor compliance to ensure that [the dealers] and their [reps] act within the limits of their registration.”

In the wake of the fiasco, the referral business from securities dealers has slowed considerably, if not stopped. The structured product business has slowed dramatically, too.

Although this is regrettable for firms that are affected, regulators are still trying to get a handle on a business they know relatively little about. No one can say definitively how much business is moved through referrals, who’s doing it and what products are garnering investor dollars. One of the greatest fears is that there could be other Portus-type disasters waiting to be discovered.

So, in an effort to close that knowledge gap, regulators are examining the business of referrals and the operation of the exempt market generally. They want to gauge how much of the securities business exists in the exempt market and the extent to which the mainstream industry is feeding that business.

Brown says that the OSC is looking at the way hedge funds have been repackaged and sold to retail investors and that it must consider whether it should rethink the definition of exempt distributions and exempt securities. He says that the OSC needs to understand the extent to which exempt offerings are being sold by registrants and non-registrants.

In mid-July, the MFDA initiated a survey of its members’ involvement in the sale of exempt securities and deposit instruments, and their use of referral arrangements. Responses to the survey are due Aug. 12.

The survey is being coordinated with the OSC’s recently launched survey of all limited-market dealers. The OSC plans to follow up its survey with focus groups and on-site reviews of selected firms come September. In the meantime, on July 8, the Canadian Securities Administrators published the latest version of its rule that aims to harmonize prospectus and registration exemptions. That rule is expected to take effect on Sept. 14.

The Portus case is also complicated by the sheer number of dealers and reps involved, and the multiple lines of enquiry that are ongoing. Regulators won’t be able to bring enforcement cases against dozens of firms and hundreds of advisors who may have breached securities rules. They are probably going to have to choose a handful of cases to prosecute, with the others simply receiving warning letters or something similar.

Apart from the looming enforcement actions, the industry also faces the prospect of client lawsuits, and the RCMP has confirmed that it has a criminal investigation into Portus underway.

In the face of this, the industry has a voluntary initiative underway to collect the fees that firms and reps earned by referring clients to Portus to serve as a possible restitution resource. Julie Clarke, senior counsel for Burlington, Ont.-based Berkshire Investment Group Inc. and its sister firm, Berkshire Securities Inc. says that about 50 firms are part of the industry effort and 23 of them (including both Berkshire firms) have signed an undertaking committing to the initiative.

The group is also seeking to co-operate with Northwater Capital Management Inc., the firm hired by Portus’s receiver, KPMG Inc., to serve as consultant on finding a replacement investment advisor for the existing Portus funds. According to the latest receiver’s report, on July 14, KPMG met with a working group of the industry committee (representatives from six dealers), to brief them on the receivership.

Although it’s unclear how Portus’s receivership will play out, dealers will, at least, have some funds set aside for client losses. Clarke says that the funds are being collected and administered by each firm individually. And, she notes, the initiative also shows that the industry doesn’t want to profit from a product that may have been misrepresented to it and its clients.

The firm responsible for the largest chunk of Portus referrals Manulife Financial Corp.
subsidiary, Manulife Securities International Ltd., has already pledged to make clients whole on their Portus investments. As a result, a planned class action suit against it has been dropped. IE