Putting the cart before the horse

Such may not be the case in the brokerage industry. A 1992 Supreme Court of Canada decision held the broker to the standard in its internal compliance manual.

Why is the brokerage industry held to a different standard than other industries? In the brokerage industry, there is a regulatory duty to “establish and maintain adequate [italics mine] internal controls.”

Problems arise, however, when firms go further than what is required by law. Indeed, many brokerages establish internal controls that exceed the standard of “adequate.” The result is the industry gets ahead of the regulators and perhaps ahead of itself.

Look at the history of the new client application form. Before any regulation existed requiring the completion of the form, internal policy at many brokerage firms required the form to be completed for each client. This form protected the firm from disgruntled clients because it could be relied upon to prove that the broker gathered the necessary information from the client.

What a good idea!

In response, the Investment Dealers Association of Canada then added a requirement addressed to supervisors (Regulation 1300.2), which includes a duty to collect “at a minimum [italics mine] the information required by Form 2.” According to this regulation, the form must be updated periodically and the brokers cannot trade, even in the slightest way, outside the objectives set out in the form. If this regulation is contravened, both the broker and manager are hauled in by the IDA.

The IDA’s new client application form does not include a signature line for the client. But brokers have had difficulty proving that they met with the client, reviewed their objectives and obtained information from the client. To remedy this, firms added a signature line for the client and have amended internal policies to require each client to sign the form.

What will the IDA do? The IDA is considering the prospect of amending Form 2 to add a signature line and the regulations may be amended to require every client to sign the form. Now the broker may be charged with the obligation to have the client sign each form. If the form is not signed, this will be sufficient evidence to support a client’s allegation that the broker breached his or her regulatory obligations.

If internal policy is law, why wouldn’t the IDA simply rely on the existence of firm policy instead of revising its own regulations, bylaws and policies, particularly since these types of firm policies are a regulatory requirement?

Through its investigation, the IDA reviews the internal policies of an accused firm. If the firm did not ensure compliance with its own internal policies, and if that failure caused the breach of the regulation at issue, then the IDA factors that into the penalty. This process is consistent with the Supreme Court’s 1992 ruling in Sterling v. Varcoe, in which a sophisticated investor was wiped out by the October 1987 crash. He sued his broker and the brokerage firm for breach of fiduciary duty and negligence.

The court found in favour of Varcoe in negligence as the trading in his Sterling account did not comply with internal policies set out by the firm’s compliance manual.

There are situations in which the firms have no choice but to draft policies that not only enforce but exceed the regulatory requirements. (For example, in which the regulation specifically provides that it is the “minimum” requirement.) However, when the firm is not charged with the duty to exceed what is stated to be the “minimum” requirement, the firm should draft policies that simply fulfil the regulatory requirements.

Does it make sense for an industry’s internal policies to exceed those set by the regulators? Regulators rely on breaches of internal policies to prove negligence, and then amend regulations to conform to the industry standards. Is this putting the cart before the horse?

Ellen Bessner is a Toronto lawyer with Gowling Lafleur Henderson LLP, practising in the area of broker liability.