Fees: Regulator asks for more money

For issuers, the hike is to be even heftier, as their fees are set to rise by 15.5% a year. The higher increase in issuer fees reflects an effort to allocate costs more evenly between issuers and dealers.

The proposed fee increases seem particularly large at a time when inflation is running at exceptionally low levels; the latest reading puts annual consumer inflation rate at just 1.3%. And the OSC’s proposed fee increases come at a time when the securities industry is still trying to shake off the lingering effects of the global financial crisis.

According to the latest data from the Investment Industry Association of Canada (IIAC), much of the industry is struggling. In the second quarter (Q2), total industry operating revenue dropped to its lowest level since the fourth quarter (Q4) of 2008, which was the height of the financial crisis. And quarterly operating profits have fallen in Q2 2012 to just $510 million _ down from $1.2 billion in both the previous quarter and the same quarter a year ago. In fact, operating profits for Q2 were even weaker than in Q4 2008, when global financial markets had completely seized up.

Moreover, the pain is not being felt equally. The IIAC data show that the large, integrated dealers accounted for more than 100% of industry operating profits in Q2; the rest of the industry is losing money. Institutional firms barely broke even in Q2, generating a collective profit of just $1 million. Whereas retail firms, collectively, lost $11 million in the quarter, that figure was nevertheless an improvement from the prior quarter, when they lost an aggregate of $20 million.

In this climate, it’s not surprising that firms would be aghast at the prospect of any cost increase, let alone a planned annual increase of almost 8% over the next three years. However, that headline number comes with a couple of important caveats.

For one, not all firms will be facing the same increases. The OSC is proposing changes to its fee model to try to limit the impact on the smallest firms. Currently, firms are divided into tiers based on annual revenue, with fees assessed by tier. (The same format applies to issuer fees, based on market capitalization.) So, in order to reduce the impact of the fee hike on the smaller firms, the OSC is proposing to split the lowest tier into two _ with those companies that fall into the new, lowest tier actually seeing their fees decline year-over-year.

According to the OSC’s proposal, firms with less than $250,000 in annual revenue would see their annual fees drop to $800 from $1,035. And fees for those with annual revenue between $250,000 and $500,000 would remain unchanged in the first year.

Firms in the lowest tier would enjoy lower fees for each of the next two years before their fees rise back above the current level (to $1,060) in April 2015.

For issuers, the cut-off would be $10 million in market cap, with firms below that threshold paying lower fees in 2013 and 2014, which wouldn’t rise above the current level until 2015. The fees of firms with market caps in the $10 million-$25 million range would have their fees remain the same for 2013, then their fees would rise in each of the next two years.

These measures are expected to spare about half of the firms from the increases that their peers will be paying. The OSC indicates that about 55% of registrants and 45% of issuers will be paying the same or lower participant fees in the year ahead. It’s the firms in the higher tiers that face annual increases over the next three years.

Moreover, these hikes would be higher than otherwise because of previous efforts to restrain fees. In order to cushion the impact of tough market conditions over the past couple of years, the OSC has been operating at a deficit and tapping its accumulated reserves to absorb the rising cost of regulation without passing this cost on to the industry. The OSC’s fees were frozen for a year in 2009; and, over the past couple of years, the regulator has kept fee hikes lower, on a percentage basis, than its cost increases.

As a result, the OSC reports that total fees collected from market participants in fiscal 2012 were only 3.1% higher than in fiscal 2006. Over the same period, consumer prices have risen by about 12%; so, notwithstanding the perception that regulatory costs are rising inexorably, fee inflation has actually lagged overall consumer inflation. And, the OSC reports, participation fee rates for all issuers _ and most registrants with less than $3 million in annual revenue _ currently are lower than the rates charged in 2003, when the OSC first adopted its current fee model.

However, not only is the regulator looking to return its revenue to cost-recovery levels, it also is aiming to rebuild the reserves that have been depleted over the past three years. The OSC says it needs to increase revenue by 6.9% from current levels just to offset the current operating deficit. On top of that, the OSC assumes that costs will increase by 5% in each of the next three years. And the regulator aims to build its general reserve back up to $30 million to provide financial flexibility. The OSC’s surplus has been drawn down to just $7 million in recent years amid the efforts to prevent fee increases.

The OSC also is facing growing obligations _ particularly as international reforms have ramped up the regulator’s basic responsibilities.

In the past year, for example, regulators have taken on responsibility for the oversight of the credit-rating agencies. Regulators also are working on a new oversight framework for over-the-counter derivatives markets, which will broaden the perimeter of regulation even further.

In addition, there are market-driven changes that are driving costs higher. For one, the Sino- Forest Corp. debacle has highlighted the need for greater oversight of emerging-markets issuers. Regulators also are in the midst of considering whether they need to start regulating proxy advisory firms; a consultation on that subject runs until Sept. 21.

And the OSC also has assumed new responsibilities with the consolidation and integration of the trading and clearing business into the new TMX Group Ltd. This will require added oversight of trading, clearing, listing and market data fees, as well as ensuring TMX doesn’t abuse its new, for-profit monopoly of the clearing business.

The OSC has pledged that the added costs of supervising this new dominant force in the trading and clearing business will not be foisted upon the rest of the industry. Thus, the OSC is propos-ing two new categories of participation fees in order to reflect the rising costs of supervision in certain areas. One of the new categories covers the credit-rating agencies; the other captures entities such as exchanges, alternative trading systems, clearing agencies and trade repositories. The OSC also is proposing other new fees in areas in which the regulator’s workload has increased and, it says, more resources are needed.

The OSC also is planning to alter the basis on which it calculates fees _ shifting to using historical information from setting fees based on the projected size of issuers and registrants. The regulator suggests this change will increase the predictability of both fees for firms and revenue for the OSC.

As the OSC’s rule proposal explains: “Using this historical data will reduce the risk that the revenue from these fees will produce significant surpluses or deficits for the commission, and will assist market participants in their

cash-flow planning.”

However, the trade-off for increased predictability is less market sensitivity. Under the proposal, fees will be set for each full three-year fee cycle based on historical data (May 1, 2012, for the upcoming year). So, firms that see a decline in their revenue over the next three years will not see their fees go down, and firms that experience growth won’t have to face higher tariffs.

Comments on the OSC’s proposal are due by Nov. 21.

© 2012 Investment Executive. All rights reserved.