The world of securi-ties regulation can often be offensive to common sense. But securities regulation is perhaps at its most absurd when it bumps into the limits of the archaic silo structure of the financial services industry that inhibits effective investor protection. Principal-protected notes are a case in point.

Financial services companies have long since moved beyond the barriers that existed among their banking, securities and insurance segments. Yet the regulatory system is still, for the most part, stuck in those silos. The result is that regulators can find themselves confounded by products that cross the lines among sectors when the regulators themselves cannot.

For example, regulators have spent years grappling with the fact that mutual funds and segregated funds face dramatically different regulatory regimes, despite the fact that they are functionally equivalent from an investor’s point of view.

Regulators have made slow and tortuous progress toward a common point-of-sale disclosure regime for both products, but these fund products are still regulated very differently.

The latest cross-sectoral challenge is the phenomenon of PPNs. The popularity of these products has surged in recent years, as investors have sought the safety of guaranteed investments. In response, financial services firms massively expanded the range of underlying instruments geared toward delivering the notes’ promised returns.

Along the way, there have been some major accidents — most notably the blowup of Toronto-based Portus Alternative Asset Management Inc. Portus had garnered explosive growth by offering small retail investors hedge fund exposure through PPNs.

Moreover, some fundamental concerns have been raised: the suitability of these products for many investors, the value of the guarantees PPNs provide, the transparency of the underlying fee structure, the quality of disclosure they offer and the role they play in exposing retail investors to liquidity and market risks those inves-tors probably don’t understand, among other things.

Regulators first sounded the alarm in the spring of 2005, when the Investment Dealers Association of Canada (predecessor to the In-vest-ment Industry Regulatory Organization of Canada) red-flagged the use of PPNs to deliver complex, expensive products such as hedge funds to ordinary retail investors who otherwise wouldn’t have been able to purchase them.

The Canadian Securities Administrators chimed in during the summer of 2006, issuing a notice and investor alert about PPNs. At the time, the CSA noted: “Many types of PPNs are more complex and pose more investment risks” than what had been contemplated when securities legislation was enacted that had excluded financial services institution deposits and had exempted guaranteed-debt instruments from securities regulation.

In some ways, this CSA notice foretold the asset-backed commercial paper debacle. ABCP is another example of a deposit product that was once quite simple but came to be linked to an increasingly complex basket of underlying assets. As a result, ABCP became riskier and harder to understand for both dealers and their clients.

An investigation by IIROC published last year found that dealers and advisors treated ABCP products as simple deposit instruments and ignored the increasing complexity of the assets underlying the paper. Consequently, IIROC found, dealers and advisors also ignored their suitability and product due diligence obligations.

Although regulators have been alert for some time to the growing risks posed by PPNs, the fact that these notes are one of those cross-sector conundrums has left them struggling to ensure comprehensive investor protection. Although some PPNs walk and talk like securities, they have historically been considered deposit products and, therefore, are under the purview of banking regulators, not securities regulators.

The result is that investors receive regulatory protection based on the packaging, not the underlying product.

The federal government, to its credit, dealt with some of these concerns a couple of years ago in its annual budget, proposing a new disclosure regime for PPNs to be administered by the Financial Consumers Agency of Canada. That new regime took effect July 1, 2008.

In response, the CSA has indicated that most of its concerns have been addressed by this effort to improve disclosure. “We have reviewed the federal PPN regulations,” says a CSA notice published this past autumn, “and think that they impose significant disclosure obligations for PPNs.”

Additionally, the CSA reported that it would push the self-regulatory organizations (IIROC and the Mutual Fund Dealers Association of Canada) to ensure that know-your-client and suitability obligations apply to all dealings in PPNs by advisors who work for member dealers of the SROs.

@page_break@The IDA had already published a due diligence guide concerning PPNs for its members in the spring of 2007. In the summer of that year, the CSA noted that the IDA’s KYC and suitability obligations apply to its member firms and their reps, regardless of what sort of investment product was being sold.

Now, the MFDA has issued a notice indicating that it plans to propose amendments to its rules to ensure that PPNs are captured by its regime as well.

This notice, published in late January, indicates that the CSA expects the MFDA to enforce the KYC and suitability obligations on the sale of any PPN in all jurisdictions, whether or not it falls within the definition of a “security.”

“This would include PPNs that are deposit instruments currently sold by [reps] outside an MFDA member,” the MFDA notice notes; adding that the CSA believes these obligations should apply to all dealings in PPNs, including reps who are also bank employees.

To comply with the CSA directive, the MFDA plans to draft rule amendments to require the sale of all PPNs, including those by dually employed reps, to be conducted through the reps’ MFDA firms. The product sales — and the advisors making the sales — would, therefore, be subject to product due diligence, KYC and suitability obligations.

The MFDA’s staff is currently developing a discussion paper for consideration by its policy advisory committee ahead of the proposal of the necessary rule amendments. Paige Ward, director of policy and regulatory affairs with the MFDA in Toronto, indicates that the SRO expects to publish the proposed amendments “sometime this summer” and that the discussion paper would go to the committee sometime before that.

Ward explains that all investment products that are sold through an MFDA member dealer — including PPNs, whether or not they are considered securities — will be subject to KYC and suitability obligations under the MFDA’s rules.

The issue is that if PPNs are not considered securities, they can be sold outside the dealer under the MFDA’s current rules. Thus, Ward says, such sales could fall outside the securities regulatory regime, thereby avoiding KYC and suitability obligations.

“Our authority to require KYC and suitability when the investment is sold through the [member dealer] is not in question,” she notes. “The primary concern is not who is selling the PPN, but that securities-licensed individuals are selling PPNs outside a dealer without attracting KYC and suitability obligations.”

At the core of these proposed changes, then, is the question of just how to classify a PPN and how to determine what sort of business must go through an MFDA member dealer. Typically, advisors are required to put their “securities-related” business through their dealers. Other, outside business activities may not have to go through their dealers.

In the case of PPNs, however, the regulators are seeking to require that any business that involves products not considered to be “securities” be routed through the member dealer. Moreover, the MFDA is looking to bring only PPNs within advisors’ securities businesses. Other deposit instruments would not be affected, which highlights the questionable reluctance to define PPNs as securities.

The proposal may not go over well with certain segments of the MFDA world, which have long resisted the SRO’s efforts to pull more of their businesses under the securities regulation umbrella.

Historically, in the mutual fund dealer world, advisors have operated at a distance from their dealers and conducted a good deal of their business outside the dealers’ oversight. Rules that bring more of that business under the dealer’s purview and into the securities regulatory regime will increase the advisors’ administrative burden.

Moreover, it may put those advisors at a competitive disadvantage with reps who aren’t licensed to sell securities but are still be able to sell PPNs.

The issue could be dealt with more easily if the CSA were simply able to define PPNs as securities. Not only would that make it straightforward for SROs to impose suitability obligations on PPN sales, but disclosure would also be subject to the civil liability provisions of provincial securities legislation.

In addition, if PPNs were considered securities, they could be sold only by registered reps — and investors would enjoy some minimum standard of protection.

But if PPNs retain their status as deposits, individuals don’t have to be registered to sell them. So, efforts to ensure that registered reps’ PPN product sales go through their dealers may be somewhat futile if clients can simply be directed to purchase the notes from an unlicensed colleague.

Despite the fact that PPNs appear to function as securities, regulators have proven reluctant to try to claim that ground. “The CSA has not expressed a view as to whether or not PPNs are ‘securities’,” an official at the Ontario Securities Commission says, by way of providing background.

The official adds: “The CSA has advised that all MFDA members and approved persons must comply with KYC and suitability obligations in selling all types of investment products, including PPNs.”

Between the federal government moving to improve the PPN disclosure system and the SROs tightening the sales compliance regime, the CSA believes that its concerns about the use of PPNs to package exotic investment products for unsophisticated retail investors will be assuaged.

However, the price for maintaining the distinction between a “security” and a “deposit” is that investors and clients are likely to be subject to confusing, divergent levels of protection.

Given the echoes of the ABCP debacle, this raises the question of whether policy-makers have really learned the hard lessons of the ABCP episode. In the case of PPNs, regulators have at least recognized the risk facing investors — and they have spent a good deal of time sounding an alarm.

What they seemingly haven’t been able to come to grips with, however, is ensuring adequate investor protection within the confines of the present regulatory structure, which insists on increasingly dubious distinctions between financial products from different sectors. IE