Regulators aim to close loophole

The prospect of EMDs providing brokerage services was not the regulators’ intent in creating the EMD category, which was designed to enhance oversight of firms raising capital in the exempt market. However, the existence of EMDs that provide such services has created a fundamental regulatory concern: clients being served by these firms are subject to a lower standard of investor protection, including no supervision by a self-regulatory organization (SRO) and no contingency fund coverage.

This apparent form of regulatory arbitrage was first flagged by the Canadian Securities Administrators (CSA) in the autumn of 2011, when they issued a notice indicating that they were concerned about EMDs (primarily U.S.-based broker-dealers) providing brokerage services without IIROC oversight.

However, rather than simply close this apparent loophole, the regulators decided to try to come up with a solution that would nudge these firms toward full IIROC oversight rather than forcing it on them.

This past summer, IIROC issued a concept paper that proposed the creation of a new registration category – the restricted dealer – which would require these firms to adhere to certain IIROC rules but allow them to continue following U.S. rules for matters such as capital, insurance and margin requirements. The idea was to create a halfway point between operating as an EMD with no SRO supervision and coming under full IIROC oversight; the hope was that this would ease the concerns about regulatory arbitrage without scaring these firms out of Canada.

However, the IIROC proposal met with sharp criticism from the Canadian securities industry. Now, IIROC’s notice announcing its decision to drop the idea says the feedback the regulator received “resonated,” and it has concluded that the proposal is “not a viable path forward.”

Instead, the regulators now will pursue the obvious solution: close the loophole that allowed this situation to arise. Thus, the CSA will propose amendments to the registration rules to restrict the activities that EMDs can engage in and require that brokerage activities be carried out through an IIROC dealer.

The CSA notice indicates the regulators will be publishing proposed amendments to the registration rules later this year. In the meantime, EMDs offering brokerage services will be allowed to continue until the new rules take effect. However, the CSA notice suggests that such EMDs should start thinking about whether they want to transfer their brokerage activities to an IIROC firm, get out of the brokerage business and just act as an EMD or utilize the international dealer exemption.

Although this new approach was always the most straightforward solution, regulators initially tried to come up with a compromise because they were reluctant to push firms out of the Canadian market – even firms that were operating in a way that created regulatory concerns.

IIROC previously said it believes the Canadian market benefits from the presence of these U.S. dealers because they provide potential benefits to investors, including lower transaction costs, access to a broader range of products, increased diversification and better cross-border integration.

However, that’s not the way much of the Canadian securities industry sees it. Comments submitted regarding the regulator’s initial proposal last autumn argued that setting up a new category for U.S.-based EMDs offering brokerage services would entrench an unlevel playing field, with some firms subject to full IIROC oversight but others operating in this new restricted dealer category.

In particular, many comments complained that these firms in the new category would benefit from less restrictive U.S. margin rules, which, in turn, brings the soundness of Canadian rules into question. If U.S. rules are good enough for some firms, why shouldn’t all Canadian firms get to follow them?

Canadian dealers also complained that the proposal was unfair, in that the new category would be open only to U.S. firms, not Canadian EMDs; and that U.S. regulators were not offering reciprocal access to their markets under a similar arrangement.

These concerns about fairness, competition and a level playing field are particularly significant at a time when much of the Canadian industry is struggling to make money. Indeed, the latest industry data indicate that only the large, integrated dealers and foreign institutional firms have been profitable in the past couple of quarters. The prospect of entrenching a competitive advantage for U.S. dealers at this time was just poor timing.

Lucy Becker, vice president public affairs with IIROC, says that it was this sort of feedback on the proposal that guided the regulator’s call: “Our decision was based on themes that emerged relating to concerns about perpetuating an unlevel playing field, insufficient comparability between Canadian and U.S. compliance rules, and lack of reciprocity.”

The recent bankruptcies of several U.S. firms over the past couple of years, she adds, didn’t factor into IIROC’s decision.

@page_break@ Not only did the Canadian industry object to IIROC’s plans, but investor advocates weren’t happy with the idea, either. The Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) for example, argued that clients dealing with U.S. firms without full IIROC registration face a number of disadvantages, including: no access to dispute resolution through the Ombudsman for Banking Services and Investments; no coverage for their accounts under the Canadian Investor Protection Fund; and their ability to sue in a Canadian jurisdiction would not be clear.

Having the industry and investor advocates on the same side for once makes simply outlawing this form of arbitrage an easier call for regulators, as far as the domestic audience is concerned. What remains to be seen is how the affected U.S. firms respond.

Although the Canadian industry and investor advocates agree that the restricted dealer proposal was a bad idea, the U.S. industry argued that the IIROC proposal was unnecessarily restrictive to U.S. broker-dealers, warning that the proposed category would further cement the idea that Canada is becoming a tougher place to do business for foreign firms.

More generally, this episode brings into question the extent to which regulators may be able to defer to one another in order to facilitate cross-border access. Mechanisms of this sort – known as “substituted compliance” and “mutual recognition” – have become particularly important in the past few years, as regulators have undertaken reforms in response to the financial crisis and have sought to ensure some level of cross-border harmonization amid increasingly globalized markets.

IIROC had indicated in its original proposal that it believed U.S. regulations are based on principles and outcomes comparable to Canada’s regulations. Now, IIROC has concluded that is not the case.

BCSC policy to favour EMDs

Regulators are planning to take business away from exempt-market dealers (EMDs) on one hand by outlawing their brokerage efforts while also diverting new business toward EMDs on the other hand, as the B.C. Securities Commission (BCSC) continues to consider whether to scrap its registration exemption for private placements.

In early January, the BCSC proposed to do away with the so-called “Northwest exemption,” which allows firms to raise capital for issuers in the exempt market without being registered. The comment period for that proposal was slated to expire in early February, but the BCSC has extended it to the end of the month in response to industry requests for more time.

Several comments already have been submitted, though, most of them from firms operating in the mortgage-investment sector that are asking that the BCSC preserve the current policy. (The BCSC is proposing to revoke their registration exemption, too.)

According to one of those comments, EMDs already are looking at the proposed change as a business opportunity. But the mortgage-investment firms say that funneling their deals through an EMD is unnecessary and will raise investors’ costs.

Investment dealers would like a piece of the action, too. The Investment Industry Association of Canada’s (IIAC) comment favours the BCSC’s proposal, saying that the other jurisdictions in Canada that currently offer similar registration exemptions for private placements should follow suit and revoke them.

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