Small dealers struggle under regulatory burden

“Financial scrutiny for small firms is over the top,” says a mutual fund dealer. “The regulators want to push us out of the business.”

That wasn’t the only comment to that effect. Translated into numbers, these remarks amounted to an average grade of 5.0 out of 10 for IIROC and the Canadian Securities Administrators and a 3.8 for the MFDA. Given these harsh scores, the question becomes: do regulators need to improve the way they address the gap between large and small firms? Or are these grades just a reflection of small mutual fund dealers still adjusting to the world of regulation?

“The majority of mutual fund dealers had never seen a regulator before the MFDA came on the scene,” says Larry Waite, president and CEO of the MFDA since its inception in 1998. Prior to the appearance of the MFDA, applying for membership, compliance reviews and reporting capital more than once a year were foreign concepts for most small dealers.

“There was a lot of anger and frustration,” says Waite. “And it was totally understandable, because their world was changing drastically.”

Not wanting to bother with all the “compliance stuff,” many small fund dealers came to the business decision in 2000 to operate as a subbranch of a larger dealership, which would take on the regulatory obligations. As a result, the MFDA member base now stands at 151 members, vs the 250 members it had in 2000 when it officially launched.

Regulatory burden isn’t the only problem for small dealers. Fees are pushing them out of business, as well, says Nelson Chang, CEO of Sterling Mutuals Inc., a mid-sized dealer based in Windsor, Ont. “There’s not much of a choice in the industry,” he says, “You need economies of scale to stay in business.”

Overhead costs such as liability insurance, back-office requirements and compliance staff are too high for many smaller players to shoulder alone.

“We’ve heard that from Day 1,” admits Waite. “But I don’t know where its coming from.” Fees are prorated, depending on a dealer’s assets under administration. Currently, firms with less than $500 million in AUA pay $3,000 annually to belong to the association. Firms with more than $500 million in AUA pay an additional $100 per $100 million in AUA to make up for the increased costs of regulating them. Of the 151 MFDA members, 58 pay $10,000 or less in annual fees.

The MFDA has also split its members into four levels, varying capital and insurance requirements for each, depending on levels of activity. A Level 1 dealer is classified as a firm that does not hold any client cash in trust, whereas a Level 4 dealer holds its client’s securities and funds on-site. The higher the level, the higher the fees.

IIROC also varies its annual fees according to the capital employed by the dealer-member plus a percentage of gross revenue for the preceding year.

While fee schedules are flexible, Chang says, it’s still not enough: “You need to have the staff to keep up with all the regulations.”

In a small firm, there’s usually the owner, who’s trying to do it all, making it even harder to keep up with the MFDA’s monthly capital reporting requirements. Dealers did approach the MFDA board about lessening the frequency of reporting.

“It was an issue that was heard and discussed at length,” says Waite. “But if a dealer is running into financial problems, you want to know about it. In the current climate, we shouldn’t lessen the requirement from monthly to quarterly.”

Perhaps a favourable balance between protecting the public interest and reducing the regulatory burden for small dealers can found be in the British Columbia Securities Commission’s “outcomes-based” approach to regulation. The BCSC was rated the best, receiving a 6.8 out of 10 for sensitivity for small firms by its members. As one dealer in British Columbia says: “I’m happy with the BCSC; it is the most progressive regulator. It’s one thing to say you are principles-based; it’s another thing to do it.”

@page_break@The positive feedback probably stems from the public commitment the BCSC made to outcomes-based regulation in 2000, says Sandra Jakab, director of capital markets regulation with the BCSC in Vancouver: “Everything we do here accounts for small- and big-firm presence.”

For the BCSC, this means being flexible in allowing dealers to meet new regulations in a variety of methods. For example, if there is a provincial rule that says a firm must review every trade at the end of day and a dealer has developed a sophisticated program for analyzing trade patterns, the regulatory objective has been met.

“We ask our staff to be always communicating with the industry,” says Jakab, “that we are open about different approaches to meeting [regulatory] objectives.”

This is increasingly important for smaller dealers. However, says Jakab, the BCSC will bend only so much for small firms on core regulatory obligations. This is especially true for succession plans for one-person shops, in which an owner’s incapacitation could prevent the firm from doing business.

IIROC addresses regulatory gaps between smaller and bigger dealers through its various policy advisory committees that allow members of all sizes to work together.

But what dealers really want to see is more small-dealer representation on the SROs’ boards of directors. IIROC was graded a 6.4 out of 10 for this; the MFDA received a 4.1. “They need to set aside seats on the board for smaller members,” says one IIROC dealer.

IIROC has four dealer-members on its seven-person board, ranging from small to large firms, as well as a variety of business models.

As for the MFDA, George Aguiar, president and CEO of Toronto-based GP Wealth Management, is the only mid-sized dealer on the MFDA’s board; the other five dealers on the board are from larger, Level 3 or 4 dealerships.

Waite accepts the member dealers’ complaints with a certain amount of pragmatism. “Com-pared to what it was in 1999 and 2000, when we first came on the scene, there’s been a huge improvement,” he says. “We’ve never been a trade association. Our overriding mandate is the public interest and not the interest of our members. There’s been confusion — and it’s still out there.” IE