Self-Regulation Of Canadian Securities Markets

For nearly 20 years, securities transaction activities have been regulated by two industry-led Self-Regulatory Organizations (SROs): the Mutual Fund Dealers Association of Canada (MFDA), which oversees mutual fund dealers (except in Québec) and the Investment Industry Regulatory Organization of Canada (IIROC), which is responsible for oversight of all investment dealers and trading activity on debt and equity markets in Canada. There is no strict definition of “self-regulation” but generally it means that the industry will police itself subject to oversight by statutory regulators such as Canadian Securities Administrators (CSA). In the absence of a statutory national regulator, securities regulators from each of the 10 provinces and 3 territories in Canada have formed the CSA, an umbrella organization whose objective is to coordinate and harmonize regulation of the Canadian capital markets.

Proponents of self-regulation claim that it offers significant advantages over government regulation. They contend that self-regulation is more flexible, nimble, and more efficient. The effective performance of market surveillance by IIROC is cited as an example of effective self-regulation. A key benefit of SROs is that they are pan-Canadian. Canada’s Constitution makes it extremely difficult to establish a national securities regulator like other countries. Numerous attempts to create a national securities regulator have failed and the latest attempt, the Cooperative Capital Markets Regulatory System, is stuck in low gear. Even it would exclude key provinces like Alberta and Quebec.

Both IIROC and the MFDA are recognized as SROs and operate under Recognition Orders by each CSA jurisdiction. IIROC and its predecessor, the Investment Dealers Association of Canada, (IDA) (until 2008, it was also an industry lobbyist!), have been regulating investment dealers as a recognized SRO since 1995. Over the years, there have been calls for reform of the SRO framework ranging from the elimination of the SRO approach, to mergers, to creation of a super-SRO comprising all registered dealers in all registration categories. Most of the calls have been from industry participants who want to see reduced regulatory “burden” and maybe even less regulation altogether. The most recent wave of discussion spurred consideration of SRO reform from industry stakeholders and the Ontario Capital Markets Modernization Taskforce. Most of the industry discussion centres on framework, not foundation.

Industry participants decry duplicative operating costs for dual-platform dealers, which inhibit scalability and add costs that are passed on to investors. The industry argues that an IIROC-MFDA merger would have the practical effect of creating a “one-stop shop” investing experience, which would enable retail investors to access a wider range of products at one point of service, without having to open multiple accounts or sign contracts with multiple entities. With oversight of investment and mutual fund dealers housed under a single SRO, mutual fund dealers could provide greater client access to products such as ETFs, and dual-platform dealers could avoid the unnecessary duplication of back-office services. There appears to be consensus that the current two-SRO framework should be revisited, and that both IIROC and the MFDA should be replaced in the future by a single pan-Canadian SRO with a mandate to regulate, at the very least, both investment dealers and mutual fund dealers. Exempt market dealers (EMDs) and Portfolio Managers (PMs) would continue to be regulated by 13 regulators, at least in the intermediate term.

Investor advocates argue that while a simple merger would make the distribution model incrementally more efficient and less prone to some forms of regulatory arbitrage, it would not address several of the fundamental investor protection issues of self-regulation.

The elephant in the room really is SRO conflicts-of-interests. With pure self-regulation there is the temptation to use a facade of industry regulation as a shield to ward off more meaningful regulation, the tendency for members to use collective action to advance their interests through the imposition of weak rules and standards, light touch enforcement, a resistance to reforms in the regulatory environment and anti-competitive restraints as opposed to those justified by public interest needs. SROs are not subject to Freedom of Information legislation that allows the public to require the production of information. Unlike a statutory regulator, an SRO is not accountable directly to the government.

Critics of self-regulation are justly concerned that it is self-serving and too lenient on firms. In addition to the inherent conflicts-of-interest, the opponents of self-regulation point to its inefficiencies, including widespread collective action problems, lack of effective enforcement, inability to gain or maintain legitimacy, and, ultimately, the failure of accountability.

Investor advocates posit that SROs’ current practices in areas such as corporate governance, transparency, rule-making, compliance oversight, enforcement, complaint-handling and investor engagement are inadequate. These practices raise serious questions about the SROs’ level of commitment to regulate member firms, protecting investors and ensuring their interests and rights are protected. Investor advocates argue that if the regulatory system is to continue to rely on SROs, practices in all these areas must be dramatically improved.

According to a 8 September 2020 MFDA-sponsored investor survey, What Canadian Investors Want In A Modern SRO, three-quarters (76%) of respondents think conflicts-of-interest among board members who govern SROs happen frequently and are not declared or eliminated before making important decisions.

So, what specific beefs do investor advocates have with the SROs?

Given the inherent tension between operating in the public interest and operating in the interest of its members, self-regulation creates a reasonable apprehension of bias. SRO Board nomination practices have shown a tolerance for “independent” members with significant historical connections to the financial services industry. Some “independent” directors have had long industry careers. While these backgrounds may increase the likelihood that these representatives understand regulatory issues, this benefit comes with a risk that these representatives will naturally sympathize with industry more than public concerns and retail investor issues could be sidelined.

SRO governance and oversight framework need to be restructured to align better with the public interest and enable greater stakeholder engagement and input. There needs to be more public interest directors (including consumer representation) on the board of directors and the definition of “independent” needs to change so that the SRO board isn’t stacked with industry and ex-industry directors. The various SRO policy/standards committees/councils would also need to include investor representation. In a new, modern SRO, ”self” regulation would evolve to Co-regulation, meaning inclusion of all stakeholders, rather than just industry participants.

Too often we see settlement agreements where the salesperson has broken the rules over an extended period of time and no sanction is applied to the firm for weak systems, defective compliance monitoring and inadequate supervision. The individual is sanctioned but the firm evades accountability. The tolerance for adulterated account documents and signature falsification creates concerns about enforcement efficacy. Most importantly, investor compensation is not top of mind.

Low enforcement intensity and wrist-slap sanctions also have drawn criticism from the investor advocacy community. SRO hearing panels seem more focused on delineating mitigating factors to disciplinary measures and lowering fines than in identifying aggravating factors and increasing fines/sanctions. This contributes to a pervasive perception that the SRO is more concerned with protecting the industry than protecting the investing public and raises questions about deterrence effectiveness.

Discount brokers charged mutual fund investors millions of dollars for advice that they could not and did not deliver. This overcharging went on for 20 years despite multiple complaints to IIROC from investor advocacy groups. Several class action lawsuits have been filed by investors. In September 2020, the CSA finally intervened and prohibited the overcharging. Industry gained big; Main Street paid a heavy price for lax SRO enforcement.  

The infamous double-billing scandal illustrated just how deficient supervision and compliance systems were even among the largest financial institutions. The industry-wide overcharging of investors was a systemic compliance system failure. Overall, including the settlements involving overcharging, the OSC no-contest settlement program resolved over 15 cases, resulting in over $350 million being returned to investors collectively. Every major investment dealer overcharged their clients. The public do not understand why so many dealer supervisory and compliance controls failed and their failure remained undetected by compliance and regulators, some dating back to 2000.

In October 2019 IIROC published guidance advising its members to review their retail client account agreements and to change or remove clauses that absolve them of liability, or that were inconsistent with regulatory obligations. The guidance encouraged members to review and revise inappropriate limitation of liability clauses and to notify clients of changes. In upcoming examinations, IIROC said it would review agreements and would, in egregious cases, refer the matter for investigation and possible disciplinary action. This lame approach to dealing with a clear and present investor harm sends the wrong message to the Canadian public.

Complaint handling rules by SROs are not up to contemporary best practice standards. Stronger rules would help reduce the number of low-ball settlements and exploitive rejections for client compensation. Investor advocates have asked for firms to advise all clients of a representative to be notified when wrongdoing has been discovered, to use Ombudsman for Banking Services and Investments’ (OBSI) loss calculation methodology and to cease referring complainants to non-independent internal “ombudsman”. A new SRO would also need to prioritize investor compensation and include more robust provisions for the investigation of systemic issues.

Investor advocates have also been especially critical of the SRO’s disproportionate focus on individuals rather than firms in enforcement proceedings. The hard facts of the matter are that the vast majority of root causes for rule breaches can be traced back to the firm: these include poor advisor recruitment and training, advice—skewing incentives/inducements/commission grids for advisors, demanding sales quotas, deficient Know-Your-Client (KYC) /risk profiling tools, weak supervision, weak administrative control systems, poor compliance processes, all in a culture of sales production. In some cases, branch managers and supervision are compensated for branch sales putting their supervisory roles in a conflict-of interest. The result is that the person at the bottom of the pyramid—the advisor— takes the fall, not the firm.

When disgorgement of ill-gotten gains is ordered, the SROs retain any cash collected rather than return it to harmed investors. To its credit, IIROC recently announced it would pursue changes to its Recognition Order to permit the returning of disgorgements to harmed investors. Under a new SRO framework, the SROs would require both individual registrants and also the firms that employ them to disgorge wrongfully earned income.

Investors want an SRO that welcomes innovation and encourages competition. They seek confidence that systemic and root causes for recurring compliance and enforcement issues are being routinely investigated and resolved, rather than treated individually and symptomatically. Above all, investors must be able to trust the wealth management industry and its regulation.

Recent Developments

A number of ideas have come forward for improving the SRO foundation. One proposal includes an enhanced governance structure that would include a board of directors consisting of industry directors, CSA representation and a majority of independent directors, a longer cooling-off period for independent directors coming from the industry and enhanced CSA oversight. Other ideas include bringing all dealer categories, including EMDs and PMs, under a super-SRO.

The MFDA suggests that market surveillance responsibilities should be consolidated under the authority of the statutory regulators. IIROC proposes the consolidation of IIROC and the MFDA as divisions of a new SRO. IIROC suggests that rather than creating a new rulebook from scratch, it would be beneficial to both industry participants and the investing public to permit dual-platform dealers and representatives the flexibility to consolidate all of their regulatory oversight under one set of rules. The proposals would see the new SRO have a mandate including registration, business conduct standards, prudential matters, policy and rule development, and enforcement.

The Ontario Capital Markets Modernization Task Force proposals include an OSC veto on SRO publications, guidance or rule interpretations and on appointments of key personnel, implementing requirements for independent directors akin to the requirements for independent directors of public companies, a requirement that statutory regulators appoint up to half of the directors of any SRO and enhanced CSA oversight of SROs.

After an informal initial consultation, on 25 June 2020 the CSA published CSA Consultation Paper 25-402 “Consultation of the Self-Regulatory Organization Framework for Consultation” which ran to 23 October 2020. The CSA expect to have recommendations ready by mid-2021.

A core discussion point going forward will be the extent to which “self” regulation is necessary, desirable, and effective. Although the allure of ensuring a system of regulation that is consistent for all registrants, and, including all such registrants in a single SRO is enticing, the CSA would have to articulate the reasons why a super SRO regulator is better than other structures, while acknowledging any trade-offs made.

Canadians saving for retirement or their children’s education need and deserve a new SRO with more transparency, investor participation and focus on advancing the advice profession. Access to affordable trustworthy advice, robust investor protection and the public interest must be paramount under a new SRO. The CSA consultation represents a unique opportunity to fundamentally reshape how the retail investment business is regulated in Canada.

Ken Kivenko, PEng, President , Kenmar Associates, Etobicoke, ON (416) 244-5803, kenkiv@sympatico.ca, www.canadianfundwatch.com