New custody rules for non-SRO registrants also introduced
Under a series of amendments to National Instrument 31-103 – Registration Requirements, Exemptions and Ongoing Registrant Obligations published on July 27, 2017, the CSA have banned exempt market dealers (EMDs) from participating in prospectus offerings in any capacity, including as underwriters and selling group members. The ban extends to securities underlying special warrants that are qualified by a prospectus and to the sale of prospectus-qualified investment funds. For prospectus deals, EMDs will be restricted to participating in a concurrent private placement, if any, meaning EMD clients will receive securities subject to a four-month hold rather than freely tradable securities under the prospectus. This is not the first time the concept of a ban was raised; similar amendments were first proposed in December 2013 but later withdrawn.
The Amendments are organized into four tranches, specifically "Custody Amendments", "Exempt Market Dealer Amendments", "Client Relationship Model Phase 2 Amendments" and "Housekeeping Amendments". According to the CSA, the Custody Amendments are intended to:
- Strengthen the Canadian client asset protection regime by enhancing custody requirements applicable to registered firms that are not members of the Investment Industry Regulatory Organization of Canada (IIROC) or the Mutual Fund Dealers Association of Canada (MFDA) (collectively, Non-SRO Firms). IIROC member firms and MFDA member firms will comply with the custodial regimes of IIROC or the MFDA;
- Impose detailed self-custody restrictions and qualified custodian requirements for client and non-prospectus qualified investment funds and address other potential intermediary risks when Non-SRO Firms are involved in the custody of client assets;
- Enhance due diligence and disclosure practices regarding client custodial arrangements; and
- Codify existing custodial best practices of Non-SRO Firms.
The remaining Amendments:
- Clarify, as noted above, the activities that may be conducted by EMDs in respect of trades in prospectus-qualified securities;
- Make permanent certain temporary relief granted by the CSA in May 2015 relating to the requirements for client reporting (the CRM2 Requirements) and also add guidance to 31-103CP regarding the CRM2 Requirements;
- Incorporate other changes to NI 31-103 of a minor housekeeping nature; and
- Set out specific guidance on client reporting requirements for firms that are only registered as EMDs.
The EMD trading ban stands in contrast to the recent trend toward an expanded exempt market through the introduction of a number of new prospectus exemptions as well as an exemption granted under the Amendments to allow advisers to trade in the securities of investment funds (including, as is the case today, those distributed under a prospectus) if the adviser or an affiliate of the adviser advises and manages the investment fund and certain conditions are met. The ban also seems out of synch with the MFDA's initiative to allow members to sell exchange-traded ETFs that qualify as mutual funds, subject to meeting proficiency requirements (MFDA Policy No. 8) that came into effect July 20, 2017. By creating greater access to ETFs, the MFDA seems to be fostering greater competition and consumer choice.
The Custody Amendments permit the use of multiple custodians to directly hold assets of a client or investment fund of a registered firm and allow for the use of a "foreign custodian" meeting the prescribed requirements of NI 31-103 where a reasonable person would conclude that using the "foreign custodian" is more beneficial to the client or investment fund than using a "Canadian custodian". The CSA advise that the rules are not meant to replicate the custodial requirements in other areas of securities legislation, including the requirement under National Instrument 81-102 – Investment Funds that, except in very limited circumstances, portfolio assets of prospectus-qualified investment funds must be held with a single Canadian custodian and cannot be held with a foreign custodian directly. Prospectus-qualified investment funds may only use foreign sub-custodians under the custodianship of a single Canadian custodian.
The Custody Amendments and related guidance also:
- Introduce more detailed client relationship disclosure information regarding the location and the manner in which client assets are held;
- Clarify the regime applicable to assets other than client cash and securities;
- Address the use of omnibus accounts by Non-SRO Firms; and
- Provide for certain limited exceptions in the case of book entry securities recorded in the name of the client or investment fund; cash and securities held for non-individual "permitted clients" (subject to written acknowledgement); and mortgages and customer collateral subject to prescribed custodial regimes.
Significantly, the Custody Amendments do not provide for any rule-based exemption that would carve out non-Canadian clients of non-resident registered firms from the application of the Custody Amendments. The CSA, however, note that they will consider granting exemptive relief on a case-by-case basis.
Future Custody Amendments
The CSA advise that future proposals to revise the Custody Amendments (including the terminology and the exemptions) may follow as a consequence of the CSA's ongoing policy work in respect of both the modernization of investment fund product regulation under NI 81-102 and derivatives regulation.
Remedial Amendments to International Dealer Exemption
The Amendments also fix a technical gap in the international dealer exemption to clarify that the exemption also applies to secondary trades in debt securities denominated in currencies other than the Canadian dollar or originally offered primarily in a foreign jurisdiction where no Canadian prospectus has been issued.
The Amendments, other than the Custody Amendments, are expected to come into force on December 4, 2017. The Custody Amendments will come into force six months later, on June 4, 2018. Canadian-registered EMDs should review their existing distribution practices to ensure timely compliance with these new business restrictions by year-end. Non-SRO Firms should also re-examine their existing custodial arrangements and begin the process of mapping out required changes to their custodial practices and related compliance procedures.
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