NIN 2000/27 - Proposed Conditions of Registration for Limited Dealers [NIN - Rescinded]
| Published Date: | 2000-06-30 |
|---|---|
| Effective Date: | 2000-06-29 |
Proposed Conditions of Registration for Limited Dealers 1
1 Section 6(2) of the Securities Rules describes the sub-categories of limited dealer. Essentially a limited dealer is any dealer other than a broker, investment dealer or securities dealer.
Commission staff are seeking comment on proposed new conditions of registration for all limited dealers, their registered salespersons and their employees. These conditions would establish requirements relating to the sale of securities that are sold under exemptions. Subject to any comments received, the Director, Registration intends to impose these conditions of registration effective October 1, 2000.
Past Commission decisions and notices have addressed the obligations of registered dealers that trade securities under exemptions. Specifically, it has been made clear that a registrant’s “know your client”, suitability and fair dealing obligations apply equally to exempt and non-exempt transactions. Commission staff remain concerned about the activities of some limited dealers (mostly mutual fund dealers) inappropriately selling risky and illiquid securities under prospectus and registration exemptions. Staff consider additional guidance and regulatory conditions necessary to raise the standards of proficiency and business conduct for limited dealers trading under exemptions.
Commonly Used Exemptions
Limited dealers commonly use the following exemptions from the registration and prospectus requirements of the Securities Act:
- the “$97,000” exemption (sections 45(2)(5) and 72(4)(2) of the Securities Act),
- the “50 purchaser” exemption (sections 89(a) and 128(a) of the Securities Rules) and
- the “$25,000” sophisticated purchaser exemption (sections 89(b) and 128(b) of the Securities Rules).
These exemptions are available to give issuers an opportunity to raise capital, without incurring the costs of preparing a prospectus and submitting to a continuous disclosure regime, from persons able to assess the merits of the investment opportunity without the need for full regulatory protection. Securities offered under these exemptions, particularly securities of non-reporting issuers, are illiquid and generally riskier than securities offered by prospectus, traded in secondary markets or traded under other exemptions.
The “know your client”, “suitability of investment”, and “duty to deal fairly, honestly and in the best interest of the client” rules apply to all securities trades that registrants make on behalf of clients. This includes trades in securities that are exempt from the registration requirement. These rules require that the registrant:
- make inquiries to learn the essential facts about each client in order to determine the general investment needs and objectives of the client,
- determine the suitability of any proposed purchase or sale for the client,
- advise the client if a proposed purchase or sale is not suitable, and
- ensure that the client’s interests take precedence over the interests of the registrant.
In addition to these general requirements, a registrant trading under exemptions has particular obligations to:
- ensure that all of the conditions for use of the exemption are met, and
- consider the suitability of the investment for the client in light of the risks of the investment and any resale restrictions on the securities.
The fact that a client may have acknowledged that he or she is a “sophisticated purchaser” and completed the applicable form (Form 20A) does not absolve the registrant of the responsibilities outlined above. In many instances, a client may be able, by virtue of his or her net worth or income, to meet the “sophisticated purchaser” definition, but may have limited investment experience or conservative investment needs and objectives (e.g., a need for low risk, liquid investments).
Dealers are cautioned that in most cases they generally cannot sell securities under the private issuer exemption in sections 46(j) and 75(a) of the Securities Act. This exemption is not available to sell securities to the public, which would generally be considered to include the dealers’ clients. Dealers should consult experienced securities lawyers before attempting to rely on the private issuer exemption.
Conditions of Registration
The Director, Registration, intends to impose conditions of registration that would apply to any limited dealer that relies on the registration exemptions in s. 45(2)(5) of the Securities Act, and s. 89(a) and (b) of the Securities Rules. Following is a description of the proposed conditions, along with an explanation of staff’s view of the procedures the limited dealer must have in place in order to comply with these conditions:
Condition
1. The limited dealer must assess the security to be sold on its merits prior to permitting its salespersons to sell that security and must conduct appropriate due diligence on the security being sold in reliance on an exemption, in the same manner as if the limited dealer were registered as an underwriter under securities legislation, or retain a person registered as an underwriter to conduct the due diligence on the limited dealer’s behalf.
Explanation
The limited dealer should ensure that it performs any due diligence required in accordance with the requirements for underwriters under securities legislation (s. 45 of the Securities Rules). Section 4.7 of LPS 3-22 sets out that the written description of the limited dealer’s procedures and safeguards for underwriting, should include:
- Separating underwriting functions from trading functions, including the establishment of safeguards for dealing with confidential information,
- Developing proficiency requirements, including corporate finance staff education and experience, commensurate with the requirements and with the responsibilities of underwriting,
- Ensuring that appropriate due diligence reviews are undertaken by or on behalf of the underwriter prior to the execution by the underwriter of a certificate, and
- Ensuring that the proceeds of a distribution are properly held, or disbursed, in accordance with the trust or other governing agreements between the underwriting and the issuer making the distribution.
In addition to the requirements in LPS 3-22, effective due diligence procedures should include:
- Using a due diligence checklist to document and assign responsibility and track workflow,
- Obtaining and reviewing the offering documents,
- Determining and documenting the purpose and objective of the investment in terms of risk profile and client suitability,
- Using worksheets that detail the financial components of the offering,
- Making an overall written assessment and adequately documenting the dealers records, as to whether the investment is likely to meet its stated objectives,
- Obtaining and reviewing material contracts, expert opinions and reports, and the business plan,
- Assessing management qualifications and track records,\
- Reviewing the issuer’s financial position and history,
- If reliance is placed on another registrant for part of the due diligence process, assessing the finding and adequacy of that registrant’s procedures,
- Maintaining a written summary of the results of the limited dealer’s due diligence, including a rating of the riskiness of the investment and detail concerning the types of investment needs and objectives for which the investment would be suitable (and unsuitable).
Appropriate records of the above and any additional due diligence inquiries made by the limited dealer must be maintained.
Condition
2. The limited dealer must deliver an offering memorandum for the securities sold in reliance on an exemption prepared in accordance with Form 43, Form 43B or Form 43C, as appropriate, to each purchaser before an agreement of purchase and sale is entered into. The offering memorandum must include a certificate signed by at least two directors if the registrant is a corporation, at least two partners if the registrant is a partnership, or by the sole proprietor if the registrant is a sole proprietor. The certificate must state,
“To the best of our knowledge, information and belief, the foregoing contains no untrue statement of a material fact and does not omit to state a material fact that is required to be stated or that is necessary to prevent a statement that is made from being false or misleading in the circumstances in which it was made.”
Explanation
All securities sold by a limited dealer in reliance on one of the identified exemptions would have to be accompanied by an offering memorandum, even if that is not otherwise required by securities legislation. This offering memorandum would have to include a certificate designed to ensure that the limited dealer takes responsibility for the information in the offering memorandum. The limited dealer would have to conduct an adequate level of due diligence so that it could provide the certificate. So as not to create an unreasonable burden for issuers, only one limited dealer would have to sign the certificate. Limited dealers who do not sign a certificate would still have to comply with the “due diligence” requirements described in the previous condition.
Condition
3. The limited dealer must assign a responsible individual who is either the compliance officer or another registrant who reports to the compliance officer to ensure that each prospective purchaser,
- Understands the security is sold in reliance on an exemption,
- Knows whether the security is liquid and if there is an established market for the security,
- Knows the dollar amount of the compensation that the salesperson receives for the sale and its percentage of the investment,
- Knows the offering memorandum is not a prospectus,
- Knows that they do not have certain protections, rights and remedies provided by the Securities Act, including statutory rights of rescission and that they have limited rights to damages only against the issuer.
The responsible individual should contact each prospective purchaser prior to the agreement of purchase and sale for the securities being accepted by the issuer, to inquire whether the prospective purchaser understands this information and to ensure that the investment is suitable for this person. The limited dealer must maintain a written record of the inquiries made by the responsible individuals.
Explanation
A significant number of problems have been identified by staff when reviewing and assessing whether securities sold in reliance on an exemption are suitable for the investors to whom they have been sold. In many cases they are not. In part, staff believes this is because there has not been an appropriate degree of supervision of trades in these securities. This condition would establish detailed requirements for compliance personnel to follow in ensuring that the trade is suitable. It would require the compliance officer, or another responsible registrant reporting to the compliance officer, to contact each client prior to the issuer accepting a purchase. This means that before a purchase order or subscription is sent from the limited dealer or salesperson to the issuer, those supervising these trades would have to contact each prospective purchaser by telephone or in person to make the inquiries set out in the condition.
As staff recognizes the time constraints on many compliance officers, the condition would permit someone other than the compliance officer to conduct this review provided that person does so under the supervision of the compliance officer and complies with the conditions.
The records of the limited dealer should include detailed notes of the inquiries made by the compliance officer or responsible person to document compliance with this condition.
Condition
4. The limited dealer must ensure that its compliance officer and any other responsible individual (described in condition 3) are registered and have completed the Canadian Securities Course, the Conduct and Practices Handbook Course and any other proficiency requirements necessary for their category of registration.
Explanation
It is important that those responsible for monitoring and supervising the sale of securities in reliance on an exemption have a sufficiently high level of proficiency. As staff believes that programs such as the Canadian Securities Course and the Conduct and Practices Handbook Course appropriately cover the analytical skills necessary to assess a security in depth, the condition of registration would require at least this level of proficiency from both compliance officers and any other registrants who would be contacting clients as described in condition 3.
Condition
5. The limited dealer must provide, or arrange to have provided, training to all salespersons that will trade in the security. Training should enable the salesperson to advise prospective purchasers about the risks associated with purchasing securities sold in reliance on exemptions, to ensure the salespersons can adequately assess the security and to ensure that the salespersons can adequately assess suitability.
Explanation
Unsuitable sales of securities under exemptions have frequently been made by salespersons who lack adequate proficiency. Staff does not propose to require a specific course. This condition would permit a limited dealer either to develop its own training program; or to require its salesperson to take an appropriate course. In either case, the limited dealer should ensure that the training gives its salespersons at least the proficiency needed to analyze and assess the merits of an offering and understand the risks of the investment. Dealers should direct their salespersons to existing courses such as the Conduct and Practices Handbook Course or similar programs to ensure their salespersons have adequate knowledge to properly assess suitability for their clients.
Some examples of programs that are currently available that limited dealers may wish to consider requiring their salespersons to successfully complete are the Canadian Securities Course and examination together with the Conduct and Practices Handbook Course, various of the financial planning programs, or the Simon Fraser University Public Companies Course.
The limited dealer should also assess whether continuing education is necessary and set out any requirements in its procedure manual.
Condition
6. The limited dealer must not, in reliance on an exemption, sell securities issued by an associated or connected party of the registrant as described in s. 75 of the Securities Rules.
Explanation
Problems often arise from conflicts of interest where the limited dealer and the issuer of the security are not independent of one another. Although this type of conflict is normally addressed by disclosure, staff consider it necessary in the context of limited dealers selling under exemptions to simply prohibit limited dealers from trading in securities of associated or connected issuers. Associated and connected are broad concepts and limited dealers should carefully review the provisions of s.75 to ensure they are in compliance with these provisions.
Condition
7. The limited dealer must not permit any person employed by the limited dealer as a registrant or otherwise to provide a referral, or pay or receive a fee or other compensation for the referral, for securities sold under an exemption, to any person who is not registered.
Explanation
Staff expects that limited dealers will comply with both the spirit and the intent of these conditions of registration. For example, changing the dealer’s organizational structure so that these securities can be sold by a non-registered person who might formerly have been employed by the dealer would not be permitted. To help ensure that limited dealers do not avoid their responsibilities under these conditions, staff believe it is important to ensure that trading and advising for their clients is provided only by the limited dealer and its salespersons or another qualified registrant.
For example, limited dealers who are not prepared to develop the systems and procedures to comply with these conditions, may refer clients interested in purchasing securities sold under an exemption, to an investment dealer. They may also refer the client to another mutual fund dealer, provided that the other mutual fund dealer is acting in compliance with these conditions of registration.
Condition
8. The limited dealer must provide notice to the commission before the first time it trades in a security in reliance on an exemption. The notice shall include the name of the security, the name of the issuer of the security, and the date on which the limited dealer anticipates commencing trading in the security.
Explanation
The condition would require limited dealers to notify the Commission if they are using registration exemptions. A filing would be required only the first time a limited dealer trades in reliance on an exemption. No further notice would be required if a limited dealer trades in another security in reliance on an exemption.
Condition
9. The limited dealer must ensure that all sales of securities under an exemption by the limited dealer, its officers or directors, and employees are recorded on the books and records of the limited dealer.
Explanation
Limited dealers are required to maintain a daily blotter (s. 29 of the Securities Rules). The blotter must show all purchases and sales of securities. This condition clarifies staff’s view that all sales of securities, whether in reliance on an exemption or otherwise, by all registrants and non-registrants employed by the limited dealer, must be recorded on the books of the limited dealer. This would require limited dealers to ensure that all employees are aware that all securities trades are dealer business, and must be recorded with the dealer. Limited dealers must then ensure that if any of those trades are being made in reliance on an exemption, that all other conditions of registration are being followed.
Condition
10.Thelimiteddealer must maintain minimum capital in accordance with s. 19(3) of the Securities Rules.
Explanation
This will require that all limited dealers who wish to engage in trading in securities in reliance on an exemption maintain a higher level of capital. Limited dealers should review the requirements in s. 19(3) of the Rules, but essentially this condition will require dealers to maintain at least $75,000 in capital, rather than the $25,000 minimum permitted for some limited dealers.
Dealer Responsibilities
Dealers are generally required to establish and apply written prudent business procedures for dealing with clients in compliance with securities legislation (also see NIN #97/30). Any limited dealer that sells securities under exemptions should ensure that these business procedures address the proposed requirements described in this notice. The dealer's policy and procedures manual should describe any procedures necessary to:
1. Ensure that the dealer and its salespersons thoroughly understand any securities offered to clients under the exemptions.
2. Ensure the salesperson offers the securities only to clients for whom they are suitable.
3. Comply with all of the conditions of the exemption, and all conditions of registration that have been imposed.
4. Supervise all registered individuals trading on behalf of the dealer.
5. Maintain adequate records of all transactions, which include the name of the issuer of the security, the total number and type of security distributed and the name(s) of the purchasers (s. 29 of the Securities Rules provides further details).
6. Outline steps a dealer must take to conduct due diligence on any security being sold in reliance on an exemption and identify the name(s) of any person who conducted a due diligence review on behalf of the dealer.
7. Assign a responsible person to ensure, before trades are accepted, that each prospective purchaser understands
- whether the security is liquid and whether there is an established market for the security,
- the dollar amount of any compensation that the salesperson receives for the sale and its percentage of the investment,
- the offering memorandum is not a prospectus,
- they do not have certain protections, rights and remedies provided by the Securities Act, including statutory rights of rescission and damages,
- the risks of the security, and
- whether the security is suitable for the prospective purchaser.
The dealer must show that it has complied with the educational requirements and maintain records appropriate for that purpose.
9. Monitor referrals from the dealer or its salespersons to registrants or non-registrants to ensure that the dealer and its salespersons do not make referrals or pay any referral fees, to non-registrants in relation to securities sold under an exemption.
Anticipated Costs and Benefits
In developing these proposed conditions, staff have considered both the costs that may be imposed on limited dealers and the benefits to investors and the market generally. Some limited dealers would need to incur costs to employ adequately trained compliance personnel, to enhance operating systems to ensure compliance and to develop appropriate training programs for salespersons if none are publicly available. Staff are aware, however, that some limited dealers have already adopted business practices that are similar to the conditions the Director, Registration, proposes to impose and are operating competitively.
Staff believe that the costs some limited dealers may have to incur would be reasonable in comparison to the improvement to investor protection and market integrity that would be realized by imposing the conditions on registration.
Comments
Interested parties are invited to make written submissions with respect to the proposed conditions of registration, which are expected to be imposed by the Director, Registration, to be effective October 1, 2000. Submissions received by August 15, 2000 will be considered.
Submissions should be sent to:
Brenda Benham
Director, Policy & Legislation
British Columbia Securities Commission
200-865 Hornby Street
Vancouver BC V6Z 2H4
Comment letters submitted in response to Requests for Comments are placed on the public file and form part of the public record, unless confidentiality is requested. Although comment letters requesting confidentiality will not be placed on the public file, freedom of information legislation may require the Commission to make comment letters available. Persons submitting comment letters should therefore be aware that the press and members of the public may be able to obtain access to any comment letter.
DATED at Vancouver, British Columbia, on June 29, 2000.
Steve Wilson
Executive Director
REF: Sections 45(2)(5), 46(j), 72(4)(2) and 75(a),Securities Act
Sections 19(3), 29, 75, 89(a), 89(b), 128(a) and 128(b), Securities Rules
Forms 20A, 43, 43B, 43C
LPS 3-22
NIN#97/30
This NIN may refer to other documents. These documents can be found at the B.C. Securities Commission public website at www.bcsc.bc.ca in the Commission Documents database.