Effective Date: December 31, 2021
The purpose of this Guidance Note is to remind all Dealer Members (Dealers) of the IIROC requirement to have written custody agreements for all external custody arrangements with third parties. In particular, to explain the application of the custody rules as they relate to certificated or non-certificated securities commonly referred to as Guaranteed Investment Certificates (GICs), term deposits and other forms of deposit investment contracts issued by financial institutions that are not negotiable and/or transferable.
Section 43531 of the IIROC Rules specifically requires custody agreements for securities held by third parties on behalf of Dealers. This includes physical and book-based equity, mutual funds and debt instruments such as treasury bills, banker acceptances, government and corporate bonds etc. This Guidance Note is intended to specifically clarify the application of the custody rules as they relate to the above noted investment contracts issued by financial institutions.
- 1In this Guidance, all rule references are to the IIROC Rules unless otherwise specified.
A basic principle of securities regulation is to protect client property. IIROC Rules provide for the requirement to “segregate” or hold in trust client securities at “acceptable securities locations” supported by written “custodial agreements” that contain prescribed minimum terms and conditions that serve to meet the protection of client property entrusted to a Dealer.
“Property” of a client may be held at external and internal acceptable securities locations in physical or book-based form. Subsection 4341(1) of the IIROC Rules defines an “external acceptable securities location” to be a situation where securities are held beyond the physical possession of the Dealer Member and for which custody agreements are required. This would also include securities held at an external location in book-based form. Subsection 4341(1) defines an “internal acceptable securities location” to be where securities are held within the physical possession or control of the Dealer Member in which no custody agreements would be required.
Purpose for custody agreements
Subsection 4353(1) sets out the requirements for the written custodial agreement for the external custodian to qualify as an external acceptable securities location. Dealers may only use the custodial services of another institution that meets specific criteria defined in the IIROC rules for an “external acceptable securities location”.
History of Custodial Agreements for Book-Based Products
IIROC first issued a Compliance Interpretation Bulletin C-74 dated June 21, 1994 entitled “Custodial Agreements”. The regulatory impetus for this Bulletin was to ensure Dealers undertook to have written custody agreements in place, as required, or face a capital penalty equal to the market value of the securities plus margin as set out in the General Notes to Form #1. This Bulletin was issued at a time where the industry was experiencing significant growth in mutual fund investment holdings by clients of Dealers. Mutual funds are securities held in book-based form by the mutual fund company and registered in the nominee name of the Dealer on behalf of its client. Certificates could also be issued registered in either the name of the Dealer or its client and physically held by the Dealer. The Bulletin served to remind Dealers of the general requirement to have custody agreements in place for book-based mutual fund positions or face a capital penalty.
In response to Dealer concerns of the inefficiencies of requiring a multitude of mutual fund custody agreements between Dealer and mutual fund companies, the SROs acted on an industry recommendation to create a standard custody agreement in which the CIPF would act as “bare trustee” for its Dealers and enter into separate custody agreements with individual mutual funds. To the extent that a Dealer dealt with a mutual fund company that had executed an agreement with the CIPF, there would be no capital penalty. In August 1994, the CIPF issued a list of mutual fund companies in which it sent out sample agreements for them to sign and return. On October 28, 1994, the former IDA (now IIROC) issued Compliance Interpretation Bulletin C-81 listing the mutual fund companies that had executed the prescribed custody agreements with the CIPF. The Bulletin in force since November 1, 1994 requires a capital charge for Dealers holding mutual fund positions on behalf of clients with no executed custody agreement.
In 1996, an issue was raised by the Operations Subcommittee of the FAS (now known as the Financial and Operations Advisory Section) as to whether bulk issues of a debt instruments issued only in book-based form require a custody agreement. The example given was that of GM issuing paper acceptances in which no certificates are ever issued. It was found that the terminology used in the prescribed standard custody agreement for physical securities was not applicable for a book-based environment. IIROC developed a prescribed custody agreement for “non-certificated” or NCI debt instruments and Bulletin C-92 dated February 8, 1996 was issued.
The former IDA (now IIROC) and the CIPF entered into an Agreement dated May 9, 2005 in which all existing custody agreements executed in the name of the CIPF as bare trustee have been assigned to IIROC to administer on a go forward basis. In the administration of these custody agreements, IIROC carries out due diligence to ensure that the custodial agreement is in prescribed form and is duly executed by those in authority. Copies of the agreement on file are available upon request.
Regulatory position on “evidence of deposits”
Are investment contracts or “evidence of deposits” issued by financial institutions considered securities for the purposes of segregation and custody or a cash deposit?
IIROC has taken the position that “evidence of deposits” referred to as GICs, term deposits and other forms of deposit investment contracts with financial institutions with maturities greater than one day must be treated as a security for which the rules of segregation and custody apply.
Dealers typically register these client investments with the issuing financial institution in nominee name. Various terminology is associated with “evidence of deposits” issued by banks and trust companies. Reviews conducted by IIROC of Dealers reporting client positions in such investments show that there is no standard description or form of documentation for these securities. The Bank Act, Trust and Loan Companies Act (Canada) and the Loan and Trust Corporations Act (Ontario) do not prescribe any specific requirements with respect to documents or instruments to be issued to evidence GICs or other debt instruments issued by banks and trust companies. Advice obtained from legal counsel also shows that there is no relevant law dealing with such requirements.
As a result, it is not uncommon to find many variations of nomenclature for “evidence of deposits” issued by financial institutions. The following is a list of examples:
- Guaranteed Investment Receipt
- Certificate Detail Buy Transaction
- Confirmation of Investment
- Confirmation of Deposit
- Confirmation of Term Deposit
- Confirm of Purchase of Investment Certificate
- Debenture Investment
- Debenture Certificate of Deposit
- Deposit Receipt
- Guaranteed Investment Certificate
- Guaranteed Investment Certificate Confirmation
- Investment Confirmation
- Issue of Debenture Confirmation
- Term Deposit
- Term Deposit Certificate
- Term Deposit Receipt
The commonality of the above noted forms of “evidence of deposit” is that they are registered in the nominee name (not the beneficiary), and are not transferable and/or negotiable.
Is there a requirement for custody agreements for these securities?
IIROC and CIPF have consulted and obtained legal counsel advice in regards to the legal risks associated with the absence of a custody agreement for such type of investments. The risk of “set-off” was raised as a primary concern where a custodian holds a non-certificated investment, or holds the certificate, instrument, etc. for a certificated investment, of which it is also the Issuer. The legal risk identified is the possibility for “set-off” by the financial institution on its obligation to pay upon redemption of the investment contract by the Dealer on behalf of its client by the amount of any obligations outstanding by the Dealer to the financial institution. Based on the foregoing, legal advice suggests that the principle of protection of client property by the Dealer is less ambiguous in the case where the Dealer has a duly executed custody agreement with the financial institution containing the prescribed regulatory provisions to guard against any set-off, lien or encumbrances.
How does a Dealer satisfy IIROC custody requirement for GICs and other forms of “evidence of deposits”?
IIROC has undertaken on behalf of Dealers to request and execute bare trustee custody agreements with any financial institutions in which Dealers hold registered in their name GICs and other forms of “evidence of deposits”. The list of executed agreements is compiled, updated and published in IIROC’s monthly custodial agreement Notice.
A Dealer may request IIROC to ask an financial institution to sign the prescribed “bare trustee” custody agreement and return it to IIROC to execute and add to a published list for Dealers. 1 The request must be accompanied with the name, address and contact person of the financial institution to which they would like a custody agreement executed. Alternatively, Dealers may provide a blank copy of the “bare trustee” agreement directly to the financial institution and have it sign the agreement and forward to IIROC to execute, or execute a stand-alone custody agreement directly between the Dealer and the financial institution containing the prescribed custody provisions.
Is there a capital requirement for holding securities not supported by a custody agreement?
Effective April 1, 2007, IIROC implemented amendments to the capital requirements for situations where the Dealer failed to execute a written custodial agreement. The capital requirements are described in the notes and instructions to Statement B and C of the Form 1. If the securities are held at an acceptable securities location and an acceptable written custodial agreement is not in place, 10% of the market value of the securities held at the location must be provided on Statement C of Form 1 in determining the Dealer’s early warning reserve. Where setoff risk with the custodian is also present, the setoff risk must be provided on Statement B of Form 1 on a dollar for dollar basis in determining the Dealer’s risk adjusted capital.
All GICs and other forms of “evidence of deposits” held on the books and records of the Dealer for which no custodial agreement has been executed with the issuing financial institution of such instruments are subject to the applicable capital and early warning charge.
As an alternative to a capital and early warning charge, each Dealer will make their own evaluation as to whether to take a capital and early warning charge for client positions held in nominee name to which an executed agreement does not exist or to have the position re-registered with the issuing financial institution in client name.
If a Dealer determines certain GICs and other forms of “evidence of deposits” will be re-registered in client name, the Dealer must ensure that the client understands that it is registered in their name at the issuing financial institution and they may now deal with the institution directly, and that the position is no longer eligible for CIPF coverage.
Is there a capital requirement for not reconciling the records of the firm to the third party statements issued by the financial institution?
The books and records of Dealer holdings of such securities must be reconciled at least monthly with records (or account statements or electronic files) provided by the issuing financial institution(s). Otherwise a capital charge will apply for unresolved differences consistent with other securities held by the Dealer at external custody locations.
Consistent with the concepts developed for the reconciliation of mutual fund positions, and the margin criteria for unresolved differences, the following rules apply for the reconciliation of GICs and other forms of “evidence of deposits” issued by financial institutions.
For margining purposes, certificated or non-certificated GICs, term deposits and other forms of deposit investment contracts issued by financial institutions that are not negotiable and/or transferable are classified into two types:
- Type I
- The issuing financial institution provides monthly files or statements.
- Capital Requirement
- Margin is only required on any unresolved differences.
- Type II
- The issuing financial institution does not provide monthly files or statements.
- There has been no loan value extended to positions held in client accounts.
- There has been no activity in the security positions held with the issuing financial institution in the last six months, except for redemptions.
- Capital requirement
The margin required on these security positions is 10% of the market value of each individual client position, calculated as at the reporting date.
A capital provision must be made, as at the reporting date of the regulatory filing, for 100% of the market value of the out of balance short unresolved differences that are still unresolved as of the due date of the regulatory filing.
For any month in which these security positions are reconciled on a quarterly, semi-annual, or annual basis, the securities are considered to be reconciled on a monthly basis and no capital provision is required except for unreconciled differences.
IIROC Rules this Guidance Note relates to:
- subsection 4341(1), and
- subsection 4353(1).
Previous Guidance Note
This Guidance Note replaces Member Regulation Notice MR080 - “Evidence of Deposits” and Custody Agreements.
This Guidance Note was published under Notice 21-0190 - IIROC Rules, Form 1 and Guidance.