Recommendations and best practices for distribution of non-arm’s length investment products

GN-3100-21-007
Type: Rules Notice> Guidance Note
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IIROC Rules
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Executive Summary

Effective Date: December 31, 2021

The distribution, by an IIROC Dealer Member (Dealer) to its clients, of investment products of an issuer that does not deal at arm's length with the Dealer raises potential regulatory and investor protection concerns. There have been at least four instances in recent years where clients of IIROC Dealers have lost money as a result of investing in non-arm’s length investment products, being Essex Capital Management Limited, iForum Securities Inc., Graydon Elliott Capital Corporation and First Leaside Securities Inc. There have been other similar circumstances involving securities dealers, mutual fund dealers and other distributors in Canada, the United States and elsewhere. At the core of the concerns identified is the fact that when a Dealer and an issuer are related, conflicts of interest may arise. Where conflicts of interest exist, potentially exist, or are perceived to exist, it becomes more difficult for the Dealer to meet its legal and regulatory obligations to its clients.  These obligations to protect the client include the duty to satisfy the high standards of conduct expected of an IIROC Dealer pursuant to section 3102 of the IIROC Rules1  and to comply with other specific and general IIROC Rules provisions relating to suitability and conflicts of interest. The wide variety of possible fact situations that could create a conflict of interest results in different legal and regulatory obligations depending on the standard of care owing to the client in each set of facts.

The investment products covered in this Guidance Note are generally referred to for convenience as "non-arm's length" products and are intended to include products issued by:

  • the Dealer itself,
  • an issuer or a selling securityholder, with which a Dealer does not deal at arm's length, or
  • an issuer or a selling securityholder which a Dealer is otherwise connected or related to.

A more detailed description of the "Investment products and issues covered by this Guidance Note" is included below.

  • 1In this Guidance, all rule references are to the IIROC Rules unless otherwise specified.
Table of contents
  1. IIROC’s Objectives

The purpose of this Guidance Note is to alert Dealers to the regulatory concerns inherent in the distribution of non-arm's length investment products to their clients, and to advise Dealers of IIROC’s expectations of them when they are involved in this activity. The existing IIROC Rules and regulatory requirements, in combination with applicable securities legislation, are considered adequate to protect clients from the inappropriate sale of non-arm’s length products. IIROC intends to increase its compliance monitoring of this product distribution by Dealers through targeted compliance reviews and/or regularly scheduled compliance examination visits.

  1. Regulatory Issues

The regulatory issues that may arise when Dealers distribute non-arm’s length investment products vary according to the particular circumstances and could include the following:

  1. Conduct standards

The possibility that Dealers and their personnel may fail to appreciate that the distribution of non-arm’s length investment products to their clients raises more conduct-related issues that must be considered than in the case where “arm’s length” investment products are distributed. In such cases, this may result in a Dealer’s failure to fully comply with the high standards of conduct set out in Part B of IIROC Rule 3100 and applicable securities legislation.

  1. Issuer scrutiny and product review  

Dealers have a responsibility to use fulsome due diligence procedures to assess investment products, especially products that are not subject to rigorous scrutiny in the marketplace by way of a prospectus review, rating agency review, analyst reports or other third party intermediaries. The Dealer’s obligations to assess an investment product’s suitability and to identify and address conflicts of interest cannot be complied with unless the Dealer has carefully reviewed and vetted all investment products which the Dealer wishes to offer for sale to clients. In the case of non-arm's length investment products, this scrutiny by a Dealer is particularly critical.

Rule 3300 sets out Dealer obligations relating to product due diligence. The standards and requirements also pertain to the investment products addressed in this Guidance Note - with the caution that heightened scrutiny and discipline are expected in reviewing products of non-arm's length issuers. In the case of investment products distributed to the public by a Dealer or its holding company, sections 2111 to 2113, inclusive, may apply as well as corresponding requirements in provincial securities legislation. These rules require the involvement of third parties such as a qualified independent underwriter, rating agency staff, analysts and other selling syndicate members, as applicable, in order to ensure that the distribution is subject to an objective review. In any distribution where such third party involvement is not mandated or otherwise applicable, Dealers should consider arranging for substitute review or enhanced measures to ensure that the appropriate due diligence is conducted and the appropriate level of disclosure and other requirements are satisfied.

  1. Conflicts of interest

When a Dealer has a direct or indirect interest (financial or otherwise) in the issuer whose investment products it is distributing, an inherent conflict of interest exists that must be addressed, pursuant to section 3111, in the best interests of the client. Where a conflict of interest cannot be addressed in this manner, the Dealer should avoid the conflict of interest by not distributing the investment product to the client.

Guidance on applying the conflict of interest management/disclosure requirements set out in Part B of IIROC Rule 3100 was included as part of the Client Relationship Model (CRM) Guidance Note that was issued by IIROC on March 26, 20122 . The guidance set out in the CRM Guidance Note also pertains to the investment products addressed in this Guidance Note, with one exception relating to conflict of interest disclosure. Specifically, the CRM Guidance Note allows for the possibility that a conflict of interest situation need not be disclosed to the client “under the ‘reasonable client’ test ... where the Dealer has taken other steps to control the conflict of interest and has effectively ensured, with reasonable confidence, that the risk of loss to the client has been eliminated.”  As we do not believe this risk can be eliminated in the case of distributions of non-arm’s length investment product, we would expect that the client would always be provided with adequate disclosure of this conflict of interest.

  1. Suitability      

IIROC’s suitability rules are a cornerstone of investor protection.  However, if there is an affiliation between the Dealer  and the issuer, the resulting conflict of interest may make it difficult for the Dealer to objectively assess and advise its client in respect of the investment, compromising this cornerstone protection. Suitability assessments can only be made after the firm’s investment product due diligence and conflict of interest management policies and procedures have been complied with. The fact that a Dealer is or may be related in some respect to the issuer, increases the burden on the Dealer to ensure that suitability determinations are made objectively and without improper influence resulting from the Dealer’s direct or indirect interest in the transaction.

Guidance on complying with the existing suitability assessment requirements set out in section 3402 is published in GN-3400-21-004.

  1. Disclosure

Full disclosure to a prospective investor of “the salient features and risks” of an investment product is important and is one of the core regulatory protections available to investors. In the case of non-arm's length products, the incentive to provide full and meaningful disclosure to an investor may be impaired. In all cases, the Dealer must ensure that the client receives full and complete disclosure of the features and risks associated with the investment product and the conflicts of interest associated with distributing the investment product on a non-arm’s length basis. However, as previously noted, in some cases disclosure alone may not be sufficient to manage these conflicts of interest and, in these cases, the Dealer should not distribute the investment product to the client.

In cases involving the distribution of non-arm’s length investment products, IIROC believes that in order for a Dealer to comply with the Rules relating to conduct standards, product due diligence, conflict of interest management and suitability assessment, enhanced disclosure to clients is required. The level and manner of this enhanced disclosure, other than as specifically required in the IIROCRules or in securities legislation, is not prescribed but should be appropriate to the particular circumstances.

  1. Protection fund coverage

Canadian Investor Protection Fund (CIPF) coverage provides for the return of client assets in the event that an IIROC Dealer becomes insolvent. CIPF does not protect against market losses regardless of how they occur. This distinction is important to emphasize in the case of non-arm’s length investment products held in a client account. In this instance, the client may mistakenly believe that they have CIPF coverage for market losses, if the losses arise due to the insolvency of the Dealer that is either:

  • the issuer of the non-arm’s length investment product, or
  • an affiliate of the issuer of the non-arm’s length investment product.

CIPF coverage does not apply to market losses in non-arm’s length investment products that arise from the insolvency of an IIROC Dealer.

  1. Investment Products and Issues Covered by the Gudiance Note

The investment products which this Guidance Note addresses are not restricted to particular issuers or product types. Any issuer or selling securityholder that does not deal at arm's length with a Dealer Member, or is the Dealer itself, is considered to be a non-arm’s length issuer.

In addition, the method of distribution is not determinative of the general standards to be applied, therefore, public, private and exempt distributions are covered. Having said that, the most common types of issuers and investment products that may be subject to the additional considerations identified above include:

Issuers or selling securityholders:

  • the Dealer itself
  • any affiliate (i.e. parent, subsidiary or entity with common control) of the Dealer [subsection 1201(2)]
  • associates (corporations, partnerships, trusts, etc) in which a person has an interest [IIROC General By-law No. 1, Section 1.1]
  • related issuers [National Instrument 33-105 of the Canadian Securities Administrators (CSA)]
  • connected issuers [National Instrument 33-105 of the CSA]
  • entities (whether or not a securities dealer or advisor) in respect of which the Dealer has, or is subject to, an ownership interest as if they were related companies [subsection 1201(2)]

investments products:

  • debt, including promissory notes, principal protected notes and asset-backed products
  • investment fund products (mutual funds, hedge funds, investment clubs etc.)
  • equities
  • “exempt” products such as limited partnership units, real estate ownership interests, and commodity-based products including those where the non-arm's length issuer is the counterparty on the contract.
  1. Summary of IIROC’s Expectations of Dealers

3 Dealer obligations in respect of the distribution of non-arm’s length products are summarized in the sequence of steps below.

  1. Step 1 – Product due diligence

As is the case for all investment products that a Dealer intends to distribute, the Dealer and its sales representatives must thoroughly understand non-arm's length products, their investment features, risks and value.

  • To gain a thorough understanding of each investment product, Dealers should refer to their obligations under Rule 3300.
  • If, following a product due diligence review, the analysis indicates that the product:
  • would be unsuitable for any client, the Dealer should not distribute the product.
  • would be suitable for certain clients, the Dealer should undertake a specific conflict of interest analysis as described in Step 2 below.
  1. Step 2 – Conflict of interest assessment4

Inherent in non-arm’s length products is the potential for conflicts of interest between the Dealer Member and its clients generally, and between each Approved Person and his/her client:

  • To properly address conflicts, the Dealer must first identify and understand the nature and extent of such conflicts of interest and assess whether they can be adequately addressed on behalf of their clients.
  • If the Dealer is not satisfied such conflicts of interest can be adequately addressed for its client base, the conflict should be avoided and the product should not be sold to any client.5
  • If the Dealer is satisfied that a conflict may be adequately addressed for some or all of its clients, then, for those clients where the conflict can be adequately addressed the Dealer may proceed to the perform the suitability assessment as described in Step 3 below
  1. Step 3 – Client specific suitability

Suitability assessments must be made in respect of client orders and recommendations6  pursuant to IIROC requirements.

  • If a proposed trade to a particular client in respect of a non-arm's length investment product is considered to be unsuitable, the trade should not be completed.
  • If a proposed trade to a particular client is considered to be suitable, the Dealer may complete the trade provided that the trade otherwise complies with applicable laws and IIROC Rules, and provided that any conflict of interest identified has been managed in accordance with the firm’s policies and procedures.
  1. IIROC Examination Expectations

In the course of carrying out compliance reviews of Dealers, IIROC Business Conduct Compliance examiners will focus on written policies and procedures, and underlying controls relating to the identification and review of non-arm’s length investment products distributed by a Dealer to its clients, and the management of conflicts of interest. The Dealer will be expected to establish an evidentiary record of, amongst others:

  1. details of the product due diligence review procedures performed and evidence of approvals,
  2. a general description of the investment product and plan of distribution,
  3. particulars of the principal business uses of the proceeds of distribution by the issuer, including transaction expenses and commissions,
  4. copies of any offering materials including advertisements and/or sales literature, as defined in in subsection 1201(2), used by the Dealer,
  5. specific references to applicable securities laws relied upon by the Dealer in connection with the distribution, including copies of any legal opinions addressing compliance with applicable securities laws, if obtained,
  6. details of the nature and extent of the potential conflict of interest, the analysis underlying its proposed management and conclusions drawn,
  7. details of the proposed management of any conflicts of interest identified with related controls specified.

 

  1. Applicable Rules

IIROC Rules this Guidance Note relates to: 

  • Part B of Rule 3100,
  • section 3402, and
  • subsection 1201(2).
  1. Previous Guidance Note

This Guidance Note replaces Notice 13-0039 – Rules Notice – Guidance Note - Recommendations and best practices for distribution of non-arm’s length investment products. 

  1. Related documents

This Guidance Note was published under Notice 21-0190 - IIROC Rules, Form 1 and Guidance.

 

  • 2See GN-3100-21-001.
  • 3[IIROC is considering a comprehensive re-write and update of this section in light of the amendments to Part B of Rule 3100 (Conflicts of Interest), Rule 3300 (Product Due Diligence and Know-Your-Product), Rule 3400 (Suitabilty) as part of the Client Focused Reforms. See Notices 20-0239 and Notice 20-0238] 
  • 4IIROC recommends that Dealer policy and procedures, and related controls, for assessing conflicts of interest generally be informed by the guidance set out within GN-3100-21-001, National Instrument 31-103 Companion Policy, Part 13 Division 2 and the CSA’s Client Focused Reforms – Frequently Asked Questions.
  • 5The conflict of interest requirements set out in Part B of IIROC Rule 3100, “Conflicts of Interest”require both the Dealer and the Approved Person to address the conflicts of interest associated with recommending a transaction in a non-arm’s length investment product in the best interest of the client
  • 6The suitability determination requirements set out in IIROC Rule 3400 require that suitability determinations be performed at times other than when a trade is being recommended to a client or when the acceptance of a client order is being considered and require that the suitability determination also consider the client’s investment time horizon and the risk profile and composition of the client’s account portfolio of investments, and puts the client’s interest first. Guidance on complying with the suitability determination requirement can be found in GN-3400-21-004.