Investor protection and the Investment Industry Regulatory Organization of Canada

Overview

The Investment Industry Regulatory Organization of Canada, (IIROC www.iiroc.ca ) is a non-profit, national Self Regulatory Organization ("SRO"). Established in 2008 through the merger of the Investment Dealers Association of Canada (IDA) and Market Regulation Services Inc. (RS) on June 1, 2008, the IIROC regulates securities dealers which operate in Canada's equity and debt markets, and is overseen by the Canadian Securities Administrators (CSA). If a dealer only handles mutual funds, the applicable SRO is the MFDA, www.mfda.ca . IIROC operates on a cost recovery basis. Firms are required as a condition of membership to pay fees which IIROC assesses. The Board of Directors approves the annual operating budget. In fiscal 2008-2009, IIROC spent about $60 million on operations. IIROC does not disclose executive compensation.

IIROC operates under Recognition Orders (available on the IIROC website) from the Canadian Securities Administrators). The securities regulatory authorities of British Columbia, Alberta, Ontario, Quebec, Saskatchewan and Newfoundland and Labrador have delegated to IIROC the authority to grant registration under provincial securities legislation. The British Columbia Securities Commission, Alberta Securities Commission, Saskatchewan Financial Services Commission and the Superintendent of Securities of Newfoundland and Labrador have delegated the authority to grant registration to both IIROC Dealer Members and their individual employees or agents. The Ontario Securities Commission (OSC) and Autorité des marchés financiers du Québec have delegated authority to registered individual employees and agents only.

The organization sets regulatory and investment industry standards and has certain authority, established via contracts with members and registrants, in that it holds disciplinary hearings and has the power to suspend, fine and expel members and registered representatives. IIROC has a stated vision to aim for excellence and regulatory best practices. Per its latest Annual Report, it oversees 212 members and their 30,588 registered employees. The report also notes that it conducted 31 disciplinary hearings, issued 11 suspensions and 4 terminations in the year. Among its other responsibilities, IIROC is the regulator for the critical client-adviser interface. It is here that investment decisions are made affecting savings and retirement plans and people’s lives. A recent survey by the Joint Standing Committee on Retail Investor Issues found that virtually all respondents (91%) consider their advisor to be among the top sources of information guiding their investment decisions. [http://www.osc.gov.on.ca/jsc/jsc_retail-investor-info-survey.pdf for full 47-page report]

IIROC investigates complaints against a dealer firm, approved person, access person or participant and takes disciplinary action when rules are broken. Money from fines and settlements is contributed to IIROC’s restricted fund, which IIROC uses to fund capital expenditures necessary to address emerging regulatory issues, projects relating to investor and industry education, and other uses authorized under IIROC’s Recognition orders.

A Jan. 2008 CSA IDA Oversight Review report concluded that they were generally satisfied that the IDA is in compliance with the relevant T&Cs of its recognition orders as an SRO, that its processes are efficient, effective, consistent and fair, and that it has adequate staffing, resources and training processes to perform its regulatory functions effectively and efficiently. However, an area of concern that is shared across jurisdictions relates to the adequacy of the number of

branch reviews performed by the IDA’s Sales Compliance department for purposes of ensuring its members’ compliance and protecting the investors that deal with members’ branches, the vast majority of whom are retail investors. www.lautorite.qc.ca/.../Rapport-inspection-ACCOVAM_04-04_08-06-ang.pdf A June 2007 Alberta Securities Commission report found numerous deficiencies at the IDA Prairie Office -everything from registration to staff turnover and enforcement issues was covered in the audit, which is usually conducted every three years.
http://www.investorvoice.ca/IDA/Audits/ASC_Audit_IDA_2007.pdf

2009 a year of white collar crime

A recent report by PricewaterhouseCoopers found that Canada was the fourth most fraudulent nation in the world -- behind Russia, South Africa and Kenya. Are Canadian retail investors protected by IIROC? A Small Investor Protection Association report concluded that 2009 was a record year for investor complaints. A new brochure Why IIROC matters to you, the Investor (available on their website in the Investors section) suggests IIROC protects investors. We decided to examine the issue in more detail.

What do we mean by investor protection?

Let's define what we mean by investor protection. We consider seven main elements:

1. Is IIROC governed and organized to represent the best interests of retail investors?

IIROC’s Board of Directors is comprised of 15 Directors, including the President and CEO, with an even number of Independent and Industry (Marketplace or Dealer Member) Directors. One of the Independent Directors resides in the U.S. Investor advocates have been critical that the board does not have a designated retail investor representative. Each Independent Director is paid an annual retainer of $15,000 plus $1500 per meeting attended in addition to Committee membership fees. The Chair of the Board can be an Industry Director or an Independent Director. Unlike the MFDA, IIROC does not need member approval of their rules before they become effective. IROC does not currently include any form of Investor Advisory Committee (IAC), so its engagement with Main Street is limited .It has suggested that investor interaction will be improved in 2010. In Sept. 2008 IIROC received mixed reviews for its $3.75 M funding for FAIR (www.faircanada.ca ) while not imposing any constraints on Board membership (the current Chairman is an industry participant). On May 25th, 2009 IROC announced the establishment of a Whistleblower Service to take prompt action on reported first-hand knowledge or tangible evidence of potential systemic wrongdoing and securities frauds by its registered individuals or firms. IIROC reports all cases of suspected fraud to law enforcement.

The Supreme Court of Canada and the Ontario Court of Appeal have refused to recognize any duty of care owed by a supervising regulatory body to individual members of the public harmed by members of a regulated association or profession .In a 2002 landmark case involving the IDA (now IIROC), Justice Mesbur noted that :

"The IDA regulates the investment industry for the benefit of the entire public. It does not undertake to protect individual investors from economic loss resulting from the acts of one of its members. Imposing that duty of care on the IDA would create an insurance scheme for dissatisfied investors who have paid the IDA nothing,"

In 2004, various provinces dramatically reduced statute of limitations periods. In Ontario, the time was reduced from 6 years to 2 years. Investor advocates, OBSI (www.obsi.ca ) and the MFDA were able to at least in Ontario allow a tolling arrangement whereby both parties could agree to stop the limitation time clock. This timeline change was critical because firms could delay complaint responses and wait out the 2 year period, eliminating the possibility of civil action . Complaint handling rules released in December, 2009 now require a substantive response within 90 days of receipt complaint or an explanation for any delay.

2 Does IIROC ensure qualified people are licensed to sell securities and provide advice?

IIROC-approved representatives must complete defined courses before and after they’re on the job. They must also complete continuing education programs covering compliance and professional knowledge and skills. These requirements help reps stay up-to-date on financial products, rules and regulations and industry trends. These reps are also required to follow Suitability and Know Your Client rules. A new National Registration regime NI31-103 is claimed to improve investor protection. Time will tell.

Investors can contact IIROC or visit their website to confirm the registration status of their dealer or dealer rep. One big issue. IIROC can only monitor and sanction those registered with it. Alleged fraudsters such as Montrealer Earl Jones, who was not registered, does not fall under IIROC’s mandate. This is left to provincial securities commissions.

However, to the extent it deals with industry wrongdoers , it does provide some measure of comfort. Faster reaction and investigation times would however result in more robust investor protection.

3. Has it introduced rules that firms must adhere to that would protect investors from abusive sales and other practices?

There are plenty of rules, some quite comprehensive. Along with IIROC’s review of the dealers’ involvement with ABCP, the SRO has made several recommendations that deal with product due diligence and has published draft guidance that sets out best practices for product reviews. That guidance goes beyond ABCP issues, noting that concerns about suitability and conflicts of interest have arisen with the emergence of other complex products such as principal-protected notes.

IIROC is currently working to improve Know-Your –Client (KYC) and Suitability Guidelines. Investor advocates have noted for years the deficiencies in the New Account Application Form which just recently, due to a controversial IIROC rule change, is no longer completed on a per account basis. The provincial regulators work under a “consensus” approach. As a result, timely approval of regulations or their amendments can become challenging. As with all regulators, the issue is the enforcement of rules, and that is where investor advocates are constructively critical.

4. Does it enforce its rules in a timely manner and with meaningful sanctions?

Canada has had two of its own alleged systemic securities frauds – business income trusts and non- bank Asset Backed Commercial Paper (ABCP). These two toxic income products have created hardship and distress for tens of thousands of Canadians. IIROC was given a golden opportunity to probe the non-bank ABCP debacle. They were advised of the problem early on by client complaints. No retail owners of toxic ABCP Notes received any IIROC facilitation of compensation for their damages due to breaches of securities rules and regulations. Were it not for the valiant and determined efforts of independent financial analyst Diane Urquhart and investor Brian Hunter, who organized the Facebook ABCP Retail Owners Group, retail investors would not have received compensation. About 1800 small investors, many seniors and retirees, were stuck with the frozen paper, unable to access their cash for over 18 months.

In Dec. 2009 IIROC settled with 3 member firms for their roles in the non-bank ABCP fiasco. The media, investors and investor advocates were critical of the modest amount in fines levied given the horrors investors had to experience when the toxic paper froze in Aug., 2007. Canaccord received a modest penalty of just $3.1 million. No individuals were sanctioned. In the much less significant mutual fund market timing fiasco, TD Waterhouse (Canada) Inc. received penalties totalling $20.7 million consisting of a fine of more than $10.3 million, plus an equal amount payable in disgorged market timing revenues, along with $50,000 in costs payable to IIROC ( then known as the IDA).

Most times however, fines are levied against low ranking individuals. Investor advocates have long argued that the fines should be applied against the firms that employ these dealer representatives. Additionally, it’s generally recognized that the publicly disclosed fines are rarely collected because IIROC lacks effective powers to collect from former advisers/salespersons. In 2008-2009 it assessed a modest $3.2 million in fines for firms and individuals. Just 36 % of fines assessed on individuals were actually collected. This deficiency raises a credibility issue on enforcement as a deterrence mechanism.

5. Does it require responsive and effective complaint handling when a dispute arises?

IIROC’s complaint handling policy has just been updated. It was generally recognized that the previous system was ineffective and exploitive of investors. Consider these recent comments by former Ombudsman for Banking Services and Investments (OBSI), David Agnew:

“While we’ve made progress, complaint-handling in financial services has a long way to go. Instead of a proper response to the client, the firm has fired off a template letter dismissing the complaint, and has done none of the proper groundwork of responding to a client.” (OBSI Newsletter, April 7, 2009)

OBSI looks to the dealer, not the adviser, to honour its recommendation for compensation to the client. A survey of complainants revealed that 61 % had not been advised of the free OBSI dispute resolution service. (IIROC figures are lumped in with banking complaints where it is expected the real problem lies)

Per the 2008-2009 Annual Report, client complaints filed directly to member firms (and filed electronically with IIROC) totalled 1940, a 28.5 % increase over the prior year. Things are getting worse as investors begin to realize the high fees they’re paying , the risks they’ve been exposed to and how hard margined funds are to pay back when the market tanks. The most recent incident involved the sale of leveraged ETF’s which apparently neither investors nor dealer reps fully understood. IIROC issued a Guidance note after SIPA, FAIR and Rosen and Associates highlighted serious problems. No rule changes have yet been introduced.

The Small Investor Protection Association has reviewed (SIPA) IIROC complaint handling proposals and found them deficient in a number of important areas. An example from the SIPA comparative analysis UK Financial Services Authority (FSA) vs. IIROC and the MFDA. The FSA policy specifies that the firm is to identify and remedy “any recurring or systemic problems” which it may become aware of in handling complaints, e.g. by analyzing individual complaints “so as to identify root causes” with consideration being given to the bearing of such causes on other processes or products as well as their correction. In contrast, the IIROC rule mandates only that internal procedures and practices must be reviewed and recommendations made to the “appropriate management level.” leaving an issue floating. Definitely not a Best practice.Clearly, a higher level of responsibility and accountability is embedded in the FSA rule. Moreover, it is much clearer about regulatory expectations and provides a basis for stronger disciplinary action. There is now a 90-day target time line for substantive responses, after which clients can choose to move the case to OBSI if unhappy with the progress of a complaint investigation or result.

Dr. P. Reeve has examined the IIROC proposals by taking the principles of fair dealing identified by the OSC in its Fair Dealing Model Concept Paper (Jan 2004) and applying them to the dealer complaint process. The title of the result speaks for itself: Flawed process; Flawed product: Defective regulation in the Canadian Investment Industry http://www.pjreeve.com/pjr/blog/Entries/2009/6/8_DEFECTIVE_REGULATION.html

If Investment Policy Statements (IPS) were made mandatory, we expect a large number of complaints could be avoided. An IPS is a sign of professionalism but it is not mandated under current IIROC rules.

If you have a dispute with an IIROC member firm or its representative and have not been able to resolve it through the firm’s complaints process, you can use the IIROC arbitration program. This program, which provides dispute restitution up to only $100,000, is run by ADR Chambers (a different firm is used in Quebec), a for-profit dispute resolution service provider. There is a cost to use this system. In addition, arbitration decisions are binding. For this reason, the parties often retain legal counsel. The process is generally faster and less expensive than the court system . A 2003 OSC Regulatory Burden Task Force Report wrote: “... Arbitration between parties of widely differing means is not a satisfactory mechanism for resolving investor disputes. The process can degenerate into a mini-trial where dealers are able to use the greater resources at their disposal to defend themselves. Consequently, we suggest that the Commission recommend to the IDA that it review its arbitration procedure with a view to correcting its perceived flaws and making it more helpful and less costly to investors. In particular, we recommend that the maximum claim be raised to at least $350,000 and that arbitration decisions be published without naming the clients involved in the proceedings.” Source:
http://www.investorvoice.ca/Research/Research_Index.htm . These recommendations were not implemented and usage slipped. Additionally, the statistics show a further fall off following the introduction of OBSI, with its no-charge and non- binding dispute resolution approach. IIROC is currently soliciting public comments that could raise the limit to $350,000 and possibly more and make other process improvements.

6. Can it provide restitution to investors in cases of financial assault?

Like other Canadian regulators, IIROC does not ordinarily provide restitution to individual investors. Investors must deal with the firm directly or OBSI (www.obsi.ca ) if the firm’s offer is not accepted (or file a civil action). An exception occurred in the case of the infamous mutual fund market timing scandal .The IDA settlements noted that all three securities firms failed to prevent market timing by big clients despite repeated warnings from numerous fund companies that the trading was unwelcome and could hurt long-term unitholders. TD Waterhouse disgorged market-timing revenue of just over $10.3 million and paid a fine of $10.3 million. RBC Dominion Securities disgorged $ 8.5 million and was fined $8.5 million. BMO Nesbitt Burns disgorged $2.2 million and was fined $1.5 million, its penalty mitigated because it acted before the IDA began investigating and voluntarily repaid the fund companies.Five fund companies were penalized a total of $205.6-million by the OSC for allowing market timing - quick in-and-out trading of fund units to exploit price discrepancies, to the detriment of long-term investors. Thirteen other fund companies split about $225,000 in trailer-commission refunds through the then IDA. Fund investors were at least partially reimbursed for losses.

7. Does it provide CDIC- like insurance in the event a dealer goes bankrupt?

The Canadian Investor Protection Fund (www.cipf.ca ) is a not-for-profit corporation and is a separate legal entity from IIROC. It protects retail investors up to $1 million per eligible account in the event of dealer insolvency. CIPF was created by the investment industry to ensure that client assets are protected within defined limits if an investment dealer who is a CIPF member becomes insolvent. All IIROC member firms are required to be members of CIPF. The investor pays no direct fees for CIPF protection. Coverage is automatic when an account is opened with an IIROC member firm. Each investment dealer contributes to the fund which CIPF maintains.

Summary and Conclusion

At the May, 2005 OSC Investor Town Hall in which IIROC participated, highly agitated investors expressed their anger and identified their priorities. These included a better functioning of the complaints process, fair and accessible restitution, and a voice in the regulatory process. To date, too little has been accomplished. For whatever reasons, the OSC has not held a Town Hall since and IIROC has been sluggish in its response.

IIROC is attempting to connect with retail investors via Roundtables with regards to the Client Relationship Model (CRM, a remnant of the robust OSC Fair Dealing Model). The CRM is aimed at improving relationships primarily through enhanced disclosure and increased transparency. It does not expressly introduce a fiduciary standard as is occurring in the UK and the U.S. although it could elevate the current standard of care and loyalty. The proof will be in the pudding if it constructively responds to the extensive input it was provided. One big issue: important personalized Rate of return reporting is not mandatory.

We can’t cover every issue in this short article. As it stands now, we conclude that IIROC has a significant number of opportunities for improvement. These include but are not limited to: better governance and transparency, enhanced investor engagement, more timely disciplinary actions / better collection of fines and substantially increased fines to change behaviour . Like the MFDA , there’s an opportunity for retail investors to be represented at the Board table. The proliferation of new and complex products presents additional challenges for IIROC and the industry as a whole. Clearly, there is much to be done to make IIROC the regulatory force it needs to be to fulfill its critical mission of protecting small, generally unsophisticated, investors. Time is of the essence.

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The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. However, please call the author to discuss your particular circumstances.