Investor Alert:
CIRO is issuing a warning to Canadian investors regarding Canada Token Trade.
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:
A more detailed description of the "Investment products and issues covered by this Guidance Note" is included below.
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.
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:
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.
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.
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.
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.
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.
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:
CIPF coverage does not apply to market losses in non-arm’s length investment products that arise from the insolvency of an IIROC Dealer.
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:
investments products:
3 Dealer obligations in respect of the distribution of non-arm’s length products are summarized in the sequence of steps below.
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.
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:
Suitability assessments must be made in respect of client orders and recommendations6 pursuant to IIROC requirements.
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:
IIROC Rules this Guidance Note relates to:
This Guidance Note replaces Notice 13-0039 – Rules Notice – Guidance Note - Recommendations and best practices for distribution of non-arm’s length investment products.
This Guidance Note was published under Notice 21-0190 - IIROC Rules, Form 1 and Guidance.