IIROC is pleased to present the Annual Consolidated Compliance Report for 2011 to assist member firms in their compliance efforts and in meeting regulatory expectations.  This Guidance Note outlines a number of current issues requiring firm attention and some general and specific examination deficiencies from the IIROC compliance examination teams (Financial and Operations Compliance, Business Conduct Compliance and Trading Conduct Compliance).  This Guidance Note will also highlight for firms the examination focus for the current year’s examination programs.

Matters Requiring Firm Attention

Repeat Significant Examination Findings

Each of the Financial and Operations Compliance, Business Conduct Compliance and Trading Conduct Compliance teams select the firms to examine each year based on a risk assessment of the firms and the elapsed time since the previous exam.  Examinations are scheduled and undertaken independently by each functional regulatory compliance area and the final report findings or deficiencies are sent to the firms on the completion of the examination.

IIROC found that the majority of member firms continue to work hard to be compliant with both IIROC Rules and securities legislation requirements.  Firms are generally very responsive to deficiencies indicated by IIROC examination staff and the majority of firms correct all deficiencies promptly. 

It is mandatory that each firm corrects all deficiencies identified in the examination reports in a timely manner.  Repeat Significant Findings may be indicative of an ineffective compliance system or a lack of “tone-from-the-top” compliance culture and will be treated by IIROC staff as a serious matter.

Outsourcing

IIROC has observed that firms continue to adjust their business models to leverage on cost efficiencies in their operations by outsourcing various aspects of their activities.  Firms are reminded to take note of regulatory obligations under National Instrument (NI) 31-103 and, in particular, Part 11 of the Companion Policy – Internal controls and systems, that require firms to document their due diligence in the selection of service providers.  This includes the need to carefully manage all risks when deciding to outsource functions, activities or processes to third-party service providers, especially those that are critical to the firm meeting its regulatory obligations and to the protection of customers. 

All such arrangements must include a comprehensive written contract that establishes all necessary obligations including the privacy and confidentiality of customer information and the ability for regulators and auditors to directly access records of the firm and inspect the operations of the service provider.  Despite the existence of any such contractual arrangement, the IIROC Dealer Member remains fully liable and accountable for regulatory compliance. 

Financial Reporting – International Financial Reporting Standards (IFRS)

On February 28, 2011, IIROC issued Rules Notice 11-0082 – an implementation notice that explained the changeover to IFRS as reflected in the amendments to Form 1 and provided specific guidance to Dealer Members as they transition to IFRS at the beginning of their fiscal year throughout 2011.  IIROC is closely monitoring the monthly financial report filings of firms as they transition to IFRS and tracking and resolving accounting issues as they are identified.

Notification to IIROC of Material Changes

On March 11, 2010 IIROC issued Rules Notice 10-0060 "Reporting of Changes to Business Models".  IIROC staff encountered a number of situations where Dealer Members have made significant changes to aspects of their business models without informing IIROC prior to implementation.

Given that IIROC uses a risk-based approach to prioritize and guide its oversight of Dealer Members it is essential that IIROC be made aware of significant changes to a Dealer Member’s business model.  This information will also assist IIROC in preparing for business conduct reviews, financial examinations and trade desk reviews of firms thereby enabling more efficient and effective regulatory supervision. 

Dealer Members are required to notify IIROC of any significant change – the introduction of a new line of business, or material operational process including outsourcing of core activities, functions or processes to third-party service providers, or significant changes to ownership structures.  If in doubt as to the significance or materiality of a planned change Dealer Members are advised to err on the side of caution and either report the change or discuss the change with IIROC staff.

Examination Findings in the 2010-2011 Examination Cycle

Each of the Financial and Operations Compliance, Business Conduct Compliance and Trading Conduct Compliance teams has compiled a list of the most common examination deficiencies encountered. 

It is important to note that the deficiencies noted below are a compilation of deficiencies encountered across the membership.  These deficiencies have not been found at all firms reviewed and no single firm has received a report containing all or even most of these deficiencies.  

Financial and Operations Compliance:

Related Party Transactions – Requirement for Written Services Agreements

IIROC examiners continue to find unwritten cost sharing/management service agreements between firms and related companies.  These arrangements involve cost sharing of management and administrative personnel between a Dealer Member firm and its holding company, affiliated financial institution or foreign broker dealer.

Unlike third-party commercial arrangements with non-arm’s length transactions there is increased potential for conflict of interest and discretion that may be exercised in the allocation of shared costs by the service provider.  Outsourcing arrangements involving non-related third parties require the detailed documentation of the due diligence and selection process and the services to be rendered for fees payable.  It is critical that the non-arm’s length cost sharing arrangements also have written agreements setting out the specific services provided and detailed method of cost tracking and allocation that can be objectively measured and independently verified to ensure completeness and accuracy of the operating income/expenses of the Dealer Member. 

In situations where cost sharing arrangements in place with related parties are determined on a fully discretionary basis by the service provider the reported operating income of the Dealer Member can be manipulated month-to-month to avoid the firm triggering regulatory early warning tests.  All cost sharing arrangements between the Dealer Member and its related companies must be based on an objective method of cost tracking based on specific services provided in order for IIROC to effectively monitor the financial operating condition of the firm as a going concern.

Inaccurate or Inappropriate Margin Provisions

IIROC continues to find situations where inaccurate margin rates have been applied.  These include deficiencies where the wrong margin rates are used and where the inventory margin is understated due to the inappropriate use or interpretation of margin offsets.

Two deficiencies are of particular concern.  The first is the use of error or suspense accounts to account for incorrect trading errors or out-of-balance security position holdings and not providing the appropriate margin to reflect the risk of potential loss to the firm.  The second is the extensive use of excel spreadsheets to manually calculate inventory margin with imbedded formulas for hedged or margin offset positions in which security margin rates are not updated, fields are missed in the spreadsheet formula calculations or incorrect margin offset rules are applied. 

Firms are required to be fully accountable for the use and margining of positions held in error and suspense accounts and have in place a process in which a supervisory person independent of the preparation of manually generated inventory margin calculations performs a review and verification of the spreadsheet calculations on a regular basis to ensure accuracy and completeness.   This is to ensure that the firm accurately quantifies their position risk exposure and effectively monitors their capital adequacy at all times.

Introducer Arrangements

The profile of IIROC membership today consists of over 100 introducer Type 2-4 arrangements including approximately 80 firms that are Type 2.  The following are the most common deficiencies identified with Type 2 introducing firms:

• Incorrect calculation of capital position by not reclassifying the comfort deposit lodged with the carrying broker as a non-allowable receivable.  This occurs in situations where the carrying broker has placed a lien on the introducer’s comfort deposit as security for possible customer bad debts such as unsecured customer indebtedness. 
• Incorrect calculation of capital position by not providing margin for “all or none” customer trade orders processed in the inventory range of accounts of the carrying broker.  These contingent trade orders remain the inventory margin responsibility of the introducer until the customer trade order is filled and trade confirmation issued showing an average traded price and reflected in the customer statement of account.
• Failure to establish credit risk management policies and procedures and/or apply the credit risk policies of the carrying broker for trades with its customer accounts.
• Failure to perform independent price verification for security holdings owned by the introducer and reported on their regulatory filings.
• Failure to margin, report and/or reconcile trades jitneyed directly with brokers other than its own carrying firm.

All introducing firms should be aware of these common examination deficiencies and take corrective action to remediate them.

Business Conduct Compliance:

Order-Execution Only Services

IIROC Rule 1300.1 requires a suitability determination to be made.  IIROC Rule 1300.1(t) and 3200 set out the documentary, procedural and system requirements for Dealer Members to receive approval to accept orders from a customer without a suitability determination.  Approval for a Dealer Member to provide an order-execution only service is predicated on the requirement that no recommendation be provided by the Dealer Member.

IIROC staff encountered situations where Dealer Members with order-execution only services have provided clients with “planning tools” to assist them with their investments.  These tools range from online tutorials and questionnaires that result in specific investment recommendations to promotions that may amount to a recommendation.  

While IIROC recognizes that Dealer Members want to assist their clients in improving their investment knowledge and attaining their investment goals, order-execution only Dealer Members must ensure they are not providing any recommendations.  Whenever a recommendation is made or advice given, a suitability determination is required.

Dealer Members are reminded of Member Regulation Notice 0098 issued September 6, 2001: “What Constitutes a “Recommendation”? Is a Suitability Determination Required under Regulation 1300.1?”.  This notice outlines IIROC’s expectations regarding what may or may not constitute a “recommendation”.

Inadequate Policies and Procedures

IIROC continues to see instances where policies and procedures have not been appropriately customized to the firm’s business and risks.  It is important that these written policies and procedures include detailed procedures covering the internal controls, supervision and testing within the firm.  In addition, these procedures should be accessible and understood by the firm’s compliance and supervisory staff and there should be adequate training around these procedures.

IIROC has enhanced its Business Conduct Compliance examination modules to ensure Dealer Member policies and procedures are adequate.

Conflicts of Interest

IIROC continues to see instances where firms have not adequately identified conflicts of interest within the firms or at the Registered Representative (RR) level.  Conflicts of interest around products and outside business activities of RRs must be identified and carefully considered to ensure that clients are protected and sold suitable products.

Dealer Members are required to have policies and procedures for managing conflicts which allow the firm and its staff to identify conflicts of interest that should be avoided, determine the level of risk that a conflict of interest raises and respond appropriately to conflicts of interest.

Dealer Members must clearly identify conflicts of interest in their business and ensure that there are adequate controls in these areas and that these conflicts are either mitigated or avoided.  In particular, it is important to consider the conflicts and the necessary disclosure around the sale of products of related or connected issuers or the proprietary products of related entities such as limited partnerships, mutual fund dealers, exempt market dealers and portfolio managers.  It is also important to consider conflicts that are associated with registrants employed by multiple related entities and ensure that these conflicts are weighed and addressed.

In addition, firms must ensure that they know and approve of outside business activities of their registrants to ensure that no conflict of interest is present.  Dealer Member firms must report all outside business activities (OBA) to the National Registration Database and must carefully consider if any conflicts of interest exist before approving any OBAs.

IIROC has enhanced its Business Conduct Compliance examination modules to ensure Dealer Members are adequately managing conflicts of interest.

Accredited Investor Qualification

IIROC continues to see a lack of adequate controls around the sale of private placements to Accredited Investors. 

In many cases clients indicated they qualified for the private placement based on an exemption which states “an individual who, either alone or with a spouse, beneficially owns, directly or indirectly, financial assets having an aggregate realizable value that before taxes, but net of any related liabilities, …exceeds a monetary threshold (in Ontario, the threshold is $1,000,000)”.  However, information contained on the New Account Application Form did not support the exemption.  In addition, there was nothing further within the client files to substantiate the clients’ qualification as Accredited Investors.

Dealer Members are required to verify the qualification of Accredited Investors based on the NAAF and any additional information available prior to permitting a client to participate in private placements.

Inadequate Controls Around Employee Accounts

IIROC continues to see instances where Dealer Members have not adequately supervised the activity within its employee accounts.

The controls and supervision of the activity in employee accounts within a firm are important for the firm to understand whether conflicts of interest are being managed and if information barriers are effective.  Supervision of employee account activity needs to be comprehensive and include all transactions.  Controls over the use of external accounts need to be effective and all accounts need to be reviewed against the grey and restricted lists.

The Focus for the Current Examination Cycle 2011-2012

Client Complaints Handling

In February 2010, the Client Complaint Handling Rule came into effect.  IIROC’s Business Conduct Compliance department will continue to review for Dealer Member compliance with Rule 2500B.

This review consists of a client complaint handling survey questionnaire and the examination of selected Dealer Members client complaints handling processes as part of the Dealer Members regularly scheduled BCC examination in the current fiscal year.

This initiative was designed to:

• ensure that firms have implemented this Rule in the context of their business models;
• gather information about the procedures and processes introduced to achieve the Rule’s desired outcomes;
• learn if and how firms implementation of the Rule has enhanced consumer protection;
• assist firms in assessing their compliance with the Rule; and
• understand any cost, challenges or operational difficulties encountered by firms.

It is anticipated that the survey and target examination results will provide examples of “best practices” which IIROC will be able to share amongst Dealer Members through a guidance notice.

Use of Titles and Designations Survey

IIROC has undertaken a targeted survey regarding the use of titles, designations and other descriptors by Registered Representatives, Investment Representatives and other employees of Dealer Member firms who deal with investors.

The unsupervised use of certain titles and designations such as “Financial Planner”, “Retirement Specialist” or “Senior Advisor” are intended to convey an impression of an advisor’s education, experience, proficiencies, and/or other credentials.  The use of such titles and credentials is intended to invite client trust and reliance and may be used by clients as a basis for comparing and distinguishing between advisors expertise and professional qualifications.  It is, therefore, important that there be appropriate rigor, consistency and controls around the use of titles.

The objective in undertaking this survey is to gain a better understanding of:

• the internal firm policies and procedures relating to the use of titles, designations and other descriptors by advisors and other employees in their dealings with investors;
• the internal approval process of Dealer Members relating to the use of such titles and designations and other descriptors;
• any prerequisite training and proficiency requirements imposed internally by Dealer Members before particular titles and designations may be used by a firm’s advisors and other employees dealing with investors;
• the internal audit process in place at Dealer Members to ensure that a firm’s policies and procedures in this area are being adhered to at the firm and its branches;
• the range of titles, designations and other descriptors currently used by advisors and other employees within Dealer Members who deal with investors; and
• investor complaints received by Dealer Members relating to the use of titles and designations.

Based on IIROC staff analysis of the information obtained through the survey, IIROC will determine the appropriate follow-up action.

Trading Conduct Compliance:

Specific Examples of Failure to Notify IIROC Regarding Significant Changes in Business Model

The Trading Conduct Compliance team encountered a number of situations where Dealer Members had made material or otherwise significant changes to their business model and had not informed IIROC prior to implementation.  This includes becoming a member or subscriber of a marketplace for the first time or beginning to offer direct market access to clients. 

As reported earlier, it is essential that Dealer Members advise IIROC of material changes to its business model in order for IIROC to properly assess the risk of a firm’s business model.  Becoming a direct member or subscriber of a marketplace for the first time is a material change of business as it subjects the firm to UMIR directly and imposes a number of supervision requirements that should be reviewed by IIROC prior to the firm’s first trade as a Participant.  Firms are also encouraged to advise IIROC if they commence (or cease) offering direct market access to clients as this may have an impact on IIROC’s risk assessment for the firm.

Compliance with Best Execution

With the ongoing expansion of the multiple marketplace environment and the challenges inherent to compliance with best execution IIROC has enhanced the Trading Conduct Compliance examination module to include testing of Best Execution.  Of particular focus is the development of an internal methodology by Dealer Members to determine best execution and the practices followed by the Dealer Members for routing orders during the pre-open, post-open and outside of “regular” marketplace hours.  The regular supervision employed by Dealer Members to ensure ongoing adherence to these internal policies will be among regulatory requirements to be reviewed.  In determining routing preferences Dealer Members must be aware of conflicts and ensure their interests do not compromise best execution.

It is very important that all Dealer Members be aware of the methodology and practice related to the execution of their trading and make this information available to their clients in some form.  In addition to being good business practice an understanding of the process enables all parties involved to better assess if Best Execution is being achieved. 

In FY12, the Trading Conduct Compliance department will be conducting a focused review of these practices at selected Dealer Members. 

Lack of Evidence of Over-the-Counter (OTC) Supervision

IIROC staff found that many Dealer Members were not sufficiently evidencing their internal review of OTC trading.  Trading Conduct Compliance will review the policies and procedures and any internal testing to confirm that Dealer Members have an effective supervision system in place to ensure compliance with IIROC Rule 2800 (4)(5).  It is also important that Dealer Members be aware of the recent adoption of the fair pricing rule and promptly make the necessary additions to their supervisory program to ensure compliance.  Trading Conduct Compliance will be reviewing Dealer Member procedures for these enhancements.

Order Protection Rule

In February 2011, the Order Protection Rule came into effect.  For those Dealer Members that have retained responsibility for the execution of trades using Directed Action Orders, the Trading Conduct Compliance department is reviewing the supervision process in place to ensure that the Dealer Member is making reasonable efforts to not trade through other better priced orders on another marketplace.  It is expected that Dealer Members will conduct testing on at least a monthly basis. 

Handling of Stop Loss Orders

Since May 6, 2010 Canadian marketplaces have continued to experience occasional sudden and sharp declines in individual securities.  IIROC’s review of these declines has revealed the triggering of Market Stop-Loss orders originating from firms which use an automated system for these types of orders.  When markets are more volatile, the frequency of these types of sudden and sharp security-specific declines dramatically increases.  In all cases the price of the security quickly reverted back to prices close to the pre-decline period.

On occasion IIROC has amended or cancelled trades as the result of this activity.  Member firms have the primary responsibility to ensure that Market Stop-Loss orders are handled in a manner consistent with best execution obligations and overall Gatekeeper responsibilities for market integrity.  IIROC recently published two Guidance Notes, 11-0113 and 11-0114 which both discuss the issue of Stop-Loss orders in the current marketplace environment.  IIROC strongly encourages Participants to review their handling of Stop-Loss orders, particularly if they use an automated system, and to consider the appropriateness of requiring clients to put limits on their Stop-Loss orders.

Conclusion

All Dealer Member firms must ensure an adequate supervisory and compliance testing system for its activities to ensure compliance with IIROC Dealer Member Rules and Universal Market Integrity Rules.  IIROC will continue to provide assistance to Dealer Member firms through the designated Manager responsible in each compliance examination unit.  Dealer Member firms are encouraged to contact their Managers if there are any questions about this report.