Unsuitable Use of Margin and Discretionary Trading
Re: Jones 2013 IIROC 58 (December 16, 2013) (Decision)
Catherine Deborah Jones was fined $22,500 and subjected to a 6 month period of close supervision. Her client SW was a dentist in her early 30s who had sold her dental practice during the course of their relationship. She had executed various Know Your Client Forms which included high risk tolerances and venture speculation.
Unsuitable Use of Margin
SW signed various margin documents authorizing the use of a margin account. A margin account was not necessarily inappropriate for her, the use of margin was excessive and not suitable for "stated objectives of SW to preserve capital". [Please note preservation of capital was inconsistent with the KYC forms she signed.]
Despite the various trades in SW's account, there were no supporting phone records or documents to show that there had been any communication with Jones in support of trades which took place while her client was out of town or overseas.
Off Book Investments
Re: Pariak-Lukic 2014 IIROC 01 (January 2, 2014) (Decision)
Pariak-Lukic ("Lukic"), an adviser, suggested second mortgages to long time clients through a private company (Lakepoint). Her husband was the promoter and owner of Lakepoint, which she disclosed. She did not advise her dealer of this activity.
Outside Business Activity
The Panel held that the inclusion of Lake Point investments in periodic financial reports prepared by Lukic wouldlead a reasonable person to conclude that Lake Point was among the investments that she was advising on. This might not otherwise have been a clear conclusion by the Panel.
The Panel also decided that the Lake Point investments could not
be an outside business activity because Lukic received no
remuneration or other personal benefit.
The appropriate penalty is to be decided separately.
The Panel recognized that supervision of Lukic's activities was not possible. The Panel stated that because Lukic failed to notify her dealer of her recommendations regarding Lake Point, her dealer had no opportunity to satisfy itself that the investments were properly qualified for prospectus exemption under securities laws. In addition to the Panel's statements, the failure to seek approval for the OBA/referral arrangements precluded the dealer from ensuring there were no conflicts, that the activity complied with securities laws and that they could otherwise supervise. It stated it is crucial to the supervisory structure is that all securities transactions be recorded on the books and records of the firm as referred to in IDA Bulletin 0481 dated July 13, 2007.
The decision in AIC Limited v. Fischer, released by the SCC on December 12, 2013, confirmed that defendants who pay damages or restitution to clients by way of administrative settlement can still be subjected to future civil proceedings seeking additional damages on the basis of alternative calculations despite the reasonableness of the restitution already paid. In Fischer, the defendant mutual fund companies argued that a class proceeding was not the preferable procedure because a regulatory settlement had been entered into with the OSC which provided restitution to the proposed plaintiff class. The SCC reviewed the adequacy of the restitution and relied upon the lack of participation of the proposed plaintiffs in the regulatory proceeding in finding that a class proceeding the preferable procedure to the already concluded OSC proceeding and the class action should be certified.
Directors & Officers
On January 2, 2014, the Ontario Superior Court of Justice in Susi v. Bourke determined that directors who had breached fiduciary duties could not succeed in their oppression claims.
White Collar Securities Proceedings
Khodjaiants and Dubinsky (sanctions decision) – On January 14, 2014, the OSC levied significant penalties against two individuals it had concluded were guilty of a so-called "corporate hijacking" scheme whereby they reincorporated dormant or defunct companies that had previously traded on the over-the-counter market and issued a significant number of shares in those companies to themselves which were then liquidated for a profit. The respondents were found guilty of breaching the fraud provisions in the Securities Act. In leveling the penalties, the Commission noted that fraud is "one of the most egregious securities regulatory violations." In addition to administrative penalties and bans from participating in the capital markets for 15 years, the respondents were ordered to disgorge more than $1 million.
HumeniukandAurora– The RCMP has charged two individuals with fraud and theft for allegedly bilking investors out of $23 million by inducing investments in a land development project in Mexico through their company, Concrete Equities. The two accused allegedly promised investors as much as a 500% return on their investments. In a related decision released on September 23, 2011, the ASC concluded the two had mislead investors, including by representing to investors in the Offering Memoranda that funds from each venture would be used solely for the purposes of that venture when in fact those funds were at times used to pay the expenses of other ventures under the Concrete Equities umbrella such as distributions to investors of those other ventures. After a sanction hearing, ASC levied administrative fines of $3.3 million (against the accused Humeniuk) and $500,000 (against the accused Aurora).
The ASC decisions on liability can be found here, and the sanction decision here. The criminal charges brought by the RCMP relate only to the development project in Mexico whereas the ASC proceedings were broader and considered various real estate ventures in which Concrete Equities was involved.
2014 Regulatory Plans and Priorities
CSA Issues KYC and KYP Guidance
On January 9, 2014, the CSA issued Staff Notice 31-336, Guidance for Portfolio Managers, Exempt Market Dealers and Other Registrants on the Know-Your-Client, Know-Your-Product and Suitability Obligations which reinforces registrants' KYC and KYP duties, including providing guidance in specific circumstances. Of particular interest is:
- Registrants cannot rely on a client's affirmation on a subscription agreement that he or she is an accredited investor; the registrant must take adequate steps to ascertain that the investor meets the criteria including a breakdown of financial and net assets;
Know Your Client
- Unregistered individuals may assist with incidental administrative tasks regarding collection of KYC information, but it is the obligation of the registrant to "know" the client;
- Adequate KYP involves moving beyond the Offering Memorandum or other issuer documentation where it is insuffcient;
- Reliance on third party reports does not relieve a registrant of his or her obligation to conduct sufficient due diligence to know the product;
Exempt Market Dealers
- An EMD's relationship with the client may be transactional or ongoing; in the case of an ongoing relationship the CSA recommends that the EMD implement a practice of updating KYC information that is consistent with the SRA concept of "trigger events";
- EMDs must be mindful of potential conflicts when they have a relationship with the issuer or seller of securities; the purchaser is the EMD's client and the EMD has obligations to that client, including suitability obligations.
- Investments in securities of a single issuer or group of related issuers that represent more than 10% of the investor's net financial assets will be viewed as potentially raising suitability concerns due to concentration.
Other Regulatory Plans And Priorities For 2014
IIROC Policy Priorities — IIROC has released its 2014 policy priorities and associated timelines.
IIROC Enforcement Decisions
Re: Jones 2013 IIROC 58 (December 16, 2013) (Decision)
Discretionary Trading and Unsuitable Use of Margin
Catherine Deborah Jones' ("Jones") was fined $22,500 and subject to a 6 month period of close supervision. Her client SW was a dentist in her early 30s who had sold her dental practice during the course of their relationship. She had executed various Know Your Client Forms which included high risk tolerances and venture speculation.
SW testified to IIROC that she wanted a return of "passive income and to maintain security of her capital" at 10% to 15% per month, accepted by IIROC to mean per annum. It was further admitted that SW "told Ms. Jones that she desired to keep her capital safe". She was described as "having a closed mind despite her intelligence and other investments". The Panel was perplexed by and acknowledged the lack of attention by SW to her investments at the early stages of her relationship with Jones.
Despite the various trades in SW's account, there were no supporting phone records or documents to show that there had been any communication with Jones in support of those trades, which took place while SW was out of town or overseas.
Unsuitable Use of Margin
SW was able to withstand a certain amount of monetary risk in her portfolio.
SW had been adamant throughout that she was interested in maintaining her capital. The understanding between her and Jones was that her draws would come out of income despite an "illogical amount of return of 10% to 15% per month".
Despite that SW signed various margin documents authorizing the use of a margin account and that a margin account was not necessarily inappropriate for her, the use of margin was admitted to be too excessive and not suitable for "stated objectives of SW to preserve capital". [Preservation of capital was inconsistent with the KYC forms she signed.]
Jones also misled management concerning SW's margin account by stating that she was in touch with SW with respect to covering margin calls which was not the case.
Misrepresentation of Solicited Orders
Jones was disciplined for misrepresenting certain orders as unsolicited, as did not do so out of neglect or inadvertence but rather as a deliberate act to mislead.
Use of Home Email Address
Jones was also disciplined by unauthorized use of her home email address in her communications with SW. Her conduct in this regard was classified as conduct unbecoming in breach of IIROC Dealer By Law 29.1.
IIROC Enforcement Decisions and Settlements
RE: Pariak-Lukic 2014 IIROC 01 (January 2, 2014) (Decision)
Off Book Investments
Pariak-Lukic ("Lukic") as adviser, suggested second mortgages to long time clients through a private company (Lakepoint). Her husband was the promoter and owner of Lakepoint. She did not advise her dealer of this activity.
Lukic's husband received advice from a lawyer acting for Lake Point that the mortgages would not be required to be qualified by prospectus because of the availability of an exemption.
It was found that Lukic had engaged in conduct unbecoming contrary to IIROC ByLaw 29.1 by making recommendations to clients regarding Lake Point and without reasonable inquiries that the issuance of the Lake Point investments were prospectus exempt.
Penalty to be Decided Separately
The Evidence – Good Notes, Good Witness, Caution Provided
Lukic was found to have kept "meticulous and impressively full notes made more or less contemporaneously with events as they occurred giving details of meetings, suggestions, possible motivations and disclaimers and cautionsgiven by her to clients regarding her not being licenced to deal in second mortgages".
It was found that in many cases she also noted suggestions by her or her husband that the clients seek independent legal advice.
She was found to be forthright and straightforward in her testimony as was her husband.
Most of the clients were her longstanding clients at the time of the events in question.
Lukic told clients that she was not licenced to deal in second mortgages and that they should look to her husband who had a mortgagebroker licence. Her husband was not registered or otherwise licenced to advise or deal in securities, but Lukic was.
Lukic advised clients that her husband was her husband, that he was mortgagebroker, that he was owner, promoter and director of Lake Point and that he would earn 1% for managing Lake Point. She also disclosed any other management fees to be earned by others, all of which was reflected in the documentation provided to clients.
Lukic received no compensation for these activities or any benefit from clients investing in Lake Point. The benefit her husband received was disclosed to clients.
Several clients requested Lukic to include their investments in Lake Point and periodic statements of financial position she prepared for the purpose of discussing their investments and financial planning. These statements were prepared by her on the letterhead of her dealer because it was a requirement that any statement of assets provided to clients had to be attached on such letterhead.
Recommending or Facilitating
It was found that Lukic did more than provide factual information about Lake Point but rather discussed the opportunity to invest in portfolio reviews with their clients, shared her husband's enthusiasm for the investment and advised them of her personal investments including anticipated yield, and cash flow. She contrasted and compared the investments to other options available including her unfavourable views of the stock market at the time.
The inclusion of Lake Point investments in periodic financial reports prepared by Lukic would incline a reasonable person to conclude that Lake Point was among the investments that she was advising on. This might not otherwise have been a clear conclusion.
Regulatory Plans and Priorities for 2014
Of note in the short-term is:
- further implementation of CRM requiring new and amended client account relationship disclosure, conflicts of interest disclosure and enhanced suitability assessment;
- new Dealer Member Rule 43 prohibiting employees and APs from directly or indirectly engaging in personal financial dealings with clients; and
- new guidance on outsourcing agreements (final guidance was issued on January 13, 2014 and confirms that most "client-facing activities" are required to be performed by APs and therefore cannot be outsourced and that certain "core" activities that are eligible for outsourcing will be subject to greater regulatory scrutiny — a copy of the full Bulletin can be found here).
Longer term initiatives include:
- new guidance on supervision and suitability requirements any time a leveraged strategy is used or recommended;
- CRM(2) providing for new and enhanced client disclosure including pre-trade disclosure of fees and charges;
- revised sanction guidelines; and
- new guidance on compliance and supervision when dealing with senior investors.
MFDA Compliance Initiatives – The MFDA has set out its 2014 compliance initiatives in a Compliance Bulletin which can be found here.
OSFI Oversight of CDOR – OSFI has announced it is taking responsibility for an enhanced CDOR oversight framework being developed by the Canadian Heads of Regulatory Agencies (which includes the Bank of Canada, Department of Finance, OSFI, the OSC, the AMF, the ASC and the BCSC) in the wake of irregularities associated with the setting of LIBOR. OSFI will set out its expectations in relation to CDOR submission activities, which are now conducted solely within major Canadian banks, throughout 2014. OSFI's announcement can be found here.
The Oppression Remedy and Fulfilment of Directors' Duties
In Susi v. Bourke, 2014 O.J. No. 11
In Susi v. Bourke,  OJ No 11, the Ontario Superior Court of Justice held that when all of the directors of a corporation fail to comply with their fiduciary duties, none of them can seek a remedy for oppression.
The case centred on a corporation, Professional Painting & Decorating Inc. ("PPD"), that had been run as a family business for many years. In 2005, PPD's bookkeeper (the plaintiff Susi) approached the owner and operator (the defendant Bourke) about purchasing the business. Although various purchase and sale agreements were negotiated and oral agreements entered into, the sale of the business was never completed. While negotiations continued, both Susi and Bourke participated in running the business and Susi became both a director and shareholder. PPD paid salaries and benefits to both Bourke and Susi, which the trial judge determined it was financially incapable of doing. The business encountered significant financial difficulties and, while Susi was on a personal leave of absence, Bourke caused PPD to make an assignment in bankruptcy and then established his own business which was essentially the successor to PPD. Susi sought damages by way of the oppression remedy and Bourke counterclaimed also seeking damages for oppression.
In reviewing the chronology of events that led to PPD's assignment in bankruptcy, the court noted that both Susi and Bourke continued to draw a salary from the company despite its worsening financial position and that paying themselves put creditors at risk. It found that this was a conflict of interest given the parties' duties as directors. Moreover, Susi kept vital financial information (a significant debt to CRA and cash flow problems) from Bourke and Bourke made no meaningful inquiries about the financial condition of PPD until it was too late. The court concluded that it was the directors' neglect and breach of fiduciary duties that led to PPD's financial crisis and collapse: "[h]ow, then, can either claim oppression? Reasonable expectations cannot be based on neglect or breach of fiduciary duty when such involves both parties although independent of the other." The directors' breach of their fiduciary duties was fatal to their claim and counterclaim for oppression.
The court went on to analyze the oppression claim of both parties in the event that it was mistaken that the breaches of fiduciary duty disentitled either party to recovery. It concluded that neither party had established that their expectations were reasonable in the circumstances, noting that the parties' expectations were based on wilful blindness and the failure to perform any due diligence as to PPD's future prospects. Having so concluded, the court did not need to consider whether there was a breach of reasonable expectations and whether any breach was oppressive, unfairly prejudicial to or unfairly disregarded either of the parties' interests.
Moreover, there was no need to consider the appropriate remedy (i.e., what would the oppressed party's position be but for the oppressive conduct) although the court's conclusion that neither party was entitled to relief due to its own failure to fulfil its fiduciary duties could have been dealt with in this context; neither party should be entitled to relief because, even on a finding of oppression, he/she had likewise breached his/her duties to PPD and therefore contributed to its downfall.
Susi v. Bourke serves as an important reminder that oppression is an equitable remedy "seeking to ensure fairness ... [t]he discretion can only be exercised to rectify the oppression, not to punish or support a different remedy." A party cannot come to court with unclean hands seeking damages to redress a perceived unfairness.
AIC v. Fischer
The Supreme Court of Canada recently released its decision in AIC v. Fischer ("Fischer"), which focused on the interpretation and application of the requirement in class proceedings legislation in Ontario and elsewhere across Canada for the plaintiff to establish that a class proceeding is the preferable procedure for the resolution of the common issues. In particular, the decision is focused on whether certification should be denied based on the access to justice provided to the proposed class in a completed regulatory proceeding (in this case, before the Ontario Securities Commission). In Fischer, the Court provided the most detailed formulation of the preferability test to date, and signaled that it will be easier than ever to certify class proceedings in Canada, even (in some circumstances) where the same issues have already been addressed in an administrative proceeding.
In 2003, the Ontario Securities Commission ("OSC")
launched an investigation into, among other things, whether
investors in specified mutual funds managed by the defendants in
Fischerhad been harmed by "market timing activities
conducted by other investors in those funds. Subsequently, the OSC
commenced enforcement proceedings against the defendants and
entered into settlement agreements with them. The settlements all
had the expressed goal of obtaining from the defendants
compensation for investors allegedly harmed by market timing
activities. As a result, the defendants collectively paid over $205
million in compensation directly to investors as part of the terms
of the settlement agreements.
The representative plaintiffs in Fischer subsequently commenced an action seeking to certify a class of the same investors who benefitted from the OSC settlements. The subject matter of the action is the same market timing activities, in the same funds, by the same investors as were the subject of the OSC proceeding.1
The issue on certification was whether a class proceeding is the "preferable procedure" for resolving the parties' dispute, a pre-condition for certification in the Ontario Class Proceedings Act and in other provincial class proceedings statutes. The preferability test requires the court to evaluate whether any alternative procedure serves the main objectives of a class proceeding: namely, access to justice, behaviour modification, and judicial economy. In Fischer, the focus was on whether the OSC proceeding met the goal of access to justice – one of the key drivers behind the class proceedings regime in North America.
The certification motion judge, Divisional Court, Court of Appeal and Supreme Court all dealt with the preferability analysis differently. The motion judge dismissed the plaintiffs' certification motion on the basis that they had not met their burden of establishing that a class proceeding would be the preferable procedure for the resolution of the common issues. He found that the OSC proceeding compared favourably with a class proceeding and, therefore, satisfied the access to justice requirement.
The Divisional Court allowed the plaintiffs' appeal from the order of the motion judge, and directed that the action be certified as a class proceeding. Despite having found that the Motion Judge correctly identified the test that must be satisfied for certification, the Divisional Court concluded that the Motion Judge erred in law in respect of his application of the preferable procedure criterion, finding that because there was some basis in fact to support the plaintiffs' assertion that the OSC settlement funds represented only a portion of their total actual damages, the OSC proceeding could not be the preferable procedure.
The Ontario Court of Appeal agreed with the Divisional Court's result but not with its reasoning. The Court of Appeal held that, in considering whether an alternative means of resolving the class members' claims is preferable to the mechanism of a class action, a court must focus on procedural issues and examine the "fundamental", "central", or "key" characteristics of the proposed alternative proceeding. In this case, their focus was on the regulatory (vs. compensatory) jurisdiction of the OSC, and the participatory rights afforded to affected investors in the OSC proceeding, which the Court concluded did not provide the plaintiffs with access to justice in relation to their claims. The Court of Appeal held that the Divisional Court's focus on the substantive matter of investors' uncompensated losses (i.e., the alleged "money left on the table") is not a proper approach to the preferability inquiry.
The Supreme Court had not had an opportunity to address the preferable procedure requirement for many years (since Hollick v. Toronto in 2001), and granted the defendants' motion for leave to appeal. Justice Cromwell, writing for a unanimous Court, upheld the appeal decisions below, and dismissed the defendants' appeal.
Justice Cromwell in effect harmonized the approaches of the appeal courts below, finding that access to justice has both a procedural dimension (i.e., will the claimants have access to a fair process to resolve their claims?) and a substantive dimension (i.e., will the claimants receive a just and effective remedy?). He affirmed that, from a procedural point of view, other non-court proceedings – including completed proceedings – should be considered in the preferability inquiry. The question then becomes "whether the alternative has the potential to provide effective redress for the substance of the plaintiffs' claims and to do so in a manner that accords suitable procedural rights"; this inquiry is effected by comparing the two alternative proceedings, from a "cost-benefit" perspective.
While Cromwell J. disagreed with the Court of Appeal's disavowal of the substantive approach taken by the Divisional Court (i.e., the comparison of the potential recoveries in the alternative proceedings at issue), he cautioned that the low evidentiary threshold at the certification stage will in many cases prevent such an analysis from taking place. In the unusual circumstances of Fischer, where the alternative procedure has run its course and its results are known with certainty, Justice Cromwell held it was appropriate for the issue of investors' uncompensated losses to factor into the substantive evaluation of the OSC proceeding as compared to a class proceeding.
Justice Cromwell further held that a class proceeding was a superior alternative from a procedural access to justice perspective, given that many aspects of the OSC settlement were confidential, and a class proceeding would provide, in his view, a better opportunity for investor participation.
It is difficult to conceive of a non-court alternative to a class proceeding that could meet the high access to justice threshold that has now been set by the Supreme Court. It is therefore more likely than ever that the battle ground for class proceedings in Canada will be the common issues trial as opposed to the certification motion. A further consequence of Fischer may be that companies are reluctant to enter into settlements of administrative proceedings which purport to compensate potential class members. Depending on the willingness of corporations to cooperate, and the flexibility of regulators, one approach may be to build access to justice safeguards into the settlement process, including enhanced participation of potential class members in settlements, and more transparency, so that such settlements stack up more favourably against class proceedings in the future.
1 After the certification motion, settlement agreements were reached between the plaintiffs and three of the five defendants, IG Investment Management Ltd, Franklin Templeton Investments Corp., and AGF Funds Inc.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.