Read between the lines of the latest tome from the Ontario
Securities Commission (OSC) and its message is clear: "Take a
bite out of the carrot we're offering, or risk the sting of the
stick we carry."
The carrot being dangled in front of Dealers, Portfolio Managers
and Investment Fund Managers is a new emphasis on what the OSC
calls outreach: online information, special seminars, education
programs and a whole lot of cautionary tales now available in
greater amounts than ever before.
The stick, of course, is the array of penalties at the OSC's
disposal should you be found guilty of the most common, or most
egregious, filing deficiencies.
This warning - or offering - is contained in the rather thick 2013
Annual Summary Report put out by the OSC, which now directly
oversees some 1,300 firms that trade or advise in securities or
commodity futures.
This includes investment fund managers, exempt market dealers,
portfolio managers and scholarship plan dealers. While the OSC also
registers the 115 mutual fund dealers and 200 investment dealers
these firms are principally overseen by their respective
self-regulatory organizations being the Mutual Fund Dealers
Association (MFDA) and of the Investment Industry Regulatory
Organization of Canada (IIROC).
The OSC report is not exactly light bedtime reading. But it
suggests you might avoid some sleepless nights if you take
advantage of the outreach resources the OSC is now offering which
include:
- A "registrant outreach" web page designed to enhance compliance awareness.
- Outreach seminars that convey practical knowledge and interpretations of financial reporting and regulatory capital matters, like the OSC seminars that were well attended last September.
- A new Registrant Resources Section of the OSC designed to provide easy, centralized access to the latest compliance materials.
The OSC is also offering some salient advice: it suggests that
firms consider engaging an independent consulting or audit firm
having the necessary compliance internal audit experience to assist
with co-sourcing or outsourcing of an effective sales compliance
audit regime. EMDs, especially those with limited time and
resources, could likely use the help.
EMDs are required to comply with regulatory capital requirements,
books and records requirements, and monthly and year end reporting
and audit requirements. In other words, they need to have enough
money on hand, the right records at their fingertips, the proper
timetable for reporting, and the ability to be held accountable
without worry. This can seem daunting for firms new to regulation,
such as a newly approved registrant. But it can even be challenging
for an experienced dealer with a rapidly growing clientele.
And you don't want to risk your principal regulator deciding to
wield the stick at his or her disposal: ongoing on site and desk
financial compliance reviews to assess capital adequacy, and any
penalties that might result.
Compliance reviews of registered firms are conducted on a
continuous basis. In its report, the OSC noted that it takes a risk
based approach to the firms selected for review. The key risk
factors impacting selection include the most recent risk assessment
questionnaire, the firm's compliance history, complaints or
whistle blowing tips or referrals form an SRO or other regulator.
For an onsite review, a registrant should expect that senior
management will be interviewed to update the regulators
understanding of the business, reviewing the most recent annual and
interim financial statements and excess working capital
calculations, reviewing the annual compliance report to the
registrant's Board, assessing the overall compliance and
supervision structure and follow up on corrective actions over past
compliance deficiencies. In addition, the commissions are
conducting "sweep reviews" which may involve reviews of
specific topics or industry sectors. If you are a new firm, you
should expect to be reviewed as the regulator would like to see
these firms get off to a good start. Not surprisingly, large or
" impact " firms are regularly reviewed.
Sweep reviews in 2013 targeted those firms with high value assets
under management or administration, high number of dealing reps,
securities custody practices, excess working capital calculation
and capital market participation fee calculations. In addition, the
OSC noted that it now regularly contacts registrant clients by
phone as a regular part of its compliance review. New last year was
also the emergence of "Mystery Shopping" whereby
regulators will contact dealing reps to assess their compliance
knowledge. All of this means that each firm needs to assess the
rigor of their orientation and ongoing training programs,
supervisory practices and record retention practices.
Based on my experience with other regulators in Canada and the US,
firms should pay close attention to their regulatory compliance
reports and remediate each finding as soon as practicable. On the
next compliance review, you can expect your regulator will perform
follow up audits on the status of remediation and expect that
findings are corrected.
The OSC noted that 6% of its compliance reviews of all registered
firms resulted in referrals to the OSC's Enforcement Branch for
investigation or suspension of registration. This is a welcome
decrease from the 10 % referral/suspension rate in 2012 and 2011.
While this statistic continues to be too a high a referral or
suspension rate, the reduction suggests that many firms are paying
close attention to enhancing their compliance practices.
The three fundamental criteria the regulators look at for
determining continued suitability of a registrant for registration
under NI 31-103 are integrity, proficiency and solvency. The OSC
noted that compliance is a responsibility that extends to everyone
in the firm, whether they are registered or not. The UDP and CCO
have extremely important compliance roles as they are ultimately
responsible for ensuring that and effective compliance system is in
place. The OSC provided several best practices for firms to
consider. At the end of the day, a firm must manage risk within its
business to ensure that it has the right people doing the right
things at the right times.
The OSC no longer provides reminders with respect to deadlines for
filings. It is the responsibility of the firm to have a compliance
structure in place that enables it to comply with all regulatory
requirements. If a filing deadline is not met, it may affect a
firm's continued suitability for registration and may result in
terms and conditions being imposed on the firm's registration
or suspension of registration. In addition, firms will incur late
filing fees of $100 for each business day that the filing is late,
to a maximum of $5,000 annually. Ouch, that hurts!
Registrants' annual audited financial statements must be
prepared using IFRS as required under NI 52-107 and Part 12,
Division 4 of NI 31-103 sets out their financial reporting
obligations. This requires EMDs to deliver their annual audited
financial statements (and related calculation of excess working
capital - the NI 31-103F1) within 90 days after their financial
year end. The financial statements are required to be prepared on a
non-consolidated basis (which IFRS refers to as "Separate
Financial Statements"). The OSC noted that the annual audited
financial statements must include a sentence indicating that the
financial statements are prepared in accordance with the financial
reporting framework specified in Section 3.2(3)(a) or for foreign
firms, section 3.15 of NI 52-107 and a description of the financial
reporting framework used. This added sentence should also be
referenced in the auditor's report.
Thankfully, starting in February 2014, the Form 31-103F1
Calculation of Excess Working Capital (Form 31-103F1) must be filed
electronically. The OSC notes that some firms are not accurately
calculating their excess working capital on Form 31-103F1. When
calculating excess working capital (EWC), registered firms should
use the accrual basis of accounting, not the cash basis of
accounting- and this includes the interim monthly financial
statements. From EWC, a firm should exclude any current assets that
are not readily convertible into cash, such as prepaid expenses and
security deposits with service providers. The definition of what
constitutes "readily convertible into cash", in my
experience, is often one the toughest judgment calls for both
management and its independent auditor.
The OSC also notes that it is concerned with firms that include in
working capital any accounts receivables, especially those due from
related parties, which are not readily convertible to cash.
Accounts receivables that are not realizable in to cash in a prompt
and timely manner should be excluded from the excess working
capital calculation. The OSC suggests that where a firm believes
that related party receivables could be promptly received, the firm
should maintain on file documentary evidence to support this
assertion. Acceptable evidence could include audited financial
statements of the related party or a bank statement supporting that
the related party has cash available at that time. This guidance is
welcomed as the determination is a challenge. It's my
experience that SROs such as IIROC and the MFDA provide a more
rigorous definition of what is an allowable asset (i.e. working
capital) for regulatory capital purposes.
The OSC noted that registrants need to deliver to it a copy off all
executed subordinated loan agreements. If the agreement is not
delivered to the OSC, then it will not be considered subordinated
for purposes of the EWC calculation. The CSA has specifically
addressed this issue in its December 5, 2013 suggested revisions to
NI 31-103. Don't forget that before you repay any subordinated
debt, you may also notify the regulator of this before it is
repaid. That notice is due 10 days before repayment. The regulator
may request further documentation to demonstrate that the EMD
continues to have excess working capital.
The OSC noted some instances where a market risk deduction(i.e. a
margin/haircut deduction from working capital) has not been made
for the value of securities held by the registrant. Each security
held is assigned a market risk margin rate as set out in Schedule 1
of 31-103F1. However, if you are an active proprietary trader be
careful with the margin rules, Unlike IIROC's inventory margin
rules, there are no capital offset rules for hedged short
positions, options and warrants. Firms are reminded to provide
supporting documentation of the market risk calculation as part
ofthe annual and interim financial statement filings.
The OSC notes that registered firms are required to know their
capital position at all times. Many people are surprised to find
that the capital required is not only the $50,000 cash in the bank.
Sufficient liquid assets are required to cover other working
capital requirements (e.g. accounts payable and accrued
liabilities), FIB insurance deductibles, market risk and
guarantees, if any. Thus, I like to suggest that an EMD maintains
liquid assets of at least$75,000 to $100,000 dependent on the
nature of the business.
What should you do in the unfortunate event your EMD reports a
capital deficiency? As Form 31-103F1 does not have early warning
indicators (as you find with other SROs), capital deficiencies do
arise. It's important that an EMD has contingency plan to deal
with these rare situations. A capital deficiency must be resolved
on a timely basis, usually within 48 hours. Thus, it's
important that financial statements and EWC calculations be
prepared and reviewed by management on a timely basis.
The OSC notes that EWC cannot be less than zero for more than 2
consecutive days. The OSC should be contacted immediately to
explain the details of the deficiency, be provided a copy of the
calculation EWC and related supporting documentation, outline the
plan to resolve the deficiency and steps to avoid its recurrence
and finally, provide evidence of how the deficiency was resolved
(cash injections and copies of the executed subordination agreement
or share capital issued).After a capital deficiency is resolved,
the OSC notes that it will either recommend terms and conditions be
placed on an EMD's registration (e.g. filing for a period the
monthly financial reports and the Form 31-103 F1) or provide a
warning letter to the registrant.
Keep your own firm in mind while you take the time to review the
report for the OSC, and be open to its advice, or help from other
professionals. One great place to start is by attending the
PCMA's Annual CFO Education Series: Financial Regulatory
Reporting Certificate Program. It is being held in Calgary,
Vancouver and Toronto in Fall 2014, and it's where we review
insignificant depth your financial regulatory requirements. It
might be a good use of your time. And along with other
refreshments, we also serve carrots.
The article was originally published in PCMA Private Capital Markets Magazine, Spring 2014
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.