Canada: Canadian Securities Regulators Propose Revised Rules To Regulate Use Of Client Brokerage Commissions

On January 11, 2008, the Canadian securities administrators (the CSA) released for a second comment period proposed National Instrument 23-102 Use of Client Brokerage Commissions as Payment for Order Execution Services or Research Services, along with an accompanying companion policy. This proposed "soft dollar" rule and policy is the CSA's response to the forty-three comment letters received after the first publication of the CSA proposals in July 20061, as well as the new restrictions on the use of soft dollars that became effective during 2006 and 2007 in the United States and the United Kingdom.

The proposed rule and policy are designed to replace recommended approaches for the use of soft dollars adopted in 1986 by the Ontario Securities Commission (OSC Policy Statement 1.9), and later by l'Autorité des marchés financiers in Québec (AMF Policy Statement Q-20). The proposed rule does not deviate to any great extent from these policies, however, the CSA provide much needed additional guidance and clarifications as to what would constitute order execution, order execution services and research services. The proposed rule also will expand the level of disclosure that portfolio managers, including managers of mutual funds, will be expected to give their clients about the use of brokerage commissions.

The proposals will have the effect of eliminating the term "soft dollars" from the lexicon of Canadian regulation, as the CSA propose to use only the more descriptive, if less colourful, phrase, "use of client brokerage commissions".

The proposals reinforce the CSA's long-standing fundamental views on the use of client brokerage commissions by registrants:

  • Client brokerage commissions may not be used to pay for any goods or services that are not order execution services or research services. Even when commissions are used to pay for permitted services, such services must benefit the client whose trades generated the commissions.
  • The amount of commissions used to pay for permitted services must be reasonable in relation to the value of the services received and the adviser must be able to justify the use of commissions to acquire the services.
  • Clients are entitled to understand what goods and services registrants are acquiring with the commissions generated from their trades.

We anticipate that many of the clarifications made in the proposed rule and policy will be welcomed by registrants, given that the proposed rules are less ambiguous than previously proposed and the CSA now provide more useful guidance on the various goods and services that may be legitimately acquired with brokerage commissions.

The rule will only apply to trades in securities for an investment fund, a fully managed account or any other account or portfolio over which an adviser exercises investment discretion on behalf of third party beneficiaries, where brokerage commissions are charged by the dealer. This means that the rules will only apply to trades in securities that are exchange-traded, or where there is an independent pricing mechanism that enables the adviser to accurately and objectively determine the amount of commissions or fees charged. However, the CSA confirm their view that advisers must consider their fiduciary duty to deal fairly, honestly and in good faith with clients where they obtain goods and services other than order execution in conjunction with trades such as principal trades in fixed income securities where a mark-up is charged. In other words, advisers would be wise to take guidance from the proposed rule even where trading in fixed income and other non-exchange traded securities.

Order execution services will include goods and services provided or used between the point at which an adviser makes an investment decision and the point at which the resulting securities transaction is concluded – this is described as the "temporal standard" for order execution services. Some clarifications about services that would constitute order execution services or research services include:

  • advice, analyses or reports regarding various subject matters relating to investments, including databases and software that support these services, as well as traditional research reports, narrowly focused publications, fees to attend relevant educational seminars and conferences and trading advice from a dealer as to how, when or where to trade an order
  • order management systems, algorithmic trading software and market data, post-trade analytics from prior transactions, quantitative analytical software, market data from feeds or databases that will be analysed or manipulated to arrive at meaningful conclusions
  • custody, clearing and settlement services that are directly related to an executed order that generated commissions
  • mixed use items to the extent that they have some elements that may meet the definitions of order execution services or research services and brokerage commissions are allocated to acquire only those acceptable elements.

We expect that advisers will need to closely review the proposed disclosure requirements under the rule to ensure that the proposals are realistic and capable of practical implementation. Although the CSA explain that they have reduced the amount of quantitative disclosure required, advisers will still be required to provide narrative disclosure, including a description of the process they follow to select dealers to carry out portfolio transactions, the names of dealers and third parties that provided goods and services and the types of goods and services provided. Some quantitative disclosure will be required, including aggregated and per client amounts of client brokerage commissions paid, as well as a reasonable estimate of brokerage commissions used to acquire permitted goods and services.

Managers of publicly offered investment funds will note that it may not be sufficient to make the required disclosure in the annual information form of the investment funds, particularly given the differences between the existing AIF disclosure rules and the new disclosure rules proposed by the CSA. The CSA explain that they will be reviewing the prospectus disclosure rules in light of NI 23-103. The CSA suggest in the companion policy that fund managers should consider making the mandated disclosure to the independent review committee for their investment funds, presumably on the basis, although this is not explicitly stated, that the fund manager is in a conflict of interest position when it is deciding to use the commissions generated from portfolio trades of the funds in the manner contemplated in NI 23-103. In our view, it would be appropriate for a fund manager to conclude, where it or an affiliate is the portfolio manager for the funds, that use of brokerage commissions is a conflict of interest matter requiring IRC input, however, we question the necessity for the CSA's prescriptive suggestion that the mandated disclosure should be made to the IRC.

Any adviser, including a manager of an investment fund, that engages sub-advisers for client accounts, will be required to report on the use of client brokerage commissions by those sub-advisers. Industry participants will need to consider the mechanics of complying with this requirement carefully to determine if this is feasible.

Registrants will want to ensure that they have appropriate compliance systems in place to, among other things, ensure that an adviser can identify which clients benefit from the use of client brokerage commissions. Advisers must be able to value the goods or services received and illustrate that the amount of brokerage commissions paid to acquire those goods and services was reasonable in relation to that value. Dealers' compliance systems should be able to ensure that brokerage commissions are charged and accepted only in exchange for order execution services and research services. Maintaining proper books and records regarding use of commission brokerage will be very important for registrants.

Although we think that improvements to the proposals are necessary, particularly in the areas of disclosure and the CSA's views about the application of the rules to fund managers, we believe that these proposals will provide welcome additional certainty and consistency in respect of an area of the investment industry that has not always been well understood. We note that the CSA propose a six-month transition period to the new rules, which means that if NI 23-102 is brought into force by the end of 2008 as anticipated, registrants will be required to comply with it in mid-2009.

If you would like more information about how proposed NI 23-102 will affect you, please call your usual lawyer in BLG's Investment Management Group or any one of the following Investment Management Group leaders. We would be pleased to assist you in preparing a comment letter on proposed NI 23-102 by the comment deadline of April 10, 2008.

Footnotes

1. The first version of the proposed rule and companion policy published in 2006 was preceded by the publication in February 2005 of Concept Paper 23-402 Best Execution and Soft Dollar Arrangements by the British Columbia, Alberta, Manitoba, Ontario and Québec securities regulators.

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