The Canadian Securities Administrators (the CSA) have published for comment a revised proposed National Instrument 23-102 Use of Client Brokerage Commissions as Payment for Order Execution Services or Research (Proposed Instrument) and a corresponding proposed Companion Policy 23-102 CP (Proposed Policy). The Proposed Instrument and Proposed Policy (collectively, the Proposal) update an earlier proposal published in July 2006 (the 2006 Proposal).
The Proposed Instrument (announced on January 11, 2008) includes several substantive changes from the 2006 Proposal. In particular, the CSA has addressed concerns raised with the 2006 Proposal (see our Osler Update on the 2006 Proposal) by:
- narrowing the scope of the Proposed Instrument's application;
- clarifying the definitions of "order execution services" and "research services";
- clarifying the obligations of advisers; and
- increasing the narrative scope, while decreasing the quantitative scope, of the required disclosure of soft dollar arrangements.
These changes are likely to address many of the concerns raised about the 2006 Proposal.
Soft dollar arrangements are a continuing area of concern for Canadian regulators because of the potential conflict of interest between dealers and advisers and their clients. The CSA is concerned that they may result in higher brokerage commission fees being paid by clients with questionable resulting benefits. In the last two years, both the U.S. Securities and Exchange Commission and the U.K. Financial Services Authority have implemented soft dollar measures. Ontario and Québec have had soft dollar policy statements since 1986; however, if enacted, the Proposal will for the first time create explicit restrictions on the use of soft dollar arrangements while providing specific guidance to advisers.
Scope of Application
The Proposed Instrument has a narrower application than the 2006 Proposal. The Proposed Instrument applies to any trade 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 charger by a dealer. The 2006 Proposal would have applied to trades in OTC markets and trades executed on a principal basis. In these instances, the lack of pricing transparency makes it is difficult to separate the purchase price of the security from any additional premiums or fees.
The Proposed Policy provides additional clarification regarding the application limits of the Proposed Instrument. Section 2.1(1) of the Proposed Policy defines "client brokerage commissions" as including any commission or similar transaction-based fee charged for a trade where the consideration paid for the security is clearly separate and identifiable. With respect to trades such as principal trades where a mark-up is charged, advisers would not be subject to the Proposal but will be subject to their general fiduciary obligations to their clients.
Definitions of "Order Execution Services" and "Research Services"
The definition of order execution services (for which soft dollars are permitted to be used) remains unchanged; however, additional clarification has been included regarding the temporal standard used to interpret the definition. The temporal standard set out in Section 3.2 of the Proposed Policy would include goods and services provided or used between the point when the adviser makes an investment decision and the point when the resulting transaction is completed.
Substantive changes have been made to the proposed definition of research services (for which soft dollars are permitted to be used) and the associated guidance, shifting the focus away from characteristics-based eligibility to the adviser's use of the research.
The Proposed Policy has also been amended to include a wider range of goods and services which will be permitted under soft dollar arrangements. The non-exhaustive list of examples now includes such items as raw market data, proxy services, publications marketed towards a narrow audience (e.g., trade magazines), seminar and conference fees, databases and software. Some of the examples include "mixed-use" items, for which only that portion that benefits clients may be paid for with client brokerage commissions.
Obligations on Advisers
The Proposal includes further clarification of the obligations of advisers to ensure that soft dollar arrangements benefit their clients. Under the Proposed Policy, the adviser should be able to demonstrate how the order execution and research services purchased with client brokerage commissions are used to provide appropriate assistance to the adviser in making investment decisions or in effecting transactions.
It is not, however, necessary for advisers to establish a direct connection between each specific good or service received and a particular client. Subsection 4.1(3) of the Proposed Policy acknowledges that a specific good or service may benefit more than one client and may not always directly benefit each particular client whose brokerage commissions were used as payment. It is, however, incumbent on advisers to have policies and procedures in place to ensure that all clients whose brokerage commissions were used as payment benefited from the use of order execution or research services.
The Proposed Instrument also addresses concerns over the difficulty of ensuring that the amount of value received is reasonable in relation to the client brokerage commissions paid. Subsection 3.1(2) of the Proposed Instrument has been amended to propose that the adviser must ensure that a good faith determination has been made with respect to the reasonableness of value received from soft dollar arrangements.
The client disclosure requirements were amended to strike a better balance between the costs of additional disclosure and the benefits to clients of increased transparency and accountability, while aiming for greater consistency with U.S. disclosure requirements.
The definition of "client" for purposes of disclosure has been clarified. Typically the "client" will be the party with whom the contractual arrangement to provide advisory services exists. However, where the adviser is also the trustee and/or the manager of an investment fund, or is an affiliate of the trustee and/or manager, the disclosure may need to be made to the investment fund's independent review committee.
The proposed narrative scope of soft dollar disclosure has been increased to provide more information to clients. In addition to the narrative disclosure requirements in the 2006 Proposal, advisers will also be required to identify the names of dealers and third parties that provided goods and services other than order execution, and the types of goods and services provided.
Additional narrative requirements include descriptions of:
- the process for, and factors considered in, selecting dealers;
- procedures to ensure that clients receive reasonable benefits from soft dollar arrangements; and
- the methods for determining overall reasonableness of the commission paid for the value received.
The proposed quantitative scope has been decreased to require disclosure on an aggregated basis of the total client brokerage commissions paid during the period and a reasonable estimate of the portion paid for goods and services other than order execution (to the extent ascertainable). Proposed guidance provides advisers with flexibility to determine the appropriate level of aggregation based on their business structure and client needs.
Comment Before April 10, 2008
A copy of the CSA's Request for Comments, including the Proposed Instrument and the Proposed Policy can be found here. Interested parties may make written submissions with respect to the Proposals before April 10, 2008.
Please contact us if you have any questions regarding soft dollar arrangements in Canada, either currently, or under the CSA's proposed regulatory framework.
John Black is a partner in the Business Law Department in the firm's Toronto office. Mark DesLauriers is a partner in the firm's Toronto office where he practises in the area of corporate and securities law. Ron Kugan is an associate in the Business Law Department of the firm's Toronto office.