Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Securities Regulation, June 2008
- On May 29, 2008, the Canadian Securities Administrators
and U.S. SEC announced that they plan on signing in mid-June
2008 a process agreement for discussions of a potential
Canadian-U.S. mutual recognition arrangement.
- Mutual recognition could provide the TSX and Canadian
investment dealers with greater freedom to operate in the
United States under Canadian regulatory oversight, while U.S.
securities markets and U.S. broker-dealers could gain greater
freedom to operate in Canada under SEC oversight.
- Since 1991, the SEC and Canada's securities
regulators have participated in the Multi-Jurisdictional
Disclosure System (the MJDS) that permits issuers in Canada
and the United States to use the same disclosure forms when
selling securities in each other's markets.
- Canada has sought to build on the success of the MJDS and
took the initiative in launching talks among the G7 countries
that resulted in the May 29 announcement.
On May 29, 2008, the Canadian Securities Administrators (CSA) and U.S. Securities and Exchange Commission (SEC) announced that they plan on signing in mid-June 2008 a process agreement for discussions of a potential Canadian-U.S. mutual recognition arrangement.
Mutual recognition could provide Canadian securities exchanges and certain other Canadian financial service providers with greater freedom to operate in the United States under Canadian regulatory oversight, while U.S. securities markets and certain other U.S. financial service firms could gain greater freedom to operate in Canada under SEC oversight. In this manner, dual regulation, redundancy, and regulatory overlap could be reduced or eliminated.
The SEC announced in March 2008 that it would explore the possibility of a limited mutual recognition arrangement with one or more foreign regulatory counterparts, and that those arrangements could provide the basis for the development of a more general approach to mutual recognition through rulemaking. Since then, in addition to the work underway with Canada, the SEC has announced that it is in discussions concerning a possible mutual recognition arrangement with Australia, and that it is pursuing a process agreement, similar to the proposed agreement announced May 29, 2008 with Canada, with the European Commission and the Committee of European Securities Regulators. Any eventual mutual recognition arrangement with any individual country would be based upon a comparability assessment by the SEC and by the foreign authority of each other's securities regulatory regime.
Since 1991, the SEC and Canada's securities regulators have participated in the Multi-Jurisdictional Disclosure System (the MJDS) that permits issuers in Canada and the United States to use the same disclosure forms when selling securities in each other's markets. Canada has sought to build on the success of the MJDS and took the initiative in launching talks among the G7 countries that resulted in the May 29 announcement.
Under current securities legislation in Canada, when Canadian retail investors want to buy or sell securities of foreign issuers listed on foreign stock exchanges:
- they cannot do so directly through a Canadian
- they have to directly contact a foreign broker-dealer or
work through a domestic dealer who retains a foreign
broker-dealer because foreign broker-dealers cannot directly
solicit retail orders or provide unsolicited information on
foreign investment products,
- the protections of Canadian securities laws do not extend
to these foreign market transactions,
- the transaction costs for such investments are relatively
high due to duplicative regulatory costs and high capital
- in some cases, they can't invest in foreign
securities at all.
Institutional investors have greater access today to foreign broker dealers than retail investors do. In proposed National Instrument 31-103 Registration Requirements released for comment by the CSA, international dealers would be permitted to trade foreign securities with high net worth individuals.
Yet, as capital markets become increasingly global, the desirability for investing in foreign products increases and duplicative and restrictive domestic securities regulatory systems represent a barrier to this trend. As Richard Nesbitt, then CEO of the TSX Group, stated in a speech to the National Press Club in 2006, "our markets are outpacing our rules".1
The potential gains in increased efficiencies, reduced costs and increased competition in the financial services market from removing regulatory barriers to global trade in securities were acknowledged by the G7 Finance Ministers at their meeting in Essen, Germany in February 2007. They committed to further liberalize cross-border capital markets by exploring free trade in securities based on a "mutual recognition" of regulatory regimes. The Canadian federal government highlighted this commitment as a priority in its 2007 federal budget. The SEC has also stated that its staff is developing a proposal to implement a mutual recognition system, a distinct change in focus from "harmonization" or "convergence" discussed in the past few years.
The liberalization of trade in securities is being discussed in academic circles as well, the leading article being one written in the Harvard International Law Journal by two members of the SEC's Office of International Affairs, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework 2 (the Blueprint). The Blueprint discusses liberalizing trade in securities under a system of "substituted compliance", which the authors promote as the basis for "mutual recognition"3, whereby foreign securities exchanges and broker-dealers would be able to obtain exemptions from registration in a particular host jurisdiction based on their compliance with substantively comparable foreign securities regulations and laws, and supervision by substantively comparable foreign securities regulators.
Once exempted from registration, a foreign exchange could place trading screens in a host jurisdiction and offer exclusively foreign-listed securities to investors on the secondary trading market in the host jurisdiction through a host jurisdiction broker-dealer or a foreign broker-dealer who had received a registration exemption under the Blueprint. Once exempted from registration, a foreign broker-dealer could offer exclusively foreign-listed securities4 to investors in the host jurisdiction. This system is currently being considered by both the SEC5 and the Canadian federal government.6
BLUEPRINT FOR FREE TRADE IN SECURITIES
The implementation of the Blueprint would involve a four-step process:7
- Foreign Entity Petition — A petition from a
foreign securities exchange or broker-dealer (a foreign
entity) seeking exemption from registration in the host
jurisdiction.8 One commenter in the Harvard
International Law Journal proposed that a home jurisdiction
should conduct an upfront review and acceptance of the
regu-latory systems of other G7 countries rather than waiting
to have the review initiated by a foreign entity.9
This may be the approach being taken given the announcement
of bilateral discussions between the SEC and Australian
regulators and between the SEC and the CSA.
- Assessment of Substituted Compliance — A
dialogue between the regulator of the host jurisdiction in
which the foreign entity is seeking the exemption, and the
regulator of the petitioning entity's home
jurisdiction. This discussion would involve a bilateral
assessment to determine the degree to which the trading
rules, prudential requirements, examinations, filing review
processes and other requirements of the two jurisdictions are
comparable. This assessment would also consider enforcement
capabilities and philosophies. This step could also involve a
collaborative discussion of whether regulatory adjustments
would be needed to bring the two regulatory systems into
closer harmony and help ensure that there are no regulatory
gaps or systemic risks. This step would conclude with the
negotiation of an enforcement, inspection and
information-sharing technical arrangement or memorandum of
understanding that would enable the two regulators to share
enforcement-related information, co-operate with each
other's enforcement investigations, share inspection
reports, conduct joint inspections, and co-operate at the
prudential oversight level. The host jurisdiction might also
wish, and will likely require, that the home jurisdiction
provides reciprocity. Because regulations change over time,
an in-depth de novo review would be undertaken after a
certain period of time. The Blueprint suggests this be done
every five years.
- Preconditions to Exemption — A dialogue between
the regulator of the host jurisdiction and the petitioning
entity, which would include the provision of information by
the petitioning entity and its agreement to certain terms and
conditions of the host jurisdiction.
- Public Comment — Public notice by the host
jurisdiction's regulator of the foreign
entity's petition, seeking public comment on the
petition. After the comment period, the regulator would
decide whether or not to approve the petition.
Once exempted from registration, (i) a foreign securities exchange could place trading screens in the host jurisdiction and offer exclusively foreign-listed securities to investors in the host jurisdiction through a host jurisdiction broker-dealer or a foreign broker-dealer who had received a registration exemption under the Blueprint, and (ii) a foreign broker-dealer could offer exclusively foreign-listed investment products to investors in the host jurisdiction.
ASSESSMENT OF SUBSTITUTED COMPLIANCE
Components Of Assessment
The second step in the implementation of the Blueprint is key to its success and acceptance by each of the G7 countries. This step, which involves the assessment of the comparability of the two regulatory regimes, would aim to ensure that the regulatory oversight of two different systems is sufficiently similar that the regulator of the host jurisdiction is not violating its legislative mandate to ensure compliance with the securities requirements of the host jurisdiction. Comparability would help ensure that the Blueprint truly constitutes substituted compliance and does not create an opportunity for regulatory arbitrage or a regulatory "race to the bottom". Comparability could also allow for closer co-ordination between the home jurisdiction and host jurisdiction regulators and help ensure that foreign transactions in the host jurisdiction do not present a threat to the integrity of the securities market in the home jurisdiction.
The review of regulatory provisions would cover exchange oversight, broker-dealer oversight and issuer requirements. These three areas would include consideration of the following types of provisions:
- Registration and authorization system.
- How customer funds are protected.
- Record-keeping, reporting and electronic audit trail
- Exchange governance and internal compliance.
- Exchange trading rules.
- Exchange rule approval process.
- Registration and authorization system.
- Minimum financial requirements.
- Protection of customer funds from misappropriation.
- Record-keeping, reporting and electronic audit trail
- Internal compliance requirements.
- Sales practice standards.
- Minimum disclosure requirements with regard to
broker-dealer conflicts of interest.
- Issuer disclosure requirements.
- Accounting standards, auditing standards and auditor
- Corporate governance, internal controls, director
independence and shareholder protection requirements.
In a January 2008 address to the Practicing Law Institute's Seventh Annual Institute on Securities Regulation in Europe,10 John White of the SEC suggested that evaluating issuer disclosure requirements would be an essential part of any mutual recognition or "substituted compliance" bilateral assessment.
Mr. White further argued that, initially, a mutual recognition system that allows U.S. investors to trade in foreign securities should be limited to "plain vanilla" securities of seasoned foreign issuers that appear to have a broad market following11, meet a certain level of public float, and have an established track record of stock trading and public disclosure.
Parameters Of Assessment
As is evident in Mr. White's remarks to the Practicing Law Institute, each jurisdiction that engages in a bilateral assessment under the second step of the Blueprint will likely set its own parameters for such assessment, which will provide a certain degree of flexibility in implementing the Blueprint, but may also lead to a lock-up.
Some commenters in the Harvard International Law Journal proposed that, to avoid problems of lock-up, the aim of substituted compliance should not be regulatory convergence or harmonization, which is often not feasible, and that the bilateral assessment of the two regulatory regimes should not take the form of a detailed rule-by-rule comparison.12 The assessment should instead be made at a much higher level, focusing on the basic regulatory principles and objectives of the regulatory regimes.
Another commenter in the Harvard International Law Journal proposed that the two jurisdictions should review not only the formal structure of securities legal requirements but their application in practice as well, including the scope of actual resources committed to regulatory oversight and the extent of actual enforcement activity.13 Research suggests that countries vary widely in their actual enforcement of securities regulation, and consequently comparable, or even identical substantive regulations, may yield different results.14 As such, widening the parameters of the bilateral assessment to include this aspect will increase the likelihood that true "substituted compliance" is achieved.
Co-Operation In Enforcement
The final stage of the assessment, arguably the most important, is the negotiation of an enforcement, inspection and information-sharing technical arrangement or memorandum of understanding that would enable the two regulators to share enforcement-related information, co-operate with each other's enforcement investigations, share inspection reports, conduct joint inspections, and co-operate at the prudential oversight level. The negotiation and application of such a co-operative arrangement is key to ensuring that a system of substituted compliance does not allow market participants to capitalize on enforcement gaps between the host and home jurisdictions.
TERMS AND CONDITIONS TO EXEMPTION
In addition to the base requirement of substituted compliance between the regulatory regimes of the host and home jurisdictions, the Blueprint envisages that the host jurisdiction regulator will set out certain terms and conditions to obtaining and maintaining an exemption from registration for petitioning foreign entities. Such terms and conditions might include:
Registration — The petitioning foreign entity must maintain its registration in its home jurisdiction.
Submission to Host Jurisdiction — The petitioning foreign entity must (i) submit to the non-exclusive jurisdiction of the courts and administrative tribunals of the host jurisdiction with respect to certain matters connected with a host jurisdiction investor trading on a foreign exchange or placing an order through foreign broker-dealer exempted under the Blueprint, and (ii) file a valid and binding appointment of an agent for service in the host jurisdiction.
Risk Disclosure Statement — The petitioning foreign entity must provide a risk disclosure statement to home jurisdiction investors that: (i) the exchange/broker-dealer is regulated by the regulator in the home jurisdiction rather than by the host jurisdiction regulator, (ii) trading on the foreign exchange is governed by rules in the home jurisdiction which differ from rules applicable to domestic exchanges in the host jurisdiction, and (iii) rights and remedies against the exchange/broker-dealer may only be governed by the laws of the home jurisdiction rather than the laws of the host jurisdiction and may need to be pursued in the home jurisdiction rather than the host jurisdiction.
Notification of Changes — The petitioning foreign entity will promptly notify the host jurisdiction of (i) material changes to its regulatory oversight or corporate governance structure, (ii) material changes to investor protections in its home jurisdiction, (iii) material changes in its trading rules (foreign exchange only), (iv) any known investigation or, or disciplinary against, it by any regulatory authority, (v) any matter known to it that may affect its financial or operational viability, or (v) any default, insolvency or bankruptcy of any of its members known to it that may have a material adverse impact on it (foreign exchange only).
Continuous Disclosure — The petitioning foreign entity will maintain updated information and submit certain specified information to the host jurisdiction at least on a quarterly basis and promptly upon request, such as (i) a list of broker-dealers exempted under the Blueprint to which it has provided access, (ii) a list of broker-dealers exempted under the Blueprint against which it has taken disciplinary action in the last quarter or against which its home jurisdiction regulator has taken disciplinary action with respect to activities on it, (iii) a list of all investigations it is conducting relating to broker-dealers exempted under the Blueprint, and (iv) a list of all broker-dealers exempted under the Blueprint to whom it has denied access.
The petitioning foreign broker-dealer will maintain updated information and submit to the host jurisdiction, at least on a quarterly basis and promptly upon request, a list of its clients in the host jurisdiction.
Co-operation — The petitioning foreign entity will, subject to applicable laws, share any and all information within its care and control with the host jurisdiction and otherwise co-operate wherever reasonable with the host jurisdiction's regulator.
Violations — If the petitioning foreign entity were to breach the terms and conditions to their exemption from registration, the exemption could be revoked.
One of the benefits that would arise from adopting a system of "substituted compliance" or "mutual recognition" amongst G7 countries that share the same broad regulatory objectives would be to introduce a greater regulatory as well as financial services competition to global capital markets.
On the regulatory side, securities regulators would compete with each other to develop the most effective and least costly practices to achieve their regulatory objectives. On the financial services side, capital markets would see enhanced competition amongst exchanges for the listings of foreign firms as well as enhanced competition among a wider range of broker-dealers seeking to market foreign securities to host jurisdiction investors. Some exchanges may see a reduction in business from foreign entities currently listed with them. However, if reciprocity is required in the bilateral assessment stage of implementing the Blueprint, opportunities lost at home may be gained abroad.
The Toronto Stock Exchange would benefit from greater access to U.S. retail investors. However, it may be that foreign broker-dealers would have a greater opportunity to benefit from mutual recognition as proposed in the Blueprint than Canadian investment dealers given that the Blueprint proposal excludes inter-listed securities and a greater percentage of Canadian securities are inter-listed than U.S. securities are.
As capital markets become increasingly global, the need to reduce barriers to free trade in securities persists. G7 governments and regulators have acknowledged this need, and have committed to finding a solution through the "mutual recognition" of regulatory regimes. The Blueprint proposed by members of the SEC's Office of International Affairs provides a viable mechanism for achieving the goal of liberalizing trade in securities amongst the G7 while upholding the gold standard of regulatory objectives, investor protection. The Blueprint allows for flexibility in regulatory schemes, co-operation in cross-border enforcement and competition amongst regulators and financial services providers while discouraging "regulatory arbitrage" that could undermine investor protection.
1. Richard Nesbitt, CEO TSX Group, Address at National Press Club (April 4, 2006).
2. Ethiopis Tafara and Robert J. Peterson, "A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework" 48 Harv. Int'l L.J. 31 (2007) (Tafara and Peterson, "Blueprint").
3. EU regulators refer to this general concept as "equivalence".
4. The Blueprint specifically envisages that it would not apply to securities inter-listed in the host jurisdiction.
5. See, for example, John W. White, SEC Staff, Remarks Before Practicing Law Institute's Seventh Annual Institute on Securities Regulation in Europe (January 14, 2008).
6. See, for example, Canada, Department of Finance, Budget 2007: Creating a Canadian Advantage in Global Capital Markets (2007) at 30-31.
7. Tafara and Peterson, "Blueprint", supra note 2 at 58-59.
8. The Blueprint contemplates either an exemption from registration or recognition or registration of foreign exchanges and foreign broker-dealers in the host jurisdiction. Recognition or registration would require a large number of exemptions from existing securities legislation of the host jurisdiction to be granted, whereas a system of overall exemption from the host jurisdiction's securities legislation would seem simpler, given that the assessment of the comparability of the two regulatory systems is a necessary pre-condition to mutual recognition. However, registration may work better for compliance and enforcement purposes.
9. Edward Greene, "Beyond Borders: Time to Tear Down the Barriers to Global Investing" 48 Harv. Int'l. L.J. 86, 94-92 (2007) (Green, "Beyond Borders").
10. White, "PLI Speech", supra note 5.
11. White suggested looking to the SEC's well known seasoned issuer definition - $700 million global public float, as a benchmark for this purpose.
12. Greene, "Beyond Borders", supra note 9.
13. Howell E. Jackson, "A System of Selective Substitute Compliance" 48 Harv. Int'l L.J. 86, 105-119 (2007).
14. Howell E. Jackson, "Variation in the Intensity of Financial Regulation: Preliminary Evidence and Potential Implications", The Harvard John M. Olin Discussion Paper Series No. 521 (Aug. 2005) available at http://www.law.harvard.edu/programs/olin_center/corporate_governance/papers/Jackson_521.pdf (accessed January 22, 2008).
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