Copyright 2009, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Securities Regulation, April 2009
On April 17, 2009, the Investment Industry Regulatory Organization of Canada (IIROC) published for comment rules entitled Over-the-Counter Securities Fair Pricing Rule and Confirmation Disclosure Requirements (the Proposed Rules). The Proposed Rules (i) will require reasonable efforts to obtain fair pricing of over-the-counter (OTC) traded securities, (ii) will amend existing trade confirmation requirements by mandating yield disclosure for fixed income securities, and (iii) will require firms to disclose on confirmations sent to retail clients for OTC transactions if the dealer's remuneration has been added to the price in the case of a purchase or deducted in the case of a sale.
In the notice that accompanies the Proposed Rules (the Notice), IIROC states that the general purpose of the Proposed Rules is to enhance the fairness of pricing and transparency of OTC market transactions.
The Proposed Rules have been published for a 90-day comment period which expires on July 16, 2009. Those submitting comment letters should be aware that a copy of their comment letter will be made publicly available on the IIROC website.
IIROC's stated objectives for the Proposed Rules are to:
1. ensure that clients, in particular retail clients, are being provided bid and offer prices for OTC securities (both fixed income and equity) that are fair and reasonable in relation to prevailing market conditions;
2. ensure that clients are provided sufficient disclosure regarding the security at issue that will enable them, as well as the clients' registered representative, to confirm through other market sources that the price being offered is a reasonable one in relation to prevailing market conditions;
3. underscore the principle that compliance activities are as important for OTC securities transactions as they are for listed securities transactions;
4. ensure that dealer members focus policies, procedures, supervisory and compliance efforts towards the OTC markets, in addition to the current focus on securities traded in organized markets, and provide dealer members' compliance departments with regulatory support for their compliance activities with respect to OTC business; and
5. acknowledge and highlight that the OTC markets differ in form and structure from the more formalized nature of the markets for listed securities, and to regulate the OTC markets taking these idiosyncrasies into account.
The need for new rules
IIROC acknowledges that the IIROC Dealer Member rulebook currently contains some rules (such as Dealer Member Rules 2800, 2800B and 29.1) which regulate dealer member activity in the debt markets in Canada, however, in its view these rules are general in nature and are not specifically aimed at the debt markets.
While some of the provisions in the Proposed Rules would apply to institutional investors as well, the primary intent of the Proposed Rules appears to be for the benefit of retail investors. The Notice contains a discussion of the unique features of the OTC market and their impact on retail investors, including that:
- retail investors in particular have less access to OTC security pricing (and yield) information than they do in the listed security markets;
- the pricing mechanisms used for fixed income securities are less understood by retail clients. Specifically, retail clients may not understand the inverse relationship between price and yield or the various factors that can affect yield calculations and the relative risk of a particular fixed income security. All these factors contribute to the difficulty retail investors are faced with when determining whether a particular fixed income security is fairly priced (and therefore offers an appropriate yield) and of appropriate risk;
- although most institutional clients have the ability to contact multiple institutional bond desks or use electronic trading systems to verify whether a price is fair, retail investors may not have this ability; and
- since in many cases it will be difficult for a retail client to confirm at a specific point in time the fairness of a price, the client must have confidence that the system itself, including the dealer member and its regulators, and all applicable laws, rules regulations and procedures, ensures that the client will receive a fair price.
The Proposed Rules
1. Over-the-counter traded security fair pricing rule
IIROC has proposed a principles-based rule that will require dealer members to provide or procure fair and reasonable prices for OTC securities (both fixed income and equity) transactions where such securities are purchased from or sold to clients. The Proposed Rule will cover transactions for both retail and institutional clients.
There are two elements to this Proposed Rule:
(i) the first part establishes a general duty to use "reasonable efforts" to obtain a price that is fair and reasonable in relation to prevailing market conditions; and
(ii) the second part addresses issues such as mark-ups and mark-downs in the case of principal transactions, and commissions or service charges in the case of agency transactions, and their impact on an aggregate fair price for a client.
IIROC expects each dealer member to have in place, and to supervise and enforce, policies and procedures that ensure that the price paid or received by the end client is a fair and reasonable one, taking into account the surrounding contextual factors, including the price prevailing in the market at that time for that security and similar or comparable securities. IIROC wants dealer member firms to use their professional judgment and market expertise to diligently ascertain and provide fair prices to clients in all circumstances, particularly in situations where the dealer member must determine inferred market price because the most recent market price does not accurately reflect market value of that security.
The fair pricing requirement will apply to all types of transactions in which a dealer member firm undertakes a purchase or sale of a relevant security for a client, whether the member is engaging in the transaction as an agent or as a principal to the trade.
In conjunction with the Proposed Rule, IIROC has issued for comment a draft guidance note (included as Attachment C to the Notice) that is intended to assist dealer members in determining fair and reasonable prices, and which transactions may require specific pricing documentation. However, IIROC has not proposed any specific requirement for documenting the considerations that went into the pricing of a transaction.
2. Fixed income security yield disclosure to clients
This Proposed Rule will require:
(i) the disclosure on trade confirmations of the yield to maturity for fixed income securities. The yield is to be calculated based on the aggregate price to the client, according to market conventions for that particular security; and
(ii) confirmations to include notations for callable and variable rate securities. In the case of debt securities that are callable prior to maturity through any means, a notation of "callable" must be included on the confirmation, and for debt securities carrying a variable rate coupon, a notation must be included on the confirmation as follows: "The coupon rate may vary".
IIROC believes that as a result of the proposed amendments, investors will be able to compare the yield disclosure to published yields of the security at issue and other comparable securities to assist that investor in determining whether a certain price is fair and reasonable, given all the surrounding contextual factors.
IIROC is proposing the yield disclosure rule as an amendment to Dealer Member Rule 200.1(h) regarding confirmation requirements (a black-lined copy of Dealer Member Rule 200.1(h) reflecting the proposed amendments is enclosed as Attachment B to the Notice). The yield disclosure requirements relating to stripped coupons and residual debt instruments already contained in Dealer Member Rule 200.1(h) is to remain in place.
3. Remuneration disclosure statement to retail clients
This Proposed Rule will require dealer members to disclose on confirmations for all OTC transactions for retail clients the following statement: "The investment dealer's remuneration on this transaction has been added to the price in the case of a purchase or deducted from the price in the case of a sale." This rule will apply to all OTC securities transactions where the amount of any mark-up or mark-down, commissions and other service charges is not disclosed on the trade confirmation sent to retail clients.
Where fee-based accounts are concerned, the proposed statement will be required on confirmations for OTC transactions if in fact there is a mark-up or mark-down, commission or other service charge relating to the transaction specifically.
In the case of introducing brokers, the proposed remuneration statement will have to be disclosed unless the amount of any and all mark-ups or mark-downs, commissions and other service charges associated with a transaction are disclosed on the confirmation, including any such form of remuneration with respect to a transaction on the part of the carrying broker.
IIROC is proposing the requirements relating to a remuneration disclosure statement as an amendment to Dealer Member Rule 200.1(h) regarding confirmation requirements (a black-lined copy of Dealer Member Rule 200.1(h) reflecting the proposed amendments is enclosed as Attachment B to the Notice).
Other Considerations/Next Steps
The Notice provides some information regarding the alternatives that were considered by IIROC. The Notice states that IIROC's rule development relating to remuneration disclosure to retail clients proved to be a more contentious proposal as compared to the other proposals.
The Notice also provides a comparison to provisions similar to the Proposed Rules. These comparable rules include those enacted by the United States Municipal Securities Rulemaking Board, the United States Financial Industry Regulatory Authority, and the United States Securities and Exchange Commission.
The Notice provides a brief discussion of the (i) effects of the Proposed Rule on market structure, dealer members, non-dealer members, competition and costs of compliance, and (ii) technological implications relating to the implementation of systems at dealer members.
The Notice observes that "market regulators' surveillance of fixed income market activity will provide the tools to monitor for patterns and trends in prices and will allow regulators to more effectively identify price outliers" and indicates that IIROC is currently considering how best to implement such a system to monitor dealer members' OTC security (both fixed income and equity) trading, which would allow IIROC to identify circumstances where trade prices do not correspond with the prevailing market at that time. This has been reported to reflect an intention of the regulators to design and implement a system that would address market manipulation issues in the bond market.
- Investment Industry Regulatory Organization of Canada seeking comments on rules designed to enhance the fairness of pricing and transparency of OTC market transactions
- The Proposed Rules require (i) reasonable efforts to obtain fair pricing of over-the-counter (OTC) traded securities, (ii) yield disclosure for fixed income securities, and (iii) remuneration disclosure on confirmations sent to retail clients for OTC transactions
- Comment period expires on July 16, 2009
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.