The Canadian securities administrators (the CSA) recently finalized National Instrument 23-102 Use of Client Brokerage Commissions, along with an accompanying Companion Policy [available here]. Subject to required governmental approvals, National Instrument 23-102 will come into force on June 30, 2010 in all provinces and territories. The coming into force of this Instrument represents the culmination of many years of "soft dollar" policy development in Canada, the most recent round of which commenced in 2005.1
National Instrument 23-102 will replace guidance on 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). Both policy statements will be rescinded effective on the same date that National Instrument 23-102 comes into force in those provinces.
The final form of National Instrument 23-102 and the Companion Policy maintains most of the key components of the last versions published for comment in January 2008, with some modifications made in response to comments received, including those provided by lawyers in BLG's Investment Management Group.
In addition to finalizing National Instrument 23-102, the CSA also published for comment proposed amendments to Form 81-101F2 Contents of Annual Information Form under National Instrument 81-101 Mutual Fund Prospectus Disclosure, and to Form 41–101F2 Information Required in an Investment Fund Prospectus under National Instrument 41-101 General Prospectus Requirements [available here]. The comment period for these proposed amendments ends on January 7, 2010. These investment fund disclosure amendments are intended to ensure consistency between the disclosure required to be given by advisers (portfolio managers) to clients pursuant to National Instrument 23-102 and the prospectus level disclosure to be given by investment funds to investors, both relating to the use of brokerage commissions. Managers of mutual funds subject to National Instrument 81-101 have long been required to provide disclosure about the use of brokerage commissions by the portfolio managers for the funds
The proposed amendments to National Instrument 41-101 will mean that non-redeemable investment funds, such as exchange-traded funds and closed-end funds, will also be required to provide information about the portfolio manager's use of such commissions. The CSA explain that they do not intend to amend National Instrument 81-106 Investment Fund Continuous Disclosure which contains different disclosure requirements regarding the use of fund brokerage commissions by portfolio managers of investment funds. National Instrument 23-102 applies to registered advisers and also to registered dealers and reflects the CSA's long-standing fundamental policies 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 goods and services or research goods and services. When commissions are used to pay for permitted services, such services must benefit the clients of the adviser and may not be used to pay for general overhead expenses of the adviser.
- The amount of commissions used 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. Registrants must adhere to best execution principles when carrying out trades for clients.
- Clients are entitled to receive information about the goods and services registrants are acquiring with the commissions generated from their trades.
Scope of Rule: National Instrument 23-102 applies only to trades in securities placed by advisers for an investment fund or a managed account where brokerage commissions or any similar transaction-based fees are paid by the fund or account in respect of those trades.
This means that the rule will only apply to trades where the commission paid in respect of the transaction is clearly separate and identifiable – for example, 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. National Instrument 23-102 clarifies that in some provinces, exchanged-traded futures contracts and certain derivative instruments are considered to be securities under the applicable securities legislation in those provinces and therefore registrants trading such instruments for client accounts must comply with NI 23-102 in respect of those trades.
Although the scope of the Instrument is limited to trades for which a brokerage commission is charged, the CSA explain that they expect registrants to be guided by the provisions of the Instrument when carrying out other transactions, such as principal transactions where an embedded mark-up is charged. An adviser that obtains goods and services other than order execution in conjunction with such transactions remains subject to its duty to deal fairly, honestly, and in good faith with clients and must make reasonable efforts to achieve best execution when acting for clients. Advisers are advised to consider any relevant conflicts of interest "given the incentives created for advisers to place their interests ahead of their clients" when obtaining goods and services other than order execution in connection with client transactions.
Permitted Goods and Services: An adviser (portfolio manager) may not direct brokerage transactions for its discretionary accounts, including investment funds and managed accounts, to a dealer if those accounts will pay brokerage commissions in exchange for goods and services provided to the adviser, unless those goods and services are:
- Order execution goods and services, which are those goods and services involved in the actual execution of the order, as well as those that are directly related to order execution. In the final version of National Instrument 23-102, the CSA adopted the same "temporal" standard for order execution goods and services as that suggested by the Securities and Exchange Commission in the United States, which means that order execution goods and services are those that are used or provided between the point at which an adviser makes an investment or trading decision and the point at which the resulting securities transaction is completed.
- Research goods and services, which include advice, analyses or reports regarding various subject matters relating to investments, as well as databases and software to the extent that they support these goods and services. Generally the CSA would expect that research goods and services will be used or provided before an adviser makes an investment or trading decision.
National Instrument 23-102 imposes similar requirements on dealers. A dealer may not accept, or forward to a third party, brokerage commissions for trades placed by an adviser if the dealer or third party will provide the adviser with goods and services that are not order execution goods and services or research goods and services. The CSA explain that a dealer must undertake a certain level of due diligence to ensure that brokerage commissions are being used to pay for only permitted goods and services. If a dealer cannot easily make this assessment about a good or service, then the CSA expect the dealer to ask the adviser about the nature of the good or service.
National Instrument 23-102 clarifies that client brokerage commissions may be paid to a dealer or to a third party in return for permitted services, in recognition of the growing practice of commission sharing arrangements and other commission management techniques.
Benefit to Clients: An adviser must ensure that permitted goods and services are to be used to assist with investment or trading decisions or with effecting securities transactions, on behalf of its client or clients. Advisers must also ensure that they make a good faith determination that their clients receive a reasonable benefit considering both the use of the goods or services and the amount of client brokerage commissions paid. The CSA clarify that these requirements may be satisfied if the adviser can show that the particular goods and services benefit its clients generally. It is not necessary for an adviser to link the benefit of a particular good or service directly back to the specific clients whose trades generated the particular brokerage commissions. The views of the CSA reflect the practical reality that a particular good or service may benefit more than one client and may not directly benefit each specific client.
Disclosure to Clients: The disclosure requirements in the final version of National Instrument 23-102 have been simplified and streamlined. Advisers will be required to provide specified narrative information to prospective clients about the expected use of client brokerage commissions when the clients are opening accounts, including when an adviser enters into a management agreement to manage an investment fund. Advisers will also be required to provide additional narrative information to all clients on a periodic basis, which must be at least annually. The CSA have dropped all quantitative disclosure requirements from the final version of National Instrument 23-102, although the CSA indicate that they will continue to monitor industry and regulatory developments to determine if quantitative disclosure would be warranted in the future.
Advisers should note that they will be required to include the prescribed information about the use of client brokerage commissions by any sub-advisers engaged to provide management services to their managed accounts or investment funds. We recommend advisers review their sub-advisory relationships to ensure that they have the contractual authority to request this information so that they can meet these new requirements. This will be particularly relevant for managers of investment funds, given the prospectus-level disclosure proposed in the amendments to National Instruments 81-101 and 41-101.
The prescribed information can be provided at a client-specific level or based on firm-wide information, or based on some other level of customization, so long as the information disclosed relates to those clients to whom the disclosure is directed.
The CSA expect that all clients of an adviser that are clients as of June 30, 2010 will receive the prescribed disclosure on or before December 31, 2010. Advisers can use this six-month window to determine the appropriate method to communicate the prescribed information to these existing clients, but should ensure that as of July 1, 2010, all new clients receive the required disclosure, which will necessitate a close review of account opening documentation and investment management agreements.
Compliance Expectations: Registrants will want to ensure that they have appropriate compliance systems in place to address the requirements under National Instrument 23-102 including, for example, policies and procedures to ensure that over time all clients whose brokerage commissions may have paid for goods and services receive fair and reasonable benefit. Dealers' compliance systems should be able to ensure that brokerage commissions are charged and accepted only in exchange for permitted goods and services. Maintaining proper books and records regarding use of client brokerage commissions will be very important for registrants. National Instrument 23-102 should be considered also in the context of compliance with the enhanced conflict of interest management and disclosure expectations mandated in National Instrument 31-103, as well the conflict of interest independent review committee procedures established for investment funds under National Instrument 81-107.
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. A second draft of National Instrument 23-102 was published for comment in January 2008.
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