Canada, in keeping with the rest of the world, has seen unprecedented change in the regulation of the financial markets over the past five years – not only in scope and detail, but also in speed of implementation. At the same time, regulators have stepped up their oversight with both broad-based and targeted compliance audits, resulting in the need for financial services participants to place an increasing focus on compliance.
The hedge fund industry has been under particular regulatory scrutiny, and it is imperative that hedge fund managers keep pace with regulatory developments and also develop effective compliance systems, including policies and procedures. Since 2007, the Investment Management practice group at Borden Ladner Gervais LLP (BLG) has annually published tips for performing a self-diagnosis of your compliance regime. This Investment Management Bulletin provides guidance for your 2013 annual compliance check-up and points out what may be ahead by way of regulatory focus.
What follows is not intended to be a complete review of all legal and compliance matters applicable to managers of privately offered pooled funds, but is a reminder of some basic compliance issues and some simple fixes. Time-sensitive requirements should be diarised.
Regulatory focus on the exempt markets
You should also be aware that the CSA is reconsidering the exempt marketplace and the exemptions available, as well as making sure that exempt market dealers, in particular, fulfil all regulatory obligations. In addition, the OSC is conducting its own review of the exempt markets and is considering a number of new prospectus exemptions. Our Bulletin entitled OSC Continues to Examine New Capital Raising Prospectus Exemptions published in September 20131 will give you some background on the OSC’s review. Before any proposed new or amended prospectus exemptions take effect, the proposed rules will first be subject to a minimum 90-day comment period.
The annual check-up: National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) requires the Chief Compliance Officer (CCO) of every registered firm to submit an annual report to the firm’s board of directors for the purpose of assessing compliance by the firm with securities legislation. Whether you are preparing a report to the board, or you are a one-person shop simply preparing a memo to file, your principal regulator’s compliance staff may ask for a copy when they conduct a compliance audit of your firm. A report that outlines the results of your review of a checklist of compliance matters can help satisfy this requirement.
Also, fund managers that are registered as advisers or dealers under NI 31-103 are considered to be ‘securities dealers’ for the purposes of the federal anti-money laundering (AML) legislation and should be prepared for a FINTRAC audit. AML legislation requires firms to, among other things, conduct a detailed assessment of and document all risks relating to AML specific to the firm’s business. The firm must also conduct a full compliance review of its AML policies and procedures to test their effectiveness at least once every two years. Firms are not required, but may wish to engage an outside service provider to conduct the review. If you do a self-review, it should be conducted by an individual who is independent of the reporting, record-keeping and compliance-monitoring functions.
Where to start: As CCO, you must make yourself familiar with NI 31-103 and other related instruments and you should have a copy of the most current versions on hand. It changes. Often. Pay particular attention to Parts 11 to 14, which deal with business operations and client relationships, and be sure to read the Companion Policy attached to NI 31-103. The Ontario Securities Commission (OSC) website2 and the websites of other securities commissions with which your firm is registered should be consulted often for current regulatory and compliance developments (you can sign up to receive regular emails from some of the Commissions). The OSC and the British Columbia Securities Commission (BCSC) both offer a Registrant Outreach Program.
In both provinces, registrant firms can contact commission staff with any compliance questions or concerns regarding industry or individual practice. In Ontario, OSC staff will be holding educational seminars this fall on various practical topics – firms can sign up through the OSC website.
For AML compliance, you should also read the FINTRAC guidelines3 that apply to you as a ‘securities dealer’. These guidelines are updated from time to time and you should make sure you are familiar with the updated versions. FINTRAC has been conducting desk-based compliance examinations on a more frequent basis. Deficiencies can result in civil or criminal penalties.
Learn from others’ mistakes: A great way to get a handle on where to start is to see where others have gone wrong. OSC Compliance and Registrant Regulation Branch staff prepare regular reports on the results of their regulatory compliance audits, which are generally published towards the end of the year; the latest was published on November 22, 2012 (OSC Staff Notice 33-7384). The BCSC also publishes an annual Compliance Report Card. In May 2013, the OSC published OSC Staff Notice 33-7405 with the results of their targeted review (sweep) of know-your-client (KYC), know-your-product and suitability practices.
OSC 2012 common deficiencies: Addressing the common deficiencies should be your first step in any self-diagnosis. OSC Staff Notice 33-738 identified key areas of non-compliance among investment fund managers, portfolio managers and exempt market dealers, including:
- Inadequate compliance systems / CCOs not adequately performing responsibilities
- Inadequate relationship disclosure information provided to clients
- Inaccurate calculations of excess working capital
- Insufficient oversight by IFMs of outsourced functions and service providers
- Improper valuation of restricted securities
- Inappropriate expenses charged to funds
- Inadequate insurance coverage
- Misleading marketing practices
In addition to the above, among the most common deficiencies found during the 2012 KYC and suitability sweep were the following:
- Misuse of the accredited investor exemption
- Inadequate suitability assessment and lack of written policies and procedures for determining suitability
- Inadequate collection, documentation and updating of KYC information
OSC Staff Notice 33-738 offers ‘suggested practices’ which you should consider. You may wish to work with your legal counsel or other compliance advisers to adopt and implement practices that are appropriate for your firm.
Registration: Failure to register your firm and individuals within the firm in all required categories and in all applicable jurisdictions can have serious consequences. Have you discussed with your compliance advisers where your firm needs to be registered and in what categories, and which individuals within the firm require registration? OSC Staff Notice 33-738 discusses a number of frequently occurring deficiencies with respect to firm and individual registrations.
Notices of changes: Have you moved offices recently? Has one of your officers resigned or changed residential addresses? One frequently occurring deficiency that can result in significant late filing fees for a registrant in Ontario, is the failure to notify the principal regulator that there has been a change in the information previously provided on the Form 33-109F6 for the firm, or the Form 33-109F4 for an individual within the firm. Most changes must be reported within 10 days. The CCO should regularly review information about the firm on file in the National Registration Database (NRD) and on the firm’s Form 33-109F6 and ensure that each registered or permitted individual reviews their personal information for continued accuracy as well.
Outside Business Activities: Commission staff are looking more closely at outside business activities (OBAs) of dealing and advising representatives of registrant firms. All OBAs must be disclosed in an individual’s Form 33-109F4. In addition to other employment, an OBA can include acting as an officer or director of another company or organisation, having a significant ownership interest in a holding company or having a paid or unpaid role with a charitable or religious organisation. Of particular concern is the potential for conflicts of interest, the possibility of an individual being placed in a position of power or influence and the ability of the individual to discharge his or her regulatory obligations to the firm’s clients. CCOs must have policies and procedures in place to ensure disclosure by individuals of their OBAs, to assess whether the OBAs are inconsistent with securities legislation or interfere with the individual’s ability to remain current on securities law and product development, and to monitor those OBAs.
Marketing: There are no published rules regarding marketing practices in the exempt market, however a registered firm is required to “deal fairly, honestly and in good faith with its clients”. Misleading marketing is repeatedly cited as a deficiency by Commission staff, and from time to time they offer guidelines as to what they see as being acceptable, and what is not. Performance data must be clear (e.g. described as net or gross of fees) and material differences between fund returns and benchmark returns must be disclosed (compounded versus simple returns, use of leverage or short positions, and concentrated versus broad portfolio holdings are all relevant). Claims must not be exaggerated – the OSC frequently comments on claims such as ‘proven performance’, ‘superior to index returns’ or ‘best in class’ and requires such statements to be softened or removed where they cannot be supported by actual performance numbers. CCOs should review the published reports of the securities regulators on the results of compliance audits of marketing practices when assessing their own firm’s practices.
Regulatory capital: When was the last time you checked your regulatory capital? Are you performing the calculation correctly using Form 31-103F1 Calculation of Excess Working Capital? All registered firms are required to ensure that excess working capital is not less than zero for two consecutive days. If at any time the firm’s working capital is less than zero, it must be reported to the firm’s principal regulator immediately. OSC Staff Notice 33-738 provides a helpful table of common mistakes made by registrants in calculating excess working capital, such as the inclusion of accounts receivable that are not readily convertible into cash and the inclusion of cash that serves as collateral or is otherwise committed. You must file a copy of any subordination agreement the effect of which is to exclude an amount from your long-term related party debt. Before repaying any part of the subordinated loan or terminating the subordination agreement, you must provide your principal regulator with 10 days’ prior written notice. Registrants cannot guarantee the debt of any other entity, including parent companies, without impacting the working capital.
Regulatory insurance: Does your firm meet the insurance requirements under NI 31-103, including providing for a double aggregate limit or full reinstatement of coverage? Minimum insurance requirements increase with your firm assets or assets under management (AUM), and your coverage should be reviewed on a regular basis (especially when there is a material change in your business or circumstances) to ensure that it continues to meet the requirements of NI 31-103. When renewing your firm’s policy, you should factor in any expected increases in firm assets or AUM for the next year in determining the amount of insurance coverage. Your board of directors should review and approve the insurance coverage your firm requires at least annually.
KYC, suitability and disclosure to clients: NI 31-103 requires all registered firms to “know your client” and to do a suitability assessment before advising or conducting a trade on behalf of a client. In addition, there is mandated relationship disclosure information (RDI) that must be provided to the client before you commence any dealer or advisory activities for that client. Develop a KYC form that is relevant to your firm, your services and products, and your client base. Your advising or dealing representative should have a meaningful discussion with each client to review (and update) KYC information provided, explain the products and services to be provided to the client, go over the RDI information provided to the client in writing, and answer questions that the client may have. KYC information must be updated – the regulators suggest at least annually, but this depends on the nature of the client and the nature of the investment. You should immediately contact a client when you know that their circumstances have changed.
Dealer firms must also know their product before they can properly assess suitability – as a hedge fund manager you may find yourself spending more time educating your distribution network about the features of your hedge fund product.
If you have legacy files that do not have a written record of KYC information, ensure that the client is contacted and that KYC forms are completed and put into the file. Note that, as a registrant, your firm cannot delegate KYC and suitability obligations to other parties. If you sell your fund through an agent, make sure that they are registered and conducting KYC, otherwise that obligation falls on you.
If you wish to avail yourself of the ‘permitted client’ exemption (available to exempt you from suitability assessments), make sure you fully understand when it is available and what practices you are exempt from. Portfolio managers acting on behalf of managed account clients may not rely on the permitted client exemption to avoid KYC and suitability obligations.
Relationship disclosure information: Make sure that all of your dealer and advisory clients have received a document (within or alongside the offering memorandum or subscription or managed account agreement) setting out your duties, your fees and the client’s investment mandate, and all other client disclosures required by NI 31-103, before you begin providing any services to them. In July 2013, the CSA published CSA Staff Notice 31-3346, summarising the results of their review of RDI practices. A number of deficiencies in registrants’ disclosure to clients were noted. CCOs should review their firm’s client disclosure against CSA Staff Notice 31-334. In addition, NI 31-103 has been recently amended to phase in, over a 3 year period, additional client disclosure and reporting obligations, including annual cost and compensation disclosure and specific investment performance reporting. These new requirements – often referred to as ‘CRM-2’ – are substantial and complex. A starting point for you to understand these new requirements should be our Investment Management Bulletin Canadian Securities Administrators Finalise Rules Requiring Enhanced Account Level Disclosure by Registrants: Effective July 15, 20137.
Ensure that your disclosure documents are updated and that key dates for the new reporting requirements are diarised.
Related party transactions and prohibited investments: Are you familiar with the investment restrictions set out in securities laws that may apply to your investment fund? For example, investment funds that meet the definition of a ‘mutual fund’ in Ontario have specific prohibitions against investments in securities of their related parties, and investments in a person or company in which the mutual fund, alone or together with its related mutual funds, owns more than 20 percent of the outstanding voting securities. In addition, a portfolio manager is prohibited from causing an investment fund for which it acts as adviser from purchasing a security of an issuer in which a ‘responsible person’ or an associate of a responsible person is a partner, officer or director unless this fact is disclosed to the client and the prior written consent of the client is obtained (note that disclosure should be provided to, and consent obtained from, each securityholder of the investment fund in order for it to be meaningful). Inter-fund trading between funds under common management is prohibited.
Client complaints: NI 31-103 contains rules on the handling of client complaints involving advising or dealing activities. As a registrant, you may have to offer a dispute resolution or mediation service, at your cost – note that the CSA are developing additional requirements. Firms operating in Quebec must comply with Quebec regulations that apply to complaints raised by residents of that province.
FATCA: If your fund is a foreign financial institution (FFI) – most Canadian hedge funds are – withholding rules and information gathering requirements that may be applicable to your fund under the U.S. Foreign Account Tax Compliance Act (FATCA) will take effect June 30, 2014. The U.S. Internal Revenue Service (IRS) portal, which will allow you to register your fund as a participating foreign financial institution, is open until December 31, 2013. Canadian FFIs are being cautiously advised to wait to do their FATCA registration until after an expected Canada-U.S. intergovernmental agreement (IGA) is released (however there may be a short window in which to register after the IGA is released, and fund managers are also advised to make themselves familiar with the information that they must provide by visiting the IRS website now). CCOs are urged to educate themselves regarding FATCA and to consult with their professional advisers to determine what their obligations are and when they come into effect.
Swaps: Canadian hedge fund managers that trade over-the-counter derivatives known as ‘swaps’ with ‘U.S. Persons’ must consider whether and to what extent new regulations released by the U.S. Commodity Futures Trading Commission (CFTC) apply to them. Managers of funds that trade in swaps should consult with their professional advisers to determine the impact of the CFTC regulations on their operations.
Offering memorandum: When was the last time you updated your funds’ offering memorandum? Did you file it with any securities commission? Certain provinces, such as Ontario, require an offering memorandum to be filed within 10 days of the first closing of the sale of units or other securities in respect of which the offering memorandum was used (in Québec, the offering memorandum must be filed ‘without delay’). Each time the offering memorandum is updated and sent to prospective investors, a new copy should be filed.
Report of trades: Fund sales made under certain private placement exemptions (accredited investor and CAD$150,000 exemptions, among others) must be reported to the securities commission in each province where sales were made, either within 10 days of the closing of each new subscription or within 30 days after the fund’s financial year-end, depending on the exemption. Make sure you use the correct form, file electronically where required and pay all applicable fees.
Financial statements: All registered firms must file with their principal regulator audited annual financial statements, together with a completed Form 31-103F1, within 90 days of their fiscal year end. Investment fund managers and dealers (other than exempt market dealers) must also file quarterly unaudited financial statements and a Form 31-103F1. Investment fund managers must include a description of any net asset value adjustments made during the year or quarter. If financial statements are filed late, late fees will be imposed in certain jurisdictions and the principal regulator may place a term and condition on the firm’s registration that requires monthly financial reporting.
All investment funds that are reporting issuers, and mutual funds that are not reporting issuers (other than those organised under the laws of certain provinces) are also required to deliver to investors (other than those that opt out) and file with the securities regulators annual audited financial statements (within 90 days of the year end) and six month interim unaudited financial statements (within 60 days). You may have to discuss with your legal advisers whether your fund is a ‘mutual fund’ for securities law purposes. If its units or shares are redeemable on demand at net asset value, the fund probably is a mutual fund. Mutual funds are governed by National Instrument 81-106 Investment Fund Continuous Disclosure (NI 81-106) and, although exempt from many of the requirements of NI 81-106 if they are not reporting issuers, they must prepare the financial statements and deliver them to their investors. If you do not want to have to file those statements with your principal regulator, you must prepare and file a one-time ‘Section 2.11 Notice’ indicating your intention not to file. A similar note must go in the financial statements. For financial years beginning on or after January 1, 2014, investment funds must present their financial statements in accordance with IFRS.
Soft dollar arrangements: All soft dollar arrangements must comply with National Instrument 23-102 Use of Client Brokerage Commissions. Disclosure of such arrangements must be given at the time of opening a client account (fund managers may wish to include disclosure in the fund’s offering memorandum) or entering into a managed account agreement, and thereafter such updates must be given annually containing the information required by NI 23-102.
Referral arrangements: All referral arrangements must comply with NI 31-103. There must be a written agreement between the payer and payee of a referral fee, and investors or other clients that are the subject of the referral arrangement must be advised of the arrangement, all in accordance with NI 31-103.
Trade Matching and Settlement: National Instrument 24-101 Institutional Trade Matching and Settlement requires registered advisers whose clients use delivery-against-payment (DAP) or receipt-against-payment (RAP) accounts (primarily institutional clients whose securities are held by a custodian) to:
- establish, maintain and enforce policies in accordance with NI 24-101
- enter into a trade-matching agreement or be provided a trade-matching statement, and
- complete and deliver an exception report if they have failed to match the trade within the required time period during any quarter
Policies and procedures manual: All of the above, and more, should be set out in or addressed in a written policies and procedures manual that has been developed for your own organisation. Registered firms that were not required to file a policies and procedures manual when they applied for registration are nonetheless required to have one, and will be asked to provide a copy of the manual when their principal regulator conducts a compliance audit. Off-the-shelf compliance manuals should only be used as a good head start and not as the beginning and the end of the development process. As important as the manual is, proper implementation is even more important to the regulators’ compliance staff, and you must be prepared to produce written documentation evidencing that implementation – failure to comply with your own written policies and procedures can constitute a ‘significant deficiency’.
Compliance is an ongoing and evolving process. NI 31-103 has placed significant emphasis on prudent business practice and the need for a registered firm to build a culture of compliance. Our bottom line? Be ready for that call from your principal securities regulator or FINTRAC to say they are coming to pay you a visit. Nothing can take the place of good preparation, keeping up with regulatory developments and solid compliance practices, even when you are focused on enhancing the wealth of your clients.
Since the date of first publication of this article, the OSC published its 2013 Staff Report (OSC Staff Notice 33-742). The deficiencies identified in this article continue to be identified as common deficiencies in 2013, however readers are directed to the newer report (http://www.osc.gov.on.ca/en/SecuritiesLaw_sn_20131107_33-742_annual-rpt-dealers.htm) for a more current discussion of areas of concern for the regulators.
Ron Kosonic is a Partner with Borden Ladner Gervais LLP, focussed on the areas of domestic and offshore hedge funds, investment management firms, securities regulation and regulatory compliance. He is a frequent author and conference speaker on hedge fund structures, regulatory compliance and registrant audit and liability matters.
Sarah Gardiner is a Partner with Borden Ladner Gervais LLP, who specialises in investment funds, investment management, alternative asset management, securities regulation and regulatory compliance. She routinely advises both Canadian and non-Canadian clients in connection with the establishment and operation of investment funds in Canada and ongoing legal and compliance issues.
Borden Ladner Gervais LLP (BLG) is a full-service, national law firm with more than 750 lawyers, intellectual property agents and other professionals in six Canadian cities. The Investment Management Group at BLG consists of a team of over 50 lawyers who understand the business, regulatory and administrative issues that face participants in the Canadian investment management industry. For more information, please visit www.blg.com