Securities laws, anti-money laundering and terrorist financing reporting regulations have, over the past few years, gone through a significant overhaul in Canada and continue to evolve at a steady pace. At the same time, regulatory oversight and compliance audits have increased, as the provincial securities commissions have hired additional staff and presently focus on registrants and compliance.
The hedge fund industry has been under regulatory scrutiny in Canada for a number of years now, and it is imperative that hedge fund managers stay on top of compliance. 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 Bulletin provides guidance for your 2012 annual compliance check-up and points out what may be ahead for you by way of new regulatory focus.
The following 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 diarized.
You should be aware that the OSC is reviewing hedge funds in Canada and considering the potential for systemic risks posed by the Canadian hedge fund industry. Very little has been published about this issue1, but it
may explain why you receive more frequent questionnaires asking you for information about your funds or visits from OSC staff.
The Annual Check-up: National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) requires the firm's Chief Compliance Officer (CCO) to submit an annual report to the firm's board of directors for the purpose of assessing compliance by the firm, and by individuals acting on its behalf, with securities legislation. For a one-person shop, the CCO and the "board of directors" may be one and the same. Whether you are preparing a report to the board, or 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.
Hedge 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 Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA) and must comply with regulations under that Act and the published guidelines of FINTRAC, the body that oversees the anti-money laundering (AML) regime in Canada. The firm must conduct a full compliance review of its AML policies and procedures to test their effectiveness at least once every two years. Firms that do not have dedicated personnel or an independent firm engaged for this purpose can do a "self-review". If feasible, this self-review should be conducted by an individual who is independent of the reporting, record-keeping and compliance-monitoring functions. Firms are not required, but may wish, to engage an outside legal or accounting firm to conduct the review.
Where to start: As CCO, you must familiarize yourself with NI 31-103 and other related instruments and you should have a copy of the most current versions on hand. Pay particular attention to Parts 11 to 14 of NI 31-103, which deal with business operations and client relationships, and make sure to read the Companion Policy attached to NI 31-103. The Companion Policy contains often extensive elaborations of the basic rules, and will give you a better sense of what the regulators expect. The OSC's website and the websites of any other securities commissions with which your firm is registered should be consulted frequently for current regulatory and compliance developments.
For AML compliance, you should also read the FINTRAC guidelines (available on the FINTRAC website) 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 of registrants on a more frequent basis. Deficiencies that are identified in these examinations can result in civil or criminal penalties under the PCMLTFA.
Learn From Others' Mistakes: A great way to get a handle on where to start is to see where others have gone wrong. Compliance and Registrant Regulation Branch staff at the OSC prepare annual reports on the results of their regulatory compliance audits; the latest being OSC Staff Notice 33-736 Annual Summary Report for Dealers, Advisers and Investment Funds Managers (published in September 2011 and [available here]). This Bulletin will discuss some but not all of the common deficiencies identified by OSC staff. Other regulators, such as the British Columbia Securities Commission and the Alberta Securities Commission, also publish annual reports.
Common Deficiencies: Addressing the common deficiencies should be the first step in any self-diagnosis, particularly since CSA staff are increasingly impatient with firms that are not aware of the CSA positions or have not addressed them. OSC Staff Notice 33-736 identified the following key areas of non-compliance:
- Inaccurate calculation of excess working capital and inadequate insurance coverage
- Compliance and supervisory challenges with the use of social media for marketing and communication with clients
- Lack of evidence that the CCO's annual compliance report has been submitted to the board of directors (or its equivalent)
- Inappropriate cross trading between client accounts
- Failure to disclose soft dollar usage to clients
- Prohibited delegation of KYC and suitability obligations to other parties and other inadequacies relating to suitability, KYC and know your product obligations
- Inappropriate expenses charged to funds
- Use of the accredited investor exemption for trades with non-accredited investor clients
- Inadequate supervision of dealing representatives
- Trading in securities without registration (i.e., as dealing representatives)
- Marketing and client disclosure that is outdated, misleading, contains unsubstantiated claims and lacks conflict of interest disclosure
- Failure to disclose outside business activities
Some of the deficiencies were likely exacerbated by the continued transition to the NI 31-103 regime, as some firms may have been slow to implement required changes, while other deficiencies may be due to a particular staff focus. The OSC Staff Notice offers suggested practices that 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 the most serious consequences. The OSC Staff Notice specifically refers to this issue, which is particularly pronounced with respect to dealing activities (acting as a dealer). 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?
In addition, deficiencies in your applications for registration of individuals (and related exemption applications) may delay the processing of applications. OSC staff has noted common deficiencies arising out of applications made during 2011. You may wish to work with your legal counsel to ensure that your applications for registration are properly and fully completed. Some of the more significant issues identified by staff include:
- Failure to disclose any trade names used by dealing representatives under "Use of other names", other business activities and reasons for leaving previous employment
- Insufficient evidence of proficiency and insufficient details about equivalency in proficiency exemption applications
- Incomplete responses relating to resignations and terminations as well as regulatory, criminal, civil and financial disclosures.
You may also be required to register in other provinces as an investment fund manager, if various CSA proposals become law. Our Bulletin entitled Canadian Securities Regulators Publish Proposals for Registration of Non-Resident Investment Fund Managers (March 2012) describes the proposals and their status [available here]. Proposed deadlines for applying in the additional provinces (where required) are set for either September 30, 2012 or December 31, 2012.
Notice of Change: Have you moved offices recently? Has one of your officers resigned or changed residential addresses? Has one of your officers taken on a new directorship? One frequently occurring deficiency, that can result in significant late filing fees for a registrant, 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. Most changes must be reported using Form 33-109F5 within 10 calendar days.
Marketing: What kind of information do you provide to your investors – in brochures or other written documents? Via your website? The OSC staff are particularly focused on marketing practices of firms, and have been for years. Reviewing registrants' websites is now standard practice by staff conducting compliance audits. You need to be ahead of staff in making sure your website is accurate and contains only appropriate information.
Staff's annual compliance reports have long pointed out what they consider to be deficiencies in marketing and sales communications and OSC Staff Notice 33-729 Marketing Practices of Investment Counsel/ Portfolio Managers published in 2007 gave guidance on staff's views on appropriate marketing practices for portfolio managers. CSA Staff Notice 31-325 Marketing Practices of Portfolio Managers published in July 2011 [available here] provides further guidance on the CSA's views about marketing by registrants, including how firms can ensure communications provided to investors are fair and not misleading. It also updates certain issues and guidance previously provided by the OSC in 2007, including the preparation and use of hypothetical performance data, exaggerated and unsubstantiated claims, policies, procedures and internal controls, use of benchmarks, performance composites and "holding out", and issues surrounding use of firm names.
Regulatory Capital: How's your regulatory capital? When was the last time you checked? 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. As noted in OSC Staff Notice 33-736, the OSC considers that some registered firms are not calculating their excess working capital accurately specifically with respect to current assets that are not readily convertible into cash. For example, you should exclude accounts receivables, especially from related parties, that are not readily convertible to cash. 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 (as calculated on Form 31-103F1 Calculation of Excess Working Capital ). Before repaying all or any part of the subordinated loan or terminating the subordination agreement, you must provide your principal regulator with 10 days' prior written notice. You cannot guarantee the debt of any other entity, including related companies, without impacting 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's 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. You should factor in any expected increases in your firm's assets or AUM for the next year when determining the amount of insurance coverage. Your board of directors should review and approve the insurance coverage at least annually.
Know-Your-Client (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. Your advising or dealing representatives should have a meaningful in-person (or telephone, if more appropriate) discussion with each client to understand their KYC information, explain your investment process and strategy and other account relationship information, assist the client in completing required documentation, regularly communicate the holdings and performance of the managed account to the client, and keep KYC information in all files up-to-date. The frequency of your updates will depend very much on the nature of the client and the nature of the investment; however, generally, you should immediately contact the client when you know that their circumstances have changed, and periodically contact them (at least annually) to assess if their circumstances have changed. If you have legacy files that do not have a written record of KYC information, ensure that KYC forms are completed and put into the file and kept current.
If you wish to take advantage of the "permitted client" exemption with respect to KYC and suitability, make sure you fully understand when it is available (you can't use it for managed accounts) and from what practices you are exempt.
Dealer firms must also know their product (KYP) before they can properly assess suitability – as a hedge fund manager you may find yourself spending time educating your distribution network about the features of your hedge fund product.
If you sell your fund through an agent, make sure that they are registered and conducting KYC in accordance with NI 31-103, otherwise that obligation falls on you. Note that, as a registrant, your firm cannot delegate KYC and suitability obligations to other parties. Even if a client has been referred to you, you should still be conducting your own KYC and suitability assessment of the referred client. You should also carefully review referral arrangements to ensure that all activity requiring registration is performed by appropriately registered firms and individuals.
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. The OSC staff is very interested in understanding how firms are complying with the "relationship" disclosure required to be given to clients, particularly in connection with information about conflicts of interest. More is coming on this front, although the CSA have not finished considering how to move forward with their proposals for requiring registrants to give clients additional annual cost and performance disclosure. See our Bulletin New Disclosure Rules Proposed for Registered Firms in Canada: Account-Level Charges and Performance September 2011 [available here].
Side Letters: Long the bane of fund managers, side letters caught the attention of the regulators in 2010. In the 2010 annual compliance report (OSC Staff Notice 33-734), the OSC explained that staff have concerns with investment fund managers giving preferential treatment to one or more investors in the same class of securities of an investment fund (for example, preferential portfolio transparency, redemption rights, fund reporting and fees), as this can disadvantage the other investors. As an alternative to side letters, and assuming a fund's constating documents permit it, consider issuing a different class of securities and disclosing the rights and terms of each such class in the fund's offering document.
Prohibited Investments: Are you familiar with the investment restrictions set out in securities laws that may apply to your investment fund? Even for investment funds that are not sold publicly under a prospectus, but that fit the definition of "mutual fund", Ontario securities laws 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 (of any type) 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). Cross-trading amongst funds, and between funds and other clients under common management, is prohibited in the absence of exemptive relief.
Client Complaints: Are you aware of, and prepared for, the September 28, 2012 (extended from September 28, 2011) deadline for making available independent dispute resolution or mediation services to your clients to resolve client complaints? After September 28, 2012, if a person or company makes a complaint to you about any of your trading or advising activities, you must as soon as possible inform the person or company of how to contact and use the dispute resolution or mediation services that you offer. All registered firms are already required to document and respond to client complaints about products or services that you offer. Firms operating in Québec must comply with Québec regulations that apply (and have applied for some years) to complaints raised by residents of that province, including the on-line reporting regime regarding complaints.
We expect that complaint handling and dispute resolution will continue to be at the regulatory forefront during 2012, as the CSA are expected to publish further guidance or rules in this area.
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 (e.g., to provide for the rights of purchasers in additional jurisdictions or to disclose changes to the fund), a new copy must be filed.
Exempt Trades: Fund sales made under certain private placement exemptions (accredited investor and $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. The report must be filed using Form 45-106F1. Fees are payable in most provinces. It is critical that you ensure that your investor is an "accredited investor" as defined in National Instrument 45-106 Prospectus and Registration Exemptions if you intend to rely on that exemption. OSC staff are focused on ensuring that no "retail" investor (that is, a non-accredited investor) be invested in a privately placed fund, particularly a hedge fund. OSC Staff Notice 33-735 Sale of Exempt Securities to Non-Accredited Investors (published in May 2011 and available here) sets out the OSC's expectations in this area, which includes personal contact and discussion with your clients about being accredited investors. "Tick the box" and certification may not be sufficient anymore with this new focus, particularly in circumstances where the accredited investor representation is inconsistent with KYC information provided separately.
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, fulfill all regulatory obligations. Our Bulletin entitled Canadian Regulators Commence a Review of Minimum Amount and Accredited Prospectus Exemptions published in November 2011 [available here] will give you some background on these issues. It is early days in this consultation, but the formal (and very general) consultation has now closed and the comments (from many different viewpoints and with many different suggestions) are posted on the OSC website. Proposals to change the exempt marketplace in the Western provinces can also be expected during 2012, based on information being disseminated by the regulators in those provinces.
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. For financial years beginning on or after January 1, 2011, all domestic registered firms must prepare their financial statements using IFRS.
All investment funds that are reporting issuers, and mutual funds that are not reporting issuers (other than those organized under the laws of certain provinces) are also required to make available to investors and file with the securities regulators annual audited financial statements (within 90 days of their fiscal year-end) and six month interim unaudited financial statements (within 60 days of the end of the interim period). You may have to discuss with your legal advisers as to whether your fund is a "mutual fund" for securities law purposes. If its units or shares are redeemable on demand at the net asset value, the fund is probably a mutual fund. Mutual funds are governed by National Instrument 81-106 Investment Fund Continuous Disclosure 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 make them available to their investors. If you do not want to have to file those statements with the applicable securities commission, 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.
Soft Dollar Arrangements: All soft dollar arrangements must comply with National Instrument 23-102 Use of Client Brokerage Commissions, which came into force on June 30, 2010. 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 updates must be given annually containing the information required by NI 23-102.
Referral Arrangements: All referral arrangements must comply with NI 31-103 and other applicable securities laws. As a registered firm, you are responsible for ensuring compliance. There must be a written agreement between the payor 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. If you are making a referral, you must satisfy yourself that the recipient of the referral is appropriately qualified to perform the services and registered (if applicable). If you are receiving a referral, ensure that you meet all of your obligations as a registrant, including KYC and suitability. You must also manage any related conflicts of interest matters, including for example, those that may arise in the context of referral fees (which are broadly defined).
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 matters discussed in this Bulletin, and more, should be set out or addressed in a written policies and procedures manual that has been developed for your own organization. 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 you would have certified that you had one when you first applied for registration). You will be asked to provide the manual when your 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 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". Oftentimes, if a compliance action isn't written down, the regulators will not accept, at face value, that it has been done.
Compliance is an ongoing and evolving process and hedge funds and their managers, in particular, are in the securities regulators' sights. 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 to say they are coming to pay you a visit. Nothing can take the place of good preparation, keeping up with regulatory developments and compliance practices, even when you are focused on enhancing the wealth of your clients.
1 See OSC Staff Notice 33-736 Annual Summary Report for Dealers, Advisers and Investment Fund Managers (September 2011) at page 13 Systemic risks potentially posed by hedge funds.
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.
Specific Questions relating to this article should be addressed directly to the author.