Membership Information Bulletin #0286-M - Publication of MFDA IPC

Contact: Joni Alexander IPC President Phone: 416-943-5827 E-mail:ipc@mfda.ca BULLETIN #0286 – M December 7, 2007 MFDA Bulletin Membership Information For Distribution to Relevant Parties within your Firm Publication of MFDA IPC Working Group Report and MFDA IPC Board of Directors’ Response The MFDA Investor Protection Corporation (the “MFDA IPC”) has received the permission of the Canadian Securities Administrators (the “CSA”) to publish the MFDA IPC Working Group Report and Response to the Report by the MFDA IPC Board of Directors. Copies of the Report and Response are attached to this Bulletin. The MFDA IPC was established in 2002 and received the required approvals from the Alberta, British Columbia, Manitoba, Nova Scotia, Ontario and Saskatchewan Securities Commissions in May 2005. Coverage of clients’ accounts began July 1, 2005. The terms and conditions of the approval orders of the MFDA IPC required that a Working Group, consisting of representatives of the MFDA IPC, the MFDA and MFDA Members, be established, with members of the CSA participating as observers. The Working Group was established in October 2005 and undertook to review a number of aspects of the MFDA IPC, including identification of risks of mutual fund dealer failures leading to investor losses, appropriate fund size, types of products that should be covered, the appropriate coverage amount per customer account, assessment methodology, long-term funding and risk management tools required by the MFDA IPC. The attached Report and Response are the results of that process. DOCs #126188 to the Board of Directors of the MFDA lnvestor Protection Corporation Septem ber 2006 Report of the Working Group to the Board of Directors of the MFDA lnvestor Protection Corporation Table of Contents 1. II. III. IV. EXECUTIVE SUMMARY 1 INTRODUCTION ............................................................................................................... 4 DEFINITIONS 5 DISCUSSION 6 Process Followe 4. ................................................................................................... .................................................................................................................... .................................................................................................................... lnvestor Protection a. Exposure Limit 9. Assessment Methodology c. Assessment Alter Risk Management En 10. 12. Other Matte Appendix A Working Gr Appendix B Consensus Recommendations ........................................................................ 30 33 Appendix C Dealer lnsolvencies ........................................................................................... 3 Essex Capital Management Inc. (1999) Vantage Securities Inc. (1998) ........................................................................................ 33 - Report of the Working Group to the Board of Directors of the MFDA Investor Protection Corporation 1. EXECUTIVE SUMMARY The MFDA lnvestor Protection Corporation (IPC) established the Working Group to review certain aspects of the IPC, including the size of the fund, its coverage policy and its assessment and funding methodologies, with the goal of ensuring the IPC fulfills its purpose of protecting investors on a failure of a member of the Mutual Fund Dealers Association of Canada (MFDA). This Report to the IPC Board of Directors describes each of the issues considered by the Working Group and sets out its recommendations. Where there is no consensus on a particular topic, the Report explains the alternative views of the members. lnvestor Protection. The risk of failure of a dealer may be reduced but not eliminated by regulations setting minimum standards for capital and risk management and by direct oversight by regulators, If a failure does occur, other provisions such as mandatory segregation of client assets may reduce client losses. An effective investor compensation scheme serves to reduce the risk of client losses further, which benefits al1 market participants by boosting investor confidence in the market. The Working Group notes that there remain gaps in investor protection as investors' assets may be under the control of various intermediaries, such as mutual fund managers and portfolio managers that are not covered by a comparable compensation fund, despite the fact that losses through fraud or insolvency are possible. Some of these market participants are not registered with or licensed by any regulator or supervisor and so are not subject to minimum standards or direct oversight. The CSA might want to consider what actions would be appropriate to take to protect invastors dealing directly or indirectly with these entities. Coverage Scope. IPC coverage was reviewed along five dimensions: geographic reach, type of assets covered, location where the assets are held, what events should be covered and who should be an eligible client. The Working Group notes that it would be best if IPC coverage were closely integrated with the pooling provisions in Part XII of Bankruptcy and lnsolvency Act of Canada (BIAC), designed so that it could be administered easily and be capable of being described in a manner the average investor is capable of understanding. Any limitations on coverage should be simple and unambiguous. Geographic scope. IPC coverage does not extend to clients with accounts in Quebec at MFDA members and the assets under administration (AUA) of mutual fund assets of these clients are not subject to the IPC assessment. Quebec residents get the benefit of the Fonds d'indemnisation des services financiers (FISF) administered by the Autorité des marchés financiers. In the Working Group's opinion, the coverage provided by the IPC and the FISF should be coordinated, so that al1 clients of MFDA dealers get the benefit of IPC coverage regardless of where they live. The Autorité des marchés financiers and the IPC Board should work together to achieve this goal, without creating overlapping coverage or duplicating costs for dealers. Report of the MFDA IPC Working Group September 2006 Covered assets. The Working Group considered various ways to define the assets that should be covered by the IPC. The Working Group is evenly split between two alternatives: one group favours keeping the current coverage language that includes a wide variety of assets and the other favours limiting the coverage to mutual funds and cash associated with mutual fund transactions. The latter group are concerned that coverage of a wider range of assets would expose the IPC and its members to an imprudent level of risk. The other group thinks that the IPC should cover assets that would reasonably be found in a client's account. All Working Group members agree that whatever the scope of coverage agreed upon by the IPC Board, care should be taken to explain clearly to customers what assets are or are not covered by IPC. Location of assets. Current IPC coverage only extends to assets belonging to eligible clients held in a client account at an MFDA member dealer. This is viewed as providing too little coverage. IPC coverage should be expanded to include assets that are not available on the insolvency of a dealer that were otherwise under the control the dealer at the time of its failure, such as cheques delivered to the dealer for mutual fund purchases that go missing before the funds can be invested in client name positions. Covered events. Similarly, the Working Group is concerned that the current language limiting coverage to losses caused by the dealer's bankruptcy is too narrow. The coverage language in the Ontario Contingency Fund Trust that makes reference to "losses resulting from conversion of client property" is helpful. Conversion is a wrongful act involving dealing with goods with the intention or effect of denying the title of another person to those goods. The Working Group recommends that the IPC extend coverage to losses arising as a result of the insolvency of a MFDA Member, including losses arising due to any conversion of funds or covered assets of a client while under the control of the dealer that is now insolvent. Eligible clients. The Working Group considered several alternative ways to define who might be an eligible client for IPC coverage and recommends that the current provisions in this regard should continue. Coverage Lirnit. Several discussions took place on the coverage limit per client account. No consensus emerged. The majority view is that the current $1 million limit should continue, despite the expectation that individual claims are unlikely to approach this limit. The minority view is that the limit should be significantly lower - $100,000 or perhaps $500,000 - a s this more appropriately balances what reasonably might be expected to be in a client account and the potential costs to the dealer members. Funding and Assessrnent Methodologies. The Working Group considered a number of topics related to the way the IPC should fund itself in the long term, including the extent to which the IPC should be pre-funded or rely on ex post assessments; the target size of the fund; the proper balance between funded amounts and back up facilities such as lines of credit; and how costs should be shared between new and existing participants. The Working Group agrees the IPC should have substantial funding on hand to support dealer operations at the early stages of insolvency and to facilitate transfer of accounts. It also is oï the view that the primary source of funding for the IPC should continue to be regular member assessments. Size o f fund. A precise estimate of the appropriate size of the funding that should be kept on hand at the IPC is not possible at present. The current target fund size of $30 million was recommended by the former President of CIPF, based on his experience. This target funding size is reasonable and the IPC Board is encouraged to make regular reassessments of this target in light of actual experiences. Report of the MFDA IPC Working Group 3 September 2006 --,.-,--A--" .Assessment rate. The Report recommends a couple of significant changes in the funding methodology. In its view, it would be preferable to fix the overall assessment rate, rather than fix the total assessment to be raised and work back to the assessment rate. The IPC Board should establish a "normal rate" for annual assessments. A fixed assessment rate would tie the total annual contribution more closely to the overall state of growth of the industry. As the funding grows, the line of credit held by the IPC should be reduced, so that the overall funding available at any time equals $30 million. As the funded size increases, there is no need to incur the standby fees charged for the full amount of the original line of credit. "" Assessment cap. The IPC sets no upper limit for aggregate coverage of client losses in the event of a dealer failure. If the amount of the loss exceeds the funds on hand, the IPC has the right to make additional assessments against its member dealers. At present, there is no limit placed on these additional assessments. In theory, each dealer has an unlimited exposure to the IPC if a series of very large failures takes place. The Working Group would prefer there be a cap on the maximum that would be payable by the IPC on any single dealer failure, but accepts that IPC members should have the same liability as do the members of other compensation funds and deposit insurance schemes. IPC members also should have the benefit of a cap on the annual assessment that the IPC may impose, consistent with the practices of other comparable funds, and recommends that the terms of the IPC be amended to introduce an annual assessment cap of iwice the normal annual assessment. The minimum fees presently in place should not be increased. Also, new dealer members should bear their fair share of contributions and should be required to pay into the IPC for a minimum of 5 years at no less than the normal rate. Risk-based assessments. Ideally, the assessment paid by a dealer would directly reflect the risk that that particular dealer posed to the IPC. However, this assessment method is not used by other investor compensation funds, in pari because of a lack of data and in part because it has been viewed as being too complicated and expensive to administer for the given premium levels. Alternative assessment methods. The Working Group examined several alternative methods of calculating IPC assessments using a combination of factors: AUA, number of approved persons (APs), and weighting by level of dealer or how the client assets are actually held. There is no consensus in favour of any given assessment method. Given the choice between an asçessment model using AUA only and one using both AUA and the number of APs, the majority view is that assessments should continue to be based on AUA only, without introducing the number of APs. The minority view is that the assessments should be based on both factors. All members agree that the AUA used to calculate assessrnents should include the AUA of mutual funds, as done now, and add the AUA of any other covered assets, such as the cash in the dealer's trust account. The members are evenly split on whether the assessments should be weighted. In the opinion of one group, weighting is justified because Level 4 dealers inherently pose greater risks to the IPC, as Level 4 dealers have greater access to client assets than other dealers. The other view is that there is no cornpelling evidence to justify weighting as there is no present evidence of a direct link between the level of dealer and the risk of insolvency causing a loss to IPC. In the future, as experience grows, weighting based on an actual measurement of risk might be justified. Risk Management. The Working Group sees no present need for the IPC to become directly involved in supewising its member dealers. Active oversight of member activities should be left to the MFDA to rninimize duplication of efforts and costs. However, there are a number of areas where action Report of the MFDA IPC Working Group September 2006 should be taken to enhance risk management. In particular, dealers and mutual fund managers, working with the regulators as appropriate, should develop best practices regarding the form of registration of client name assets, the handling of client assets, and the duties and appropriate controls that should be in place regarding acting on purchase, redemption and registration instructions. Further, the value of al1 assets covered by the IPC should be recorded on the dealer's books and reported to the MFDA on the monthly financial questionnaire sufficiently segmented by asset type so that levels and kinds of assets can be monitored. Client Communications. The Report sets out nine principles that the Working Group recommends be applied in redrafting both the MFDA requirements that govern communications with clients regarding the IPC (the Policy) and the information brochure that is provided to clients of member dealers (the Brochure). In particular, the Brochure and other materials should not promise more coverage than the IPC in fact offers. Care must be taken to ensure investors are not misled about the coverage - or lack thereof - for client name assets. II. INTRODUCTION The Mutual Fund Dealers Association of Canada (MFDA) was recognized as a self-regulatory organization (SRO) by order of the securities commissions in British Columbia, Alberta, Saskatchewan, Ontario and Nova Scotia' in 2001. The recognition orders required the MFDA to create a compensation fund for clients of dealers that are members of the MFDA. The MFDA lnvestor Protection Corporation (IPC) was established on November 14, 2002, Its primary purpose is to provide protection to eligible clients of MFDA dealers if the clients' property held by their dealer is unavailable as a result of the insolvency of the dealer. The MFDA, IPC and the Canadian Securities Administrators (CSA) view this coverage as being in the public interest. The IPC applied to be approved as a protection plan by the securities regulators in British Columbia, Alberta, Saskatchewan, Manitoba, Ontario and Nova Scotia and received the required approvals in May of 2005. Coverage of clients' accounts commenced July 1, 2005. In response to cornments received from the public during the securities regulators' review process, a condition was attached to the approval orders requiring that the IPC set up a working group to review various aspects of the IPC. The mandate of the Working Group that was established by the IPC Board included, but was not limited to, a review of the following topics: Identification of the risks of mutual fund dealer failures leading to potential investor losses; Consideration of the size of fund that is appropriate having regard to identified risks; amount of customer assets held in client or nominee name; average size of customer accounts; average cash flow of customer monies through the dealer, and other non-mutual fund products being covered under the fund; The type of products that should be covered; The appropriate coverage amount per customer account; The assessment methodology, including whether it should be risk based; The appropriate long term methods of funding the MFDA IPC; . 1 Further, the MFDA has applied to the securities commissions in Manitoba, Newfoundland and Labrador, and New Brunswick for recognition as an SR0 and entered into a Co-operative Agreement with the Autorité des marchés financiers in Québec. Report of the MFDA IPC Working Group Septernber 2006 .. " ~ " "" 5 The types of risk management tools required by the MFDA IPC; and The appropriate MFDA IPC advertising requirements. The Working Group was to deliver its written report setting out its recomrnendations to the IPC Board and the various securities regulators. The IPC Board would then evaluate the recommendations and provide its evaluation to the regulators. The Working Group was set up in the fall of 2005 and cornrnenced work in November 2005. A list of the Working Group members is attached as Appendix A. The dealer rnernbers were chosen from applicants with the aim of reflecting the diversity of the MFDA membership in size, the way assets are held, scope of operations and rnembership level. III. DEFINITIONS Holding securities. The concepts relating to the holding of client assets are very important to the rnatters reviewed by the Working Group. The terrns 'client name', 'nominee narne', 'held at the dealer' and 'held at the mutual fund' came up repeatedly during its discussions. The terms combine questions of legal and beneficial ownership, whose name appears on the list of securityholders kept by the issuer or registrar, and whether and how the position appears on the statement of account issued to the client by the dealer. The concept of "holding" a security also suggests that someone has possession of some physical object, such as a stock certificate, rather than the current reality where most investrnents are not certificated and consist only of entries in the electronic books and records of dealers and issuers. Held at the dealer. In this Report, securities or other assets that are registered in a narne other than that of the client and the client's evidence of ownership consists of the purchase confirmation and the entries that appear on the account staternents issued by the client's dealer are referred to as being held at the dealer, Redemptions of mutual funds held in this manner would not require the dealer to provide the mutual fund with the client's signature or a trading authority from the client. Client cash in the dealer's trust account would also be a client asset held at the dealer. Held at the mutual fund. In this Report, where the dealer has passed along the details of the client purchaser to the rnutual fund2 and the ownership register kept by or on behalf of the mutual fund lists the client as the legal owner, the client's assets are referred to as being held at the mutual fund. Redemptions of rnutual funds held in this manner would require the dealer to provide the rnutual fund with the client's signature or a trading authoritylpower of attorney from the client. Client cash in the possession of the mutual fund manager, custodian or registrar prior to the cornpletion of the client's purchase would also be assets held at the rnutual fund. The term is not intended to include or refer to the mutual fund's portfolio of securities that is required to be held by the custodian. Client name vs. nominee name. Mutual funds held at the dealer are likely to be registered in the name of the dealer, a custodian on behalf of the dealer, a trustee of a self-directed 2 Many financial assets other than rnutual funds rnay be held in uncertificated. but registered forrn at the issuer and so this terrn could have been changed to a more genericform, such as "held at the issuer". For example. the bank issuer of a terrn deposit purchased through a rnutual fund dealer rnay well record the client's narne on its deposit register. However, as the Working Group's discussions focussed on rnutual funds that form the bulk of the client assets dealt wifh by mutual fund dealers, the more specific term is used in the report. Report of the MFDA IPC Working Group September 2006 retirement savings plan or a nominee3 of any of these. Generically, these are in nominee name. Only Level4 mutual fund dealers are permitted to hold client assets, other than cash, in nominee n a ~ n e . ~ Following on from this, one might expect that mutual fund positions registered in the name of the client at the mutual fund would be referred to as being in client name, Common usage is not quite so precise and some dealers refer to any position that is not registered in their own name as being in client name, even when the actual position is recorded in the name of another intermediary, such as their carrying dealer. However, in this Report, where assets are referred to as being in client name, the Working Group means that the client is the registered owner of the asset on the books of the issuer. Mutual fund manager. ln this Report, the person or Company that directs the business, operations and affairs of a mutual fund is called the mutual fund manager. The manager is not automatically required to be registered with the securities regulatory authoritie~,~ although many are registered as dealers or portfolio managers. It may act as registrar for the funds it manages or contract that activity out to an affiliate or third Party. IV. DISCUSSION 1. Process Followed Many of the topics in the Working Group's mandate were inter-related and dealing with each separately often proved difficult. Despite this challenge, the Working Group developed a sequential work plan and studied each topic carefully. It reviewed information from the Canadian lnvestor Protection Fund (CIPF) and other Canadian contingency funds on previous dealer failures; examined the coverage provided by CIPF, the Securities lnvestor Protection Corporation (SIPC) in the United States and comparable funds in the European Union; identified alternatives and formulated recommendations where consensus was achieved. The goal of the Working Group was to ensure the IPC efficiently and effectively might fulfill the purpose for which the IPC was established: to protect investors on a failure of an MFDA dealer. The Working Group agreed that a failure of dealer that resulted in client losses would negatively affect investor confidence in al1 mutual fund dealers. An effective investor protection fund should reduce the risk of clients losing money if their dealer becomes insolvent and therefore is in the interests of al1 concerned: the investing public, the dealers, the MFDA and the provincial securities regulators. The Working Group generally took a clean slate approach to the topics under review. The only fixed requirement was that there must be an investor protection fund for MFDA members. The discussions were not otherwise constrained by the current structure of the IPC, including the relationship between the IPC and the MFDA. However, the Working Group acknowledged that it had to take note of the current requirements and be able to explain why its recommendations A 101inee s 3 - 3 a covpan) 'ridi 5 esiaL sneo oy an riCrTe0 ar, 10 oe .Seo as 1 gener c 'eg btereo s onner 01~ 1 0 or 6 ~ ooro cen f ca-es Tne .se of iiom nee narnes s rnp $esine process r q O' sec.r 1) transfers and makes it clear that the assets are not the beneficial property of the intermediary As O' J ~ r 30 29% !ne MF»A memoersn p ccns sec of 51 L t v e 2 aea ers 35 e c' tne 1o.a n.moer MF DA !lenoers fi9 1 e,e 3 cea.ers 39 ana 26 Leie 4 ged ers 25 ' Leve 2 oea ers are no1 of pemined to hold ciient cash or hold client assets in nominee name. ~ e v e3 dealers may hold ciient cash in l a trust account but are not permitied to hold client assets in nominee name. Level4 dealers may hold client cash in a trust account and hold client assets in nominee name 5 In some provinces. a mutual fund manager may be subject to regulatory review as a "market participant". As such, the securities commission may order an examination of the managei's financial affairs or conduct a compliance review of its books and records. Report of the MFDA IPC Working Group 7 Septernber 2006 ." " " .,. . .." were more appropriate than the current provisions where they differed. It also took note of the discussions between the MFDA, IPC and CIPF on a possible merger of the IPC with CIPF. The prospect and ease of a protection fund merger was a relevant but not determinative factor in the Working Group's discussions. "" The relationship between the IPC and the MFDA, including which entity has the ultimate decision-making authority on particular issues, was not part of the Working Group's mandate and was not discussed. The Report's recommendations are addressed to the IPC Board, as the Board is the designated recipient of the Report. However, the Working Group acknowledges that, in most cases, implementation of recomrnended changes will take the agreement of and cooperation by al1 of the IPC Board, MFDA and the CSA. This Report describes each of the issues considered by the Working Group and sets out its recommendations. Where there was no consensus on a particular topic, the Report explains the alternative views expressed by Working Group members. A summary list of the consensus recommendations is set out in Appendix B. The Report also contains some conclusions and observations that were made during the course of the Working Group discussions that do not rise to the levei of recommendations. These are not listed in Appendix B. 2. Causes of Mutual Fund Dealer Failures In order to get a better understanding of the possible causes of dealer failures, the Working Group received presentations from representatives of CIPF, the Ontario Contingency Trust Fund and the British Columbia Contingency Trust Plan. The presenters described seventeen failures of investment or securities dealers where one of the compensation funds was involved, The representatives also explained key features of their funds, including coverage, size and funding methods. In addition, the Working Group had the benefit of a presentation by a representative of the Autorité des marchés financiers which is responsible for administering the protection and compensation program "Fonds d'indemnisation des services financiers" (FISF) that addressed its operations, coverage, funding and experiences as a fund that cornpensates victirns of fraud, fraudulent practices or embezzlement that occur in connection with the distribution of financial products and services in Québec. Two cases were of particular interest and relevance to the Working Group's deliberations: the 1998 failure of Vantage Securities Inc. (Vantage) in British Columbia and the 1999 failure of Essex Capital Management Inc. (Essex) in Ontario. Vantage was the first dealer failure to take place afîer the introduction of the special regime to govern securities dealer insolvencies set out in Pari XII of BIAC. Both Vantage and Essex raised issues relating to the treatment of client assets recorded as being on the books of the dealer rather than on the books of the issuer of the investment. Essex also introduced issues that might arise on the concurrent failure of the dealer and related entities including issuers. For more details on these two insoivencies, please see Appendix C. The Working Group deterrnined that one or more of four factors was the source of most of the failures of the investment dealers or securities dealers: Outright fraud, as in Essex; Bad credit practices; Losses on proprietary trading; or Operational failures. Even where there was no thefi of client assets by the dealer, client losses were unlikely to take place unless the dealer broke at least sorne of the regulatory requirements governing how client assets are to be handled. . Report of the MFDA IPC Working Group September 2006 The Working Group review was hampered by a lack of data specific to mutual fund dealer failures. Until the Working Group process was well advanced, no mutual fund dealer had failed. One failure has now taken place, but the insolvency process is not far enough advanced to be useful to the Working Group's discussions. This gap meant that the Working Group had to extrapolate from the failures of other types of dealers and then decide how this experience would apply to mutual fund dealers. The general consensus of the Working Group is that there are fewer sources of risk arising from the general business practices of mutual fund dealers than for investment dealers or securities dealers as mutual fund dealers are not permitted to make margin loans and proprietary trading generally is nota material part of their business. The MFDA's oversight program should bring a mutual fund dealer's operational problems to light and the related losses should be flagged by the MFDA's early warning system. The consensus is that fraud is the most likely trigger of the insolvency of a mutual fund dealer that would result in client losses, but there is no information on which to predict the probability of fraud or the likely size of the loss in the event fraud occurs. Overall, the likelihood of fraudprecipitated failure leading to client losses may be reduced by: The actions of the MFDA to set and enforce minimum capital standards and risk management and internal control requirements; The arnount of capital at the dealer; and The fidelity bond coverage at the dealer.6 Regulatory requirements and the actions of regulators do not eliminate the risk of fraud or dealer failure. The risk of fraud or significant internal control failures always is present at an interrnediary, no matter what its category of registration. . . 3. Bankruptcy Legislation Implications It became evident early on in the Working Group's discussions that the operation of the bankruptcy legislation is very important to how the coverage provided by IPC should be structured, Part XII of BlAC establishes a special regime for adrninistering bankruptcies of securities firms, including nutual fund dealers. When a dealer becomes bankrupt, the securities and cash held by the firm for its customers or for its own account vest in the trustee and are pooled in the "customer pool fund", The dealer's trust account containing client money is likely to be included in the customer pool fund by the trustee administering the bankruptcy. The dealer's general cash account will be pooled in the customer pool fund. The one exception to pooling is 'customer name securities', which is defined to include securities held for customers by the bankrupt firm that are registered in the customer's name and are not otherwise in negotiable forin.' These customer name securities are not pooled and are to be returned promptly to the relevant customer by the bankruptcy trustee. 6 It was noted during the Working Group discussions that in sorne circurnstances fidelity bond coverage rnight expëcreo Wnere ine ioss is arge inere may oe an appreciac e oe a, oefore :ne no! pro, oe ine p r i i e c t . ~ n . ! If s e i o r o'f.cers or o rectors of ihe oea er are a rec:my nvolreo in !ne mproper bena, OL' c a.m s pa a o that led to the loss, the insurance Company may seek to deny coverage altogether. In the failure of Oslei Inc., where both of these circurnstances were present, the insurance claim was only paid after extensive discussions over eight years. Section 253 of BlAC defines customer narne securities as meaning "securities that on the date of bankruptcy of a securities firm are held by or on behaif of the securities fnm for the account of a custorner and are registered in the narne of the custorner or are in the process o f being so registered, but does no1include securities registered in the name of the customer that, by endorsement or othenuise, are in negotiable form. " 7 Report of the MFDA IPC Working Group September 2006 Securities positions properly registered in the name of the customer on the books of a mutual fund or other issuer at arm's length to the dealer should be unaffected by the bankruptcy of the dealer. However, as was seen in the Essex case, if the issuer of the investments and the dealer are related and fail at the same time, there may be some additional exposure for clientss and the compensation fund if the records of the two entities are not clear and distinct from each other, The issue of what constituted customer name securities in the context of mutual funds arose in the bankruptcy of Vantage, a securities dealer based in British Columbia. In Vantage, the trustee did not challenge customer name status for regular client accounts where the client's name was on the records of the mutual funds. However, the securities held in self-directed registered retirement savings plan accounts, where Vantage acted as custodian and administrator, were pooled despite the fact the customers' names may have appeared on the register of the mutual fund in some fashion. In that case, the dealer was seen to be holding these securities for its clients. Customers have a priority claim to the assets in the customer pool. The value of these assets is allocated among customers in proportion to their "net equity", which is the net value of the customer's securities in his or her account with the firm as of the date of bankruptcy. Note that the definition of net equity does not include assets that are not securities. The Working Group was advised by counsel that, while not entirely free of doubt, the existence of a limited power of attorney or limited trading authority is unlikely to turn a true customer name security into an asset that will be pooled. However, it was evident over the course of the Working Group's discussions that there is no common industry practice regarding how positions are registered or, for that matter, what is meant when a position is referred to as being 'in client name'. There is a clear need for guidance to the industry regarding registration practices to ensure full customer name securities treatment for assets on the books of the issuers. The greatest benefit from pooling is achieved if al1 assets covered by the compensation fund are included in the customer pool fund under Part XII. If IPC coverage extends to unpooled assets, the IPC may be in the position of having to pay investors for losses when the rest of the assets in that same class are not in the customer pool and the priority given to client claims would not be available. For example, segregated funds are presently covered by IPC but may not be a 'security' under BIAC. 4. lnvestor Protection Gap The operations of CIPF and IPC go a long way to protect investors from losses on the failure of their dealers. However, the Working Group o b s e ~ e d this protection is not complete, Both that CIPF and the current IPC coverage only provide coverage to the assets held in a client's account at a member dealer. For clients of investment dealers, this would cover most of the assets that the client purchased through his or her dealer, as the bulk of client assets are held by the investment dealer in its own (nominee) name. In the case of mutual fund dealers, more than 8 % of the clients' mutual fund assets are held in client name at the mutual funds. 0' Securities positions held directly at these mutual funds, client money handled by mutual fund 8 lnvestor compensation funds do not protect investors from losses caused by the insolvency of an issuer in which they have invested. The only funds of this type are deposit insurance schemes and insurance compensation plans. N3 orle r a s srff cent n f o r r a ' O? Io v a r e a Drec se C c.. a i on of in s f g-re T r e MFDA es1 n.aieo ina. a apprcx male, 84 of m,l~a 1-nd assets are recoraeu r i c e r l ' l a r e T r s es1 ria!e ooes ro! r c .ae mutual fund assets for clients of MFDA dealers located in Quebec Report of the MFDA IPC Working Group September 2006 managers" and client assets managed by other asset managers, such as portfolio managers, are not covered by a comparable compensation fund, despite the fact that losses through fraud or insolvency are possible. In some provinces in Canada, portfolio managers registered with the securities commission are required to contribute to the provincial contingency fund," but these contingency funds provide only minimal coverage. In addition, the MFDA and Investment Dealers Association of Canada (IDA) impose a whole range of standards on their members that mitigate the risk of dealer failure and reduce the opportunities for fraud, such as minimum capital, internal control and risk management requirements. Dealers are also subject to an active oversight program by their respective SROs. Client positions held a mutual fund and client cash under the control of a mutual fund manager are subject to different rules. Part 6 of National Instrument 81-102 Mutual Funds dictates who may act as a custodian of a mutual fund's portfolio assets. Most of other the entities providing services to the mutual fund, such as the mutual fund manager and the registrar, are not required to be registered" with the securities commissions, no capital or internal control requirements exist and their operations are seldom subject to direct review by the securities r e g ~ l a t o r s . 'Portfolio managers may be registered, but the standards that are ~ imposed may not be as high as for MFDA or IDA member dealers and the level of direct oversight by the regulators is fairly light. The Working Group is not suggesting that al1 mutual fund managers should be registered or that al1 mutual fund and other asset managers necessarily have to be part of a compensation fund. Prudent market participants with responsibility for managing other's assets may well have established equivalent risk management controls for themselves, However, the lack of defined minimum standards for risk mitigation, lesser oversight from a regulator or S R 0 coupled with the lack of compensation fund coverage raised concerns during Working Group discussions. The Working Group would like to highlight this apparent gap in investor protection with the CSA and recommends that the CSA should consider what actions might be appropriate to take to protect investors dealing directly or indirectly with these entities that are not currently covered by some form of investor protection program or other specific requirements designed to reduce the risk of loss to investors. The Working Group was particularly concerned that many investors may mistakenly believe that they are covered by the IPC when, in reality, they are not. This poses a significant challenge regarding communicating IPC coverage (and the limits to the coverage), as discussed later in this Report. 10 .. The same observations can be made for client assets at issuers (or their managers) such as the issuers of s and reaeemeo d recr from pr nc Fa pro,ecteo no!es or nedge f ~ i o wrere me nvesrmenis are p ~ c n a s e o ine ss.er rarler i l a n Vaoeo n ine seionoary marner Hohever In s fias 101 Pan of r i e WorK ng Gro. p s discussions , Io Canaça a r a [ne dn teo Sia:es pon'o o maragers a,e rare / reqL reo !O o n a compensai on gr Cori fiqency '-no o i rre ass-rra: on !la! !ne r c enis assets i oe nelo a l a oea er or rn 'o p a l ) c - s t x a r and s i w i l l b e remote from the manager's failure. In several countries in Europe, asset managers are required to participate in the compensation fund on the same basis as dealers, even if they do not hold or otherwise have access to any client assets. .: ': Tqe reg,siraion of r r - r ~ afi ~ n o managers has oeen 'a sed s e m a [.mes of rne CSA Tne mcsi recel! of tnese s r tne Coris..ila!..~ri P;ipcr or) rnc Reg srrat.ori Tr~gger and HegLiarea Acri/,it.s 'na: bas PLD isnea as p a l of ine CSA Reg sirai on Reform Proeci ana rnar can De fo.na ai "-,. . ;. , . , ., . ~ .. .;. .-<<',,.. .. >! . :.:: . r.5 . . . . - C . . : . . . . .. ..>.... . .. . . . . . - . . .... .- .-. . .--.-- - For a sverlapbetween the mutual fund AUA figure tnd the norninee asset numbers, but the current .eporting requirements do not allow precise :alculations. idditional details about the type and value of issets that are held hy dealers for clients may Working Group "Consensus Recommendations" / / Response of the Board assist in monitorinr the potential exposure of the IPC in the eveit of the failure of the dealer." The Board agrees with this recommendation and the reasons for it and will request this information, categorized by type of asset, from the MFDA. (See recommendation 17.) IPC should take action to be recognized as a customer compensation body under Part XII of the Bankruptcy and Insolvency Act. The IPC, working with the MFDA, should apply the principles set out in this report in revising both the MFDA requirements that govem communications with clients regarding the IPC and the information brochure that is provided Io clients of member dealers. IPC should consider whether the brochure and any other materiais to be made available to customers should be focus group tested before use. The MFDA and the IPC Board should take care in setting requirements for use of logos etc, to take into account the range of circumstances of memhers and the other businesses that may be carried on, so as to minimize the opportunities for client confusion as far as possible. IPC should consider whether a change of name might be warranted to tie in the name more closeiy to the coverage that is provided particularly in light of the limited coverage offered to clicnrs of I ~ , v e l 2 Level 3 dealers. and 'l'hc procrss of refunding IPC meniber dcüler coninburions io thc Ontano Çoniingency Tmsi Fund should be canied out as promptly as Recognition under BIAC could be quite helpfu in allowing the IPC to do ils job effectively. The Board will pursue ohtaining this recognition through its legal counset. The Board agrees and will work with the MFûA to pursue the development of matenals hased on the client information already in circulation. The Board recognizes that clear communication of its coverage policy and the limitations of its coverage is a prionty. The Board will consider testing any revisions to the brochure and consult with CIPF on its experience before a final decision is made. The Board agrees that these matiers should he considered in conjunction with the requirements for logos and the distribution of brochures or other material Io clients. [ The Board agrees with the need for clarity and will consider this recommendation in the context of revised materiai to he provided to clients. l'tiis re~.omiiiendaiion will hc forwïrded lu the appropriate parties. 1 1 1