The Enforcers

Last year was a busy one for securities regulators. As the credit market—and subsequently the economy—collapsed, they faced public pressure to take aggressive action against risky investments and Ponzi-like schemes that left many investors holding the bag.

In Canada, the Investment Industry Regulatory Organization of Canada (IIROC) bore the same pressures as its global counterparts—pressures it appears affected cases under investigation and, to a certain extent, prosecuted by the organization’s enforcement staff.

IIROC handed down 46 enforcement decisions in 2009, prompting payments from firms and individuals totalling over $34 million, according to IIROC statistics. The implications weren’t just financial: seven Approved Persons were permanently barred from registration in any capacity, and four Members were permanently suspended from the organization. It also issued temporary suspensions and warning letters, placing conditions on those Members and Approved Persons who had acted contrary to its member rules.

Gatekeeper functions Several 2009 decisions—including three settlements related to the sale of Asset-Backed Commercial Paper (ABCP), and some relating to the failure of Approved Persons to properly perform their gatekeeper functions—are notable. That IIROC took the steps to prosecute Approved Persons for failure to properly perform their gatekeeper functions appears to be an important trend emerging from the organization’s 2009 enforcement decisions.

The most common violation in 2009 involved Dealer Member Rule 29.1, which provides that Members and Approved Persons shall “observe high standards of ethics and conduct in the transaction of their business” and “shall not engage in any business conduct or practice which is unbecoming or detrimental to the public interest.” Specific activities that resulted in penalties under Rule 29.1 in 2009 included the misappropriation of client funds, the facilitation of suspicious or questionable transactions without making diligent inquiries to ensure the legitimacy of the transaction, and the acceptance of large deposits of cash contrary to legislation on the proceeds of crime (money laundering).

ABCP Settlements The $34 million secured by IIROC in 2009 can be attributed to three ABCP settlements, which involved Canaccord Financial Ltd., Credential Securities Inc. and Scotia Capital Inc.

Both Canaccord and Credential admitted in settlement agreements with Staff that they did not take steps to adequately ensure their sales staffs involved in selling ABCP knew the complexities and risks of the product; and as a result, they did not ensure that clients purchasing ABCP appropriately understood the product, in contravention of Rule 1300.1(a). Canaccord agreed to pay a $3.1 million fine, while Credential agreed to a $200,000 fine. Both firms agreed to retain an independent consultant to verify the actions the firms had already taken with respect to due diligence practices and procedures relating to fixed-income securities.

The Scotia Capital settlement arose under different circumstances. In its settlement agreement, Scotia Capitaladmitted that between July 25 and August 10, 2007, it failed to adequately respond to emerging issues in the ABCP market insofar as it continued to sellABCP without engaging compliance and other appropriate processes for the assessment of such emerging issues,contrary to Rule 29.1(ii). Scotia agreed to make a $28.9 million payment to IIROC, to pay $320,000 in investigation costs, and to retain an independent consultant to verify the remedial actions taken by Scotia with respect to its fixed-income business.

Dealers, Advisors: Gatekeepers The gatekeeper function is a crucial element of front-line prevention against market manipulation. IIROC has stressed this link, and further indicated that it views KYC procedures as essential to ensuring this duty is met.

Usually, gatekeeper-related prosecutions—those relating to the failure of Approved Persons to properly perform their gatekeeper functions—are brought under Rule 29.1, and Rule 1300.1(a), which provides that “each Dealer Member shall use due diligence to learn and remain informed of the essential facts relative to every customer and to every order or account accepted.”

Several 2009 cases illustrate how important IIROC is to the gatekeeper function. In one decision, a hearing panel found that John Anastasios Collias’s failure to perform his gatekeeper functions was a contravention of Rule 1300.1(a). Collias had opened up accounts for two adult children of a man named Brian Smith, who was referred to him by a market-making company in the U.S.

The hearing panel found that in opening the accounts, Collias failed to determine the background of the Smith children; their sources of income; the relationship between the Smiths and the market-maker that referred them; the depth of the Smith children’s investment knowledge and the purpose of the accounts.

Shortly after Collias opened the accounts, 50,000 shares in Nevada-incorporated, British Columbia-based company Beeston Enterprises Ltd. were deposited into each account. Beeston’s shares were listed for trading on the OTCBB. The hearing panel found that Collias didn’t research or make any examinations into Beeston.

If he had, he might have found out that Brian Smith was the CEO and President of Beeston, information that was publicly available. During a one-month period—during which Collias made five trades involving shares of Beeston—the company’s share price rose dramatically, a fact which the hearing panel held was “peculiar, suspicious or appeared to be consistent with market manipulation, deception or other improper market-related activity,” given that there were no press releases or other public disclosures made during that period.

The Hearing Panel found that Collias should have made inquiries to learn the facts surrounding the opening of the accounts. It also determined that he failed to use due diligence to learn the essential facts relative to the orders to sell and buy Beeston shares, in that he failed to identify red flags accompanying the rapid rise in share price, in violation of Rule 1300.1(a). Collias was fined $5,000 and ordered to pay $5,000 in costs. Notably, the hearing panel did not find that Collias’s actions amounted to a breach of Rule 29.1, as the conduct “lacked the qualities of gross negligence or moral turpitude” that in the panel’s view were requisite for a finding of a violation of Rule 29.1.

Ensuring legitimacy In another gatekeeper decision released in 2009, a hearing panel found that Konstantinos Georgakopoulos had failed to perform his gatekeeper function by facilitating transactional activity in the accounts of two brothers, David Amsel and Mayer Amsel, who were conducting what appeared to be manipulative trades. David Amsel opened up an account with Georgakopoulos while he was employed at Wolverton Securities. Mayer Amsel had past regulatory issues in the U.S., and as a result, Georgakopoulos had been instructed by his compliance department at Wolverton to handle David Amsel’s account with care.

Georgakopoulos later moved to Golden Capital Securities, where David Amsel had an account, and once there opened up an account for Mayer Amsel. The brothers made a number of trades in their accounts in an apparent attempt to run up the price of a certain stock. Georgakopoulos was found to have failed to make inquiries to ensure the legitimacy of the transactions he facilitated for the brothers, despite the fact that the circumstances called the activity into question. The hearing panel found that Georgakopoulos was either a willing participant in (or wilfully blind to) trading activity that appeared to be consistent with market manipulation. The hearing panel held that Georgakopoulos’s actions amounted to a violation of both Rule 29.1 and Rule 1300.1(a). As a penalty, Georgakopoulos was suspended from approval for a period of three years, fined $50,000, ordered to pay $24,576 for disgorgement of commissions, and $40,000 in costs.

In a similar case, a hearing panel found that Daniel Murray Trenholm’s failures in the performance of his gatekeeper functions amounted to a violation of both Rule 1300.1(a) and Rule 29.1. Trenholm was the RR for five client accounts, all of which were closely related. The client application forms for all five of the accounts listed the same address, and all of the accounts were involved in suspicious transactions in the same stock. Trenholm took instructions from an individual named Jim Matheson for all five accounts, even though Matheson was not authorized in writing to provide instructions on the accounts.

The hearing panel found that Trenholm failed to determine the “essential facts” relative to the relevant orders and accounts, in that he failed to determine who was funding the trades, the reasons for the trades, the relationship between the related accounts, or the relationship between the clients and the company whose stock they were trading. In doing so, they determined, he failed to perform his role as gatekeeper. Trenholm was suspended for three years, fined $15,000, ordered to pay $15,000 in costs and ordered to rewrite the CPH examination prior to reapproval.

Ensuring that Members and Approved Persons monitor activity in client accounts, make inquiries where appropriate and maintain a close watch on suspicious activity is of paramount importance to IIROC, and is likely to be a priority in coming years. In IIROC staff’s view, Members and Approved Persons are uniquely situated to monitor activities that could potentially amount to suspicious trading and/or market manipulation; as a result, Members and Approved Persons must remain alert to their ongoing responsibilities as gatekeepers.

Looking ahead 2010 promises to be another busy year for enforcement-related activity, with eight decisions handed down in the first two months alone. However, reported decisions tell only part of the story: as of February 28, 2010, IIROC has 230 ongoing investigations and 122 prosecutions under review.

The year ahead will also see the organization taking a closer look at systemic and supervisory issues, ensuring that firms and individuals are performing appropriate due diligence and are recommending suitable investments to clients. In addition, IIROC has indicated that it will be focusing on market manipulation and gatekeeper violations, and will target rogue brokers and recidivists.

David Di Paolo is a partner at Borden Ladner Gervais LLP in Toronto. He is the Manager of BLG's Toronto Commercial Litigation Group and is the Regional Chair of BLG's Securities Litigation Group.

Cait Sainsbury is an associate at Borden Ladner Gervais LLP in Toronto. She is a member of BLG’s Commercial Litigation and Securities Litigation Groups.

David Di Paolo, Cait Sainsbury