Don’t get caught in regulatory traps

Registration requirements are strict and might stand in the way of an advisor providing access to an investment that’s truly in the client’s best interests.

Mutual fund or insurance-registered reps, for example, may feel a specific stock is the best tool to round out a portfolio; but they can’t act on that belief without IIROC registration. Similarly, those same reps might want to acquire a private placement or real-estate investment—but those transactions require registration as an Exempt Market Dealer.

A desire to do right by the client frequently spurs advisors to find work-arounds to secure client access to financial products they otherwise couldn’t provide—most often by soliciting licensed dealers to conduct the transactions.

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The practice, called referral arrangements, began innocently enough back in 2004. When clients approached advisors registered with mutual fund dealers about buying specific stocks, advisors could either turn the business away, or refer clients to an IIROC firm that was likely to poach the customer.

Quid pro quos solved this dilemma: the non-IIROC introducing party would obtain the desired stock or other investment from a registered dealer and have that dealer process the trade in exchange for a promise not to spirit the client away.

“These people were referring trades. They weren’t referring clients,” says David Gilkes, director of the Exempt Market Dealers Association of Canada. Clients didn’t always understand that, though, so “investors started to see mutual-fund dealers almost as investment dealers.”

Problem was, they weren’t, so MFDA and IIROC field examiners started looking for trades done on a referral basis where the processor of the transaction hadn’t done proper know-your-client reviews or suitability assessments—or where the initiator simply wasn’t registered to engage in a full-on securities transaction.

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“There’s nothing wrong with referring a client to someone else who can do the service you can’t do,” Gilkes adds, “but you can’t pretend you can do this service, and you can’t act as a surrogate for that person.”

And, of course, the IIROC firm is required to take the client on properly—including properly conducting a know-your-client and know-your-product review to ensure suitability. It’s the job of the MFDA or insurance advisor to explain this to the client, and to ensure both firms are aware of the referral arrangement so they can both do proper compliance at the firm level.

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Follow the money

How money changed hands was also a problem. In some cases, investment dealers were functioning much like discount brokers: processing trades and taking a commission from the mutual fund dealer, not the client. The OSC stepped in and specified agreements for these transactions had to be between actual dealer firms, and not just advisors, to ensure proper oversight.

But by the time firms established those requirements, the practice had spread beyond mutual fund and securities advisors to include portfolio managers (many of whom register only with their provinces and have no relationships with self-regulators that oversee trading), and insurance agents (who register in their provinces but aren’t required to register with securities regulators).

These advisors referred clients to both investment dealers for conventional securities transactions, and EMDs (then called limited-market dealers) for private placements and real estate investments.

Further, the practice spread to western Canada, where reps who’d never heard of referral arrangements saw an opportunity to act as intermediaries between clients who wanted specific securities, and investment dealers who were licensed to sell them. They started cold-calling clients to encourage transactions, even though they weren’t directly licensed to sell investments.

Registration triggers

That regulatory trap is particularly problematic for advisors who don’t carry full securities licences but have been in the business a long time.

By and large, this cadre of advisors has a solid foundation of knowledge about less-common products and how they can balance out client portfolio needs. Often, they buy such products for their own portfolios and want to let clients in on a good thing.

But what starts as an act of fiduciary intent can trip the business trigger requiring the rep (and the firm he or she works with) to be registered as an EMD or investment dealer.

By wanting to be helpful or provide good customer service, they end up performing activities—often as simple as delivering the subscription agreement to a customer or delivering a client cheque to a dealer or EMD—deemed to be in furtherance of a trade.

Avoid both scenarios because securities regulators take them seriously.

Read the full story: Why good service can bite you >