Proposed Securities Act May Create a More Investor-Friendly and Efficient Canadian Securities Trade

Last week, The Court discussed the constitutionality of the proposed federal Securities Act. This second post discusses the potential effects that the Act may have on the securities trade in Canada.

In a move to address systemic inconsistencies in Canadian securities regulation, the federal government recently drafted a federal Securities Act, intended to coordinate and harmonize securities regulation. The draft Act was referred to the SCC for a reference on the Act’s constitutionality. The first post of this series addresses this matter in depth. The proposed federal Securities Act (“Act”) is expected to revolutionize the securities trade in Canada. In anticipation of the SCC’s decision on the constitutionality of the Act, it is worthwhile in the meanwhile to examine the new rules and regulations outlined in the Act, and the potential effects these provisions may have on Canadian capital markets.

What’s the Difference?  The New Provisions

While drafting the Act, the federal government used an approach whereby the fundamental provisions are included in the legislation, while specific and technical requirements are included in accompanying rules and regulations. Like existing provincial securities legislation, the Act contains all of the foundational principles. The rules and regulations are separate from the Act so that they can be easily changed and adapted to the dynamics of the markets over time.

The Act was highly influenced by provincial legislation, particularly the Alberta and Ontario statutes. Many provisions of the federal legislation are identical or quite similar to the provincial statutes. In the following areas, the draft Act has not made substantial changes.

1. Prospectus and registration requirements
2. Continuous and timely disclosure requirements
3. Regulation of take-over
4. Civil liability

Significant changes have been incorporated in other areas that will have a crucial impact on the Canadian securities market.

The Establishment of the Canadian Securities Regulatory Authority (“CSRA”)

Administration of the scheme will be the responsibility of the CSRA, a crown corporation responsible for its own funding. A CSRA Board of Governors will be appointed on recommendation of the federal Minister of Finance after a “Council of Ministers” has been consulted. The Council of Ministers will comprise of the federal Minister of Finance and representatives appointed by the provincial commissions. The CSRA will contain two branches: a regulatory division and an adjudicatory division.

The regulatory division will fall under the control of the Board of Governors, headed by a Chief Regulator. The Chief Regulator will be responsible for all operations relating to securities regulation.

A federal securities tribunal will exist as the adjudicatory division.  Responsible for conducting enforcement hearings, the tribunal will be controlled by the Chief Adjudicator. The Tribunal will have the authority to review and/or even strike down decisions made by the Chief Regulator. Decisions of the Tribunal can be appealed to a provincial court of appeal. The Tribunal will also be vested with the power to make orders in the public interest and the ability to impose administrative penalties (to a maximum of $1 million, or any amount obtained or lost as a result of violating the Act).

Self-Regulatory Organizations

The Chief Regulator will have the power to recognize a self-regulatory organization (such as an exchange, a clearing agency, or an auditor oversight organization). Approval by the Chief Regulatory will be mandatory for all self-regulated organizations. The power of the Chief Regulator is a significant difference from the existing scheme. The Chief Regulator will also be given the power to designate certain business entities with prescribed services. More information on this power will likely be outlined in the regulations.

Registration

Registration (under provincial regulation) is required for any person who trades in an exchange or security contract.  In comparison, the Act adopts the Ontario business trigger test by requiring registration of those “in the business” of trading in securities and exchange contracts.

The Act requires registrants to deal in good faith with clients. Positive requirements are imposed with respect to the identification, disclosure and management of conflicts of interests. Section 110 of the Act states “A registrant must deal fairly, honestly and in good faith with their clients.” Requiring this behaviour of registrants specifically is new to the draft Act.

Notably, provincial statutes do not consistently provide a requirement that “front-running” be prohibited. Front-running involves a broker taking advantage of their knowledge of pending orders from customers and trading securities for their own account(s).  This is referred to “material order information” in the Act. In addition, unfair practices with respect to investor relations are prohibited under the proposed Act.

Additionally, the Act includes provisions that will give the Minister of Finance the power to designate a federal dispute resolution body to deal with complaints respecting registrants.

New Treatments for Derivatives

Significant changes have been proposed in derivatives regulation. Without yet having access to the specific regulations concerning derivatives, the Act suggests that a national and consistent framework for derivatives classification and treatment will lead to harmonization. New definitions have been created and other definitions have been altered, such as:

1. Prescribed derivatives: Those derivatives with securities-like features will be treated as securities.
2. Exchange-traded derivatives: These derivatives will only be permitted to be traded on recognized exchanges.
3. Designated derivatives: Risk disclosure statements will be required to be filed and delivered.
4. Excluded derivatives: The Act gives power to exclude derivatives from the above categories.

The prescribed derivative category is new and  will most likely capture those securities seen as “hybrids” under the existing provincial schemes. Typically, these products were treated as derivatives despite a predominant security-like nature. A clear and concise classification for derivatives addresses the inconsistencies in both definitions and treatments found when comparing all thirteen provincial  and territorial statutes.

A “Voluntary” Regime

As mentioned in the first post of this series, the proposed Act will operate on a voluntary basis, applicable only in those provinces and territories that elect to be bound by the legislation. Despite the advantages of a voluntary system, there is still potential for the federal system to be rendered less effective.

If the purpose of the Act is to harmonize and coordinate securities regulation across the country, a province’s decision to opt out may result in inconsistencies in the Canadian securities trade. Consider the hypothetical situation where a designated derivative is to be traded between investors in two provinces, one of which has not opted in. Since this type of security would be classified by the federal regulator, it is unclear how a non-participating province would react if they disagreed with the federal classification. There are many instances where problems could arise on semantics alone.  Perhaps when the regulations are released we will have better idea of how the challenges associated with non-cooperating provinces will be addressed. Until then, we must raise these concerns in order to facilitate comprehensive analysis of the proposed Act.

Specific provisions, however, will apply throughout Canada irrespective of whether a province has opted in or not. These provisions are those relating to criminal offences and punishment, and will replicate the related existing offences in the Criminal Code.

More Dealer Protection Leads to a More Predictable Regime for Investors

The Act will benefit investors through increasing dealer protection and giving regulators more power to crackdown on securities fraud.

In an article by David Baines, Baines argues that the proposed Act favours dealers and issuers at the expense of investors and consumers. He lists the advantages to dealers by outlining the administrative and bureaucratic shortcuts that the Act permits, such as registration with only one national body (as opposed to thirteen). I respectfully question Baines’ assertion that companies currently must deal with all thirteen provincial and territorial regulators. The existing system uses the “passport” system, where issuers only deal with the securities regulator of their home province. The passport system is a strength of the current scheme.  Other operational inefficiencies for dealers do exist, many of which are addressed by the Act. For example, the Act clarifies definitions of derivatives, expanding registration requirements and allowance of self-regulatory agencies. I also question Baines’ statement that the Act favours dealers at the expense of investors. In my opinion, creating clear rules and eliminating bureaucratic red tape for dealers is a benefit that certainly has the potential to be passed on to the investor through cost savings.

Dealer protection is not enough to create investor-friendly capital markets. The existing passport system does not strenuously enforce securities fraud. Two methods currently exist to address securities fraud: (1) through a provincial regulator calling a hearing; and (2) prosecution of offenders at the request of provincial commissions under the applicable Securities Act. Both of these methods require provincial commissions actively watching and identifying dishonest behaviour. Finance Minister Jim Flaherty has suggested that a federal regulator would be “tougher.” Baines argues that while the U.S. Securities and Exchange Commission is known as the world’s toughest regulator, scandals such as Enron and Bernie Madoff have occurred. A country with approximately 275 million more people than Canada is bound to experience more fraud given the size of the market.

A federal regulator has the potential to be more effective in identifying and prosecuting securities fraud through examining Canada-wide patterns and coordinating enforcement action across the provinces.

First, the proposed monetary penalties are greater and may have a stronger deterrent effect.  For a general offence, the penalty is now a fine up to $5 million or imprisonment up to five years.  New criminal provisions relating to fraud and market manipulation were also been proposed, carrying maximum imprisonment terms of up to fourteen years. Moreover, new offences and penalties relating to insider trading and tipping have also been included.

Secondly, offenders will find it more difficult to escape the scrutinizing eye of the federal regulator. The “evidence gathering” rules set out in the draft Act will allow investigators to compel third-party entities (companies not the target of the investigation) to give written evidence and will force brokerage firms to disclose stock-trading information. This proposal mirrors the U.S. method of grand jury questioning. Although individuals cannot be compelled under these rules, these rules are a good start towards moving Canada closer to a more effective enforcement model (like the one used in the U.S.). Ultimately, stronger methods of both deterring and identifying fraud would benefit investors.

The Act is not perfect. Its voluntary nature will pose challenges, and its proposed enforcement provisions may not go far enough. However, it represents the first step of the process to regulate securities at the national level, a long overdue move in Canadian capital markets.