Notice and Proposed Changes to Proposed Rule: OSC Rule - 31-507 - SRO Membership - Securities Dealers and Brokers

Request for Comment OSC Rule

June 19, 1998

RULE 31-507 - SRO MEMBERSHIP - SECURITIES DEALERS ANDBROKERS -
NOTICE OF PROPOSED CHANGES TO PROPOSED RULE

NOTICE OF PROPOSED CHANGES TO

PROPOSED RULE 31-507

SRO MEMBERSHIP - SECURITIES DEALERS AND BROKERS

Substance and Purpose of Proposed Rule

The purpose of the proposed Rule is to address certain regulatory issues that arise in connection withoversight of securities dealers and brokers. The proposed Rule requires all securities dealers and brokersto be members of a self-regulatory organization, self-regulatory body or stock exchange recognized bythe Commission (a "SRO") under section 21.1 of the Act. The Commission has recognized theInvestment Dealers Association of Canada (the "IDA") under section 21.1 of the Act. The proposed Ruleconforms to the fundamental principle in paragraph 4 of section 2.1 of the Securities Act (Ontario) (the"Act") under which the Commission should, subject to an appropriate system of supervision, use theenforcement capability and regulatory expertise of recognized self-regulatory organizations.

The proposed Rule is substantially similar in effect on all securities dealers and brokers as National PolicyStatement No. 49 ("NP 49") was on "national dealers".

The 1989 National Regulatory Working Group

In May 1989, the Canadian Securities Administrators (the "CSA") created the National RegulatoryWorking Group, which tabled and made available to the public its Final Report entitled "Capital,Financial Reporting and Audit Requirements for the Securities Industry" in December 1989 (the"NRWG Report"). Among the recommendations contained in that report was a recommendation thatwould require certain dealers and advisers to become members of a SRO and contribute to the CanadianInvestor Protection Fund ("CIPF"). This recommendation was partially adopted through theimplementation of NP 49. The NRWG Report recommendation that all dealers be required to becomemembers of a SRO is proposed to be implemented in the proposed Rule and proposed Rule 31-506 SROMembership - Mutual Fund Dealers.

The NRWG Report made a number of recommendations to the CSA to deal with the regulatory concernsexpressed in the report relating to the lack of sufficient oversight of both dealers operating in multiplejurisdictions and advisers holding property of their clients, particularly those advisers operating inmultiple jurisdictions.

The CSA considered the recommendations, which included mandatory membership in a SRO,formalization of relationships between the Canadian securities regulatory authorities and SROs,information sharing arrangements between and among SROs and the Canadian securities regulatoryauthorities, a lead regulator system of regulation for registrants where one regulatory body would havejurisdiction over all registrants, increased oversight of SROs by the Canadian securities regulatoryauthorities, introduction of new regulations relating to internal control procedures, risk-based capital,segregation requirements and trade reporting, and implementing revised early warning reporting to theCanadian securities regulatory authorities. In addition, the CSA considered increased direct regulation ofdealers and advisers by the CSA and restricting the ability of registrants to hold client property.

The proposed changes to the proposed Rule extends the effect of the Rule to require brokers, beingmembers of The Toronto Stock Exchange, to become members of the IDA. The proposed changes alsochange the effective date for current registrants to link it to the next date the registrant is required to filefinancial statements under the Act rather than the next renewal date.

Currently, the IDA is the only SRO recognized by the Commission. The IDA is a participating SRO inthe CIPF, the industry funded investor compensation fund. CIPF covers losses of securities and cashbalances, within prescribed limits, suffered by clients of a participating firm in case of that firm'sinsolvency. Regular levies assessed on firms finance CIPF. These levies are based on the firm's grossrevenues. The client loss coverage provided by CIPF is much higher than that afforded by the OntarioContingency Trust Fund to which securities dealers contribute.

Summary of Proposed Rule

The proposed Rule requires membership in a SRO recognized by the Commission. At the present time,the IDA is the only SRO recognized by the Commission for member regulation purposes. Membership inthe IDA would require all member dealers to make contributions to CIPF.

Summary of Written Comments Received by the Commission

The Commission received three comment letters on the draft proposed Rule which was published onOctober 3, 1997. The comments were a combined letter from the Canadian Dealing Network Inc. andThe Toronto Stock Exchange and letters from First Affiliated Securities Inc. and the Rice FinancialGroup Inc. In addition, the Commission received fourteen letters preceding the publication in response toa letter sent to the industry by the Executive Director of the Commission.

The comment letters received in respect of the draft published Rule may be summarized as follows:

two of the letters were very supportive and the third objected to the SRO Rule;

one of those in support stated that the imposition of a SRO would play an important role in improvingthe operation and public perception of Ontario's junior capital markets and would add an effective sourceof prevention and recourse in respect of unacceptable sales and marketing activities;

one commentator requested to know who the SRO would be. This questions has now been answered;and

the organization that objected to the Rule was concerned about the increased capital, bonding andregulatory standards associated with a member of the SRO and felt that since certain dealers conductvery limited business within the capital markets and do not operate trust accounts or hold client assets,the increased regulatory standards were unnecessary.

The letters received in response to the letter from the Executive Director prior to publication of the Rulemay be summarized as follows:

of the fourteen letters received, two respondents did not want to become members of a SRO;

a commentator suggested that membership should be classified based on whether the registrant handledclient money and the size of the registrant's operations and that the regulatory regime shouldaccommodate smaller member firms; and

some of the commentators requested an extended period of time prior to implementation of the new SRORule.

Authority for Proposed Rule

The following sections of the Act provide the Commission with authority to adopt the proposed Rule.Paragraph 143(1)1 of the Act authorizes the Commission to make rules prescribing requirements inrespect of applications for registration and the renewal, amendment, expiration or surrender ofregistration. Paragraph 143(1)2 of the Act authorizes the Commission to make rules prescribingconditions of registration or other requirements for registrants or any category or subcategory ofregistrant.

Alternatives Considered

The Commission considers increased reliance on the self-regulatory system to be consistent with thepurposes of provincial securities legislation. SROs can bring industry expertise to bear on members andcan apply uniform standards on a consistent basis across provincial boundaries. They can react faster thangovernment agencies to changes in market conditions and to activities and trends of concern. As thesystem under NP 49 has worked well since its adoption in June 1993, the proposed Rule extends thesystem to all securities dealers and brokers. Under proposed Rule 31-506 SRO Membership - MutualFund Dealers, Ontario is, in effect, also extending NP 49 to all mutual fund dealers. Some CSAjurisdictions are considering taking the same approach as Ontario.

Unpublished Materials

In proposing the Rule, the Commission has not relied on any significant unpublished study, report orother material.

Anticipated Costs and Benefits

There are substantial benefits involved in a self-regulatory organization system of regulation. Aself-regulatory organization system helps to ensure compliance with regulatory requirements and alsohelps to provide consistent application and interpretation of the regulatory requirements.

Participants in the capital markets will benefit as additional levies are collected as a result of increasedmembership in CIPF to the extent that this provides an increased fund in the event of an insolvency of amember firm.

Clients of affected dealers will benefit from the protections afforded by a SRO system and the availabilityof CIPF for those dealers that are not currently required to be members of a SRO and do not currentlycontribute to the CIPF.

The proposed Rule will impose costs to dealers that are not currently members of a SRO and do notcurrently contribute to the CIPF. These costs will include fees for membership in the SRO as well as thelevies of CIPF which are based on the level of activity in the capital markets, i.e. gross revenues of theparticipant. Brokers already contribute to CIPF as a result of their membership in The Toronto StockExchange.

Based on experience to date under NP 49, the Commission believes that the benefits of the proposedRule justify the costs.

Comments

Interested parties are invited to make written submissions with respect to the proposed Rule.Submissions received by July 17, 1998 will be considered.

Submissions should be sent to the Ontario Securities Commission in duplicate, as indicated below:

c/o Daniel P. Iggers, Secretary

Ontario Securities Commission

20 Queen Street West

Suite 800, Box 55

Toronto, Ontario M5H 3S8

A diskette containing the submissions (in DOS or Windows format, preferably WordPerfect) should alsobe submitted. As the Act requires that a summary of written comments received during the commentperiod be published, confidentiality of submission cannot be maintained.

Questions may be referred to any of:

Tanis MacLaren

Associate General Counsel

Ontario Securities Commission

(416) 593-8259

Randee Pavalow

Policy Co-ordinator

Ontario Securities Commission

(416) 593-8257

Proposed Rule

The text of the proposed Rule including the proposed changes follows, together with footnotes that arenot part of the Rule but have been included to provide background and explanation.

Dated: June 19, 1998.

ONTARIO SECURITIES COMMISSION RULE 31-507

SRO MEMBERSHIP - SECURITIES DEALERS AND BROKERS_(1),(2)

PART 1 MEMBERSHIP REQUIRED

1.1 Membership Required

(1) A securities dealer⁽³⁾ shall be a member of a SRO⁽⁴⁾ recognized by the Commission under section 21.1of the Act.

(2) A broker⁽⁵⁾ shall be a member of a SRO recognized by the Commission under section 21.1 of the Act.

1.2 Primary Audit Jurisdiction - A securities dealer and a broker that has its head office located inOntario shall be subject to the primary audit jurisdiction of the SRO recognized by the Commission ofwhich it is a member.

PART 2 EFFECTIVE DATE

2.1 This Rule shall be effective on , 1998⁽⁶⁾ for an applicant for registration as a securities dealer orbroker.

2.2 This Rule shall be effective for a securities dealer on the earlier of:

(a) the first date on which its annual financial statements must be filed under the Act after , 1999⁽⁷⁾; and

(b) , 1999⁽⁸⁾.

2.3 This Rule shall be effective for a broker on the earlier of:

(a) the first date on which its annual financial statements must be filed under the Act after , 1999⁽⁹⁾; and

(b) , 1999.

PART 3 EXEMPTION

3.1 Exemption - The Director may grant an exemption to this Rule, in whole or in part, subject to suchconditions or restrictions as may be imposed in the exemption.

1. ⁰ This Rule is new.

2. ⁰ A general definition rule has been adopted as Rule 14-501 Definitions. It contains definitions ofcertain terms used in more than one rule. Rule 14-501 also provides, among other things, that terms usedin a rule and defined in Section 1 of the Securities Act or subsection 1(2) of the Regulation will have therespective meaning given to them in the Securities Act or Regulation, as appropriate. A nationaldefinition rule has also been adopted as Rule 14-101 Definitions. It contains definitions of certain termsused in more than one National Instrument. National Instrument 14-101 also provides that a term used ina National Instrument and defined in the statute relating to securities of the applicable jurisdiction, thedefinition of which is not restricted to a specific portion of the statute, will have the meaning given to itin the statute relating to securities of that jurisdiction. National Instrument 14-101 also provides that aprovision in a National Instrument that specifically refers by name to a jurisdiction, other than the localjurisdiction shall not have any affect in the local jurisdiction, unless otherwise stated in the provision.

3. ⁰ The term "securities dealer" is defined in Rule 14-501 as "a person or company registered under theAct in the category of securities dealer".

4. ⁰ The term "SRO" is defined in National Instrument 14-101 Definitions as "a self-regulatoryorganization, a self-regulatory body or an exchange". The Commission has recognized the InvestmentDealers Association of Canada under section 21.1 of the Act.

5. ⁰ The term "broker" is defined in Rule 14-501 as "a person or company registered under the Act in thecategory of broker".

6. ⁰ The Commission expects this date to be six months after the later of the date the Rule is adopted bythe Commission in final form and the date the Rule becomes effective under the Act.

7. ⁰ The Commission expects this date to be eighteen months after the later of the date that the Rule isadopted by the Commission in final form and the date the Rule becomes effective under the Act.

8. ⁰ The Commission expects this date to be eighteen months after the later of the date the Rule isadopted by the Commission in final form and the date the Rule becomes effective under the Act.

9. ⁰ The Commission expects this date to be eighteen months after the later of the date the Rule isadopted by the Commission in final form and the date the Rule becomes effective under the Act.