What Should be Keeping you Awake at Night…
November 6, 2013
David Di Paolo, Partner
Agenda
Top 5 litigation/regulatory enforcement risks facing
mutual fund dealers
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5. Beware of your brand new
acquisitions
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Beware of your brand new
acquisitions
• What are the risks?
• Excessive leveraging
• OBAs
• Compliance failings
• How do you minimize the risks?
• Proper due diligence
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4. Your Advisor’s Undisclosed OBA’s
Could be Your Responsibility
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A refresher – what is unauthorized OBA and
why is the MFDA so concerned about it?
•
The MFDA has been concerned for some time about
Approved Persons (“APs”) engaging in unauthorized
outside business activities (“OBA”). In particular, the
MFDA is concerned about conflicts of interest that may
arise as a result of unauthorized OBA.
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OBA – MR-0040
• MR-0040 is intended to “clarify the obligations” of Members and
Approved Persons regarding OBA.
• OBA is defined in MR-0040 as “any business carried on by an
Approved Person other than business done on behalf of the
Approved Person’s MFDA Member firm.”
• Broad scope - OBA can include:
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•
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securities sold outside of the Member;
referral of securities related business outside of the Member; and
activities you may not consider – e.g. real estate transactions,
business ventures, and other employment.
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Permitted OBA
• Under MFDA Rule 1.2.1(c), an Approved Person can only be
gainfully employed in a dual occupation provided that:
• The securities commission in the jurisdiction in which the AP carries on business
specifically permits him or her to devote less than his or her full time to the
business of the Member for which he or she acts on behalf of;
• The activity is not prohibited by a securities commission in the jurisdiction in which
the AP carries on business;
• The Member is aware of and has approved the outside activity;
• The Member has appropriate procedures to ensure continuous service to
clients and to address potential conflicts of interest;
• The activity does not bring the MFDA, its Members, or the mutual fund industry
into disrepute; and
• Clear disclosure is provided to clients that any activities related to the outside
activity are not the business of the Member and are not the responsibility of the
Member.
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Forbidden OBA
• MFDA Rule 1.1.1(a) requires that all securities related
business must be carried on through the account of
the Member.
• As a result, OBA involving the sale of any securities
outside of the Member (this includes things such as
investment clubs or managed account arrangements)
is prohibited.
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Regulatory Penalties
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•
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The MFDA expects that Members to take reasonable
measures to detect unauthorized OBA. Detective
measures to identify unauthorized OBA should be
incorporated into existing supervisory processes of
the Member.
Failure to have policies and procedures to detect
undisclosed OBA, or a failure to follow such
policies can result in the MFDA imposition fines
against Members
Minimum fine against Members = $25,000
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Civil Liability
• In addition to regulatory sanctions and
penalties, clients are pursuing dealers when
money invested in an OBA has been lost
• OBSI
• Civil claims
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Civil Liability
• Failure to detect OBA can result in civil liability for
both:
1) Failure to supervise
2) Vicarious liability
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The Member’s obligations – what you can
do to ensure your interests are protected
Your obligations:
1. The Member must be aware of and approve the OBA.
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•
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The Member must have adequate policies and procedures in place to
address notification and approval of OBA, as well as ongoing
compliance by APs with MFDA Rules and By-Laws as they relate to the
OBA;
Members that allow OBA must, as part of their approval process, obtain
basic information about the proposed OBA. That information should
include (a) the name and nature of the business, (b) title of the AP, (c)
the number of hours the AP plans to devote to the OBA, and (d) a
description of any potential conflicts of interest.
The Member’s policies and procedures should require APs to notify
the Member in the event of any material changes to the OBA.
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The Member’s obligations – what you can
do to ensure your interests are protected
2. While Members do not have a specific obligation under the
Rules to supervise OBA on an ongoing basis, Members do
have a duty to monitor the activities of their APs and ensure
they are in compliance with MFDA Rules and applicable
securities legislation.
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•
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Members have an ongoing obligation to ensure that the distinction
between Member business and OBA is properly disclosed to the client;
Members have an obligation to monitor for conflicts of interest and must
follow up on all client complaints that relate to OBA; and
Members are required to take reasonable measures to look for
evidence of undisclosed OBA.
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Unauthorized OBA – What to Look For
• Members should, during their existing review procedures, be on
the lookout for signs that may indicate an AP is engaged in
unauthorized OBA, including:
• agreements, loan documents, financial planning documents, or documents
evidencing the sale of securities outside the Member located in client files during a
branch review;
• reference to activities the Member is not aware of in the AP’s advertising or on the
AP’s website;
• patterns of redemptions where there is no re-purchase – may indicate AP is
making recommendations aimed at funding client participation in his or her OBA;
• unexplained decreases in book size or an AP’s commission levels may indicate
movement of client assets to investment activities offered to clients by the AP; and
• lifestyle changes.
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So you’ve discovered a “bad
seed” – now what?
• When a Member becomes aware of an AP’s undisclosed OBA, the
MFDA expects that the Member will conduct a reasonable
investigation to ensure any potential issues are properly addressed.
• Members should ensure they have access to the necessary files to
complete an investigation into the nature and extent of the
undisclosed OBA.
• The Member must take steps that are appropriate for the type of
activity identified, and should be alert to potential client concerns.
• The Member must take action to resolve any issues, which may
include providing disclosure to clients, considering disciplinary
measures, or any other suitable steps.
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So you’ve discovered a “bad seed” –
now what?
• Any information the Member receives that suggest the
OBA of an AP may bring the mutual fund industry or the
Member into disrepute must be “followed up”.
• Client complaints should be dealt with in accordance with
Policy 3.
• Any complaints involving allegations of theft or
misappropriation must be promptly reported to the MFDA
in compliance with Policy 3.
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3. Class Action Law Suits against
Mutual Fund Dealers are here to stay
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Overview of a Class Action
• Procedural mechanism
• Collective response to a civil wrong which has led to
loss by group of similarly situated plaintiffs
• Small loss x large numbers of customers = large loss!
• Cost of defending even unmeritorious claims
• Customer relations/institutional reputation may be
harmed even if class not certified
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Overview of a Class Action
• Process governed by Class Proceedings
legislation (or by analogy):
• Judge must “certify” the action
• Limitation Period suspended for entire class once
claim filed
• Cost consequences limited to representative
plaintiffs
• Possible funding by CPF
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Avoiding Class Actions
The Problem
• Low Threshold

Certification
• Certification

Settlement
• Settlement
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$ for Class Counsel
• $ for Class Counsel 
More Class Actions
Statistics
• Number of securities class
actions has been steadily
increasing since 2008
• As of January 2012, there
were 45 active Canadian
securities class actions
• Approximately $24.5 billion
in outstanding claims
• Vast majority of these
actions are based in
Ontario
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Canadian Securities Class Actions
• Traditionally:
• Primary market liability
• Secondary market liability
• Oppression Class Actions
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Emergence of Class Action Suits in
the Dealer Context
• Failure to supervise a certifiable issue
• Ontario
• Alberta
• Nova Scotia
• In Ontario, proposed representative plaintiffs claimed
damages for negligence in relation to two advisors’
recommendations regarding leveraging - claim is
against both the advisors and the dealer.
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Emergence of Class Action Suits in
the Dealer Context
• two significant new issues:
1. an advisor can be the subject of a class proceeding
regarding the suitability of the advice given to his or
her clients as a class
2. the issue of whether a dealer has properly
supervised the recommendations made by advisors
is a certifiable common issue in a class proceeding
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Impact of Suitability as a Common
Issue
• Broker dealers may see an increase in class actions
• Takes away defence of client individuality
• Would make certification of the common issue of
breach of duty much easier, especially if claim is in
relation to one investment or one investment strategy
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Avoiding Class Actions
The Solution
1. preventative action
2. pre-certification strategies
3. create disincentives for class counsel
4. fight
2. OBSI – The New Frontier
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Ombudsman for Banking Services and
Investments (“OBSI”)
• OBSI is the national independent dispute resolution
service for consumers and small businesses with a
complaint they can’t resolve with their banking
services or investment firm.
• At present all IIROC and MFDA member firms must
participate in the OBSI process if clients elect to
initiate the process
• Where a complaint has merit, OBSI may recommend
compensation up to a maximum of $350,000.
OBSI
• OBSI has a mandate to investigate complaints,
including the power to interview staff of the
participating firm and the complainant and obtain
copes of the relevant documents from the
participating firms.
• Following the investigation of a complaint, OBSI is
required to make a determination and
recommendation.
OBSI
• An OBSI recommendation is not binding on a
participating firm.
• However, if a participating firm does not accept the
recommendation of OBSI, OBSI must make public the
name of the participating firm, the recommendation
and the circumstances of the case.
OBSI - Critiques
• OBSI is funded by the industries it investigates.
• From the client side, there appear to be issues with
respect to OBSI’s independence due to perceived
conflict of industry funding and a lack of power in
dealing with financial institutions.
• On the dealer side, there have been a number of
complaints that OBSI is pro-client and fails to apply
appropriate legal standards in assessing
liability/damages
OBSI - Critiques
1) Loss Calculations
• Of particular concern is OBSI’s loss calculation
methodology used to figure out compensation to be paid
to aggrieved customers.
• OBSI assesses opportunity costs on suitability without
consultation. Many of OBSI’s decisions are not only
factoring in money lost if a dealer puts a client in an
unsuitable investment, OBSI is also awarding costs for
lost opportunity.
• This often results in increased costs to a dealer
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OBSI – Critiques
2) Limitation Period
• OBSI has adopted a self-imposed limitation period of
six years from the time when it believes an investor
knew, or ought to have known, there was a problem
with their investments.
• Ontario Limitations Act, 2002 = 2 year limitation
period
3) Approach to OBAs
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Lack of Co-operation
• In early 2012, only one firm had refused an OBSI
recommendation since its inception
• Within the past six months, 4 firms have refused to
compensate complainants as per OBSI’s
recommendation
• These firms have been “named and shamed” on
OBSI’s website
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.
• OSC has made no comment with respect to firms
refusing to comply with an OBSI recommendation
• The Investor Advisory Panel has suggested that the
OSC require a regulatory review whenever a firm
ignores OBSI’s decision
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1. Guess What – You’re A Fiduciary!
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The CSA’s Proposal
The CSA released a consultation paper which
proposed introducing the following statutory “best
interest” standard:
Every adviser and dealer (and each of their representatives) that provides
advice to a retail client with respect to investing in, buying or selling
securities or derivatives shall, when providing such advice,
1. act in the best interests of the retail client, and
2. exercise the degree of care, diligence and skill that a reasonably
prudent person or company would exercise in the circumstances
The CSA’s Proposal – Why now?
The CSA has identified the following concerns they
hope a statutory standard would address
1.The current standard of conduct does not recognize that the securities
industry is not like other business transactions that rely on “buyer
beware”
2.Many investors do not have the financial knowledge that their advisors
do
3.There is a gap between what standard of conduct currently exists and
what clients expect of their advisors
4.Suitable investments may not necessarily result in investments in the
client’s best interests
5.Current conflict of interest rules are not implemented effectively
Understanding fiduciary obligations
A fiduciary is a legal concept wherein an agent or
trustee has an absolute obligation to act for the sole
benefit of the principal or beneficiary.
Current Duty for Dealers
There is no current statutory fiduciary obligation in
Ontario.
Whether a dealer owes a fiduciary duty to a client is
determined at common law on a case by case basis.
The existence of a fiduciary duty will depend on the
circumstances of the dealer/client relationship.
Impact of a Best Interest Standard
Suitability
•Suitability of investments would no longer be the standard
for a dealer/advisor
•The new standard would be whether you acted in the “best
interests” of the client
•“Best interest” has not clearly been defined by the CSAdoes it mean the cheapest option?
•This may result in liability even if the investments were
suitable
Impact of a Best Interest Standard
Compensation
• Does an advisor recommend only the cheapest option or else be
placed in a conflict of interest?
• What if the cheapest option is not the most suitable for the
client?
• What impact would a new standard have on commissions?
• Australia and the UK have set limits on how advisors and
dealers can profit from their advice
Impact of a Best Interest Standard
Legal
• Would take away defence of client individuality
• If there is found to be a breach of fiduciary duty, damages will
not be reduced for contributory negligence
• Easier for a plaintiff to be awarded punitive damages
• May result in an increase in class actions for Know-Your-Client
claims if every client is treated as being owed a fiduciary duty
• Likely to increase the cost of litigation
• Will registrants become liable for market losses?
Summary of Top 5 Risks
5. Beware of your brand new acquisition – they may
cost more that you pay
4. Your advisor’s undisclosed OBA’s could be your
responsibility
3. Class Action Law Suits against Mutual Fund Dealers
are here to stay
2. OBSI – The New Frontier
1. Guess What – You’re a Fiduciary!
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THANK YOU
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