Securities Law & Instruments

Headnote

 

U.S. registered broker dealer exempted from dealer registration under paragraph 25(1) of the Act for provision of prime brokerage services – relief limited to trades in Canadian securities for institutional permitted clients – relief is subject to sunset clause.

 

Applicable Legislative Provisions

 

Statutes Cited

 

Securities Act, R.S.O. 1990, c. S.5, as am., ss. 25(1), 74(1).

 

Instruments Cited

 

Multilateral Instrument 11-102 Passport System, s. 4.7.

National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations, s. 8.5, 8.18, 8.21.

National Instrument 81-102 Investment Funds.

 

December 16, 2016

 

IN THE MATTER OF

THE SECURITIES LEGISLATION OF

ONTARIO

(the Jurisdiction)

 

AND

 

IN THE MATTER OF

THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS

IN MULTIPLE JURISDICTIONS

 

AND

 

IN THE MATTER OF

MERRILL LYNCH, PIERCE, FENNER & SMITH INCORPORATED AND

MERRILL LYNCH PROFESSIONAL CLEARING CORP.

(the Filers)

 

DECISION

 

Background

 

The principal regulator in the Jurisdiction has received an application from the Filers (the Application) for a decision under the securities legislation of the Jurisdiction (the Legislation) exempting the Filers from dealer registration under section 25(1) of the Securities Act (Ontario) (the Act) in respect of Prime Services (as defined below) relating to securities of Canadian issuers and that are provided in Canada to Institutional Permitted Clients (as defined below) (the Exemption Sought).

 

Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):

 

(a)           the Ontario Securities Commission (OSC) is the principal regulator for this Application, and

 

(b)           the Filers have provided notice that section 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of the other provinces and territories of Canada in which the Filer relies on the exemption found in section 8.18 [International dealer] of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) other than the province of Alberta (the Passport Jurisdictions and together with the Jurisdiction, the Jurisdictions).

 

Interpretation

 

Terms defined in National Instrument 14-101 Definitions and MI 11-102 have the same meaning if used in this decision, unless otherwise defined.


For the purposes of this decision, the following term has the following meaning:

 

“Institutional Permitted Client” shall mean a “permitted client” as defined in section 1.1 of NI 31-103, except for: (a) an individual, (b) a person or company acting on behalf of a managed account of an individual, (c) a person or company referred to in paragraph (p) of that definition, unless that person or company qualifies as an Institutional Permitted Client under another paragraph of that definition, or (d) a person or company referred to in paragraph (q) of that definition unless that person or company has net assets of at least $100 million as shown on its most recently prepared financial statements or qualifies as an Institutional Permitted Client under another paragraph of that definition.

 

Representations

 

This decision is based on the following facts represented by the Filers:

 

1.             Each of the Filers is a corporation formed under the laws of the State of Delaware. Both of the Filers’ head offices are located at One Bryant Park, New York, New York, 10036, United States of America (U.S.). Merrill Lynch Professional Clearing Corp. (MLPro) is a subsidiary of Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPFS). MLPFS is a wholly-owned subsidiary of Bank of America Corporation, held through its wholly-owned subsidiaries BAC North America Holding Company and NB Holdings Corporation.

 

2.             Each of the Filers is registered as a broker-dealer with the U.S. Securities and Exchange Commission (SEC) and is a member of the Financial Industry Regulatory Authority (FINRA). This registration and membership permits each of the Filers to provide Prime Services (as defined below) in the U.S.

 

3.             MLPFS is a member of a number of major U.S. securities exchanges, including the New York Stock Exchange and NASDAQ. MLPFS is also a member of the Chicago Board Options Exchange, the MIAX Options Exchange, the International Securities Exchange, the BOX Options Exchange, and other principal U.S. commodity exchanges, and trades through affiliated or unaffiliated member firms on all other exchanges, including exchanges in Canada, France, Italy, Japan, Singapore, Spain, Taiwan, Mexico, Korea and the United Kingdom.

 

4.             MLPro is a member of the New York Stock Exchange and NASDAQ. MLPro is also a member of the Chicago Board Options Exchange, MIAX Options Exchange, International Securities Exchange, BOX Options Exchange and other principal U.S. commodity exchanges, and trades through affiliated or unaffiliated member firms on all other exchanges, including exchanges in Canada, France, Italy, Japan, Singapore, Spain, Taiwan, Mexico, Korea and the United Kingdom.

 

5.             MLPFS provides a variety of capital raising, investment banking, market making, brokerage, and advisory services, including fixed income and equity sales and research, commodities trading, emerging markets activities, securities lending and investment banking for governments, corporate and financial institutions. MLPFS also conducts proprietary trading activities.

 

6.             MLPro provides Prime Services (as defined below) and third party securities clearing services.

 

7.             MLPFS provides trade execution services and Prime Services (defined below) through two different business units and the two business units are separated by information barriers. MLPFS relies on section 8.18 [International dealer] of NI 31-103 to provide trade execution services in respect of “foreign securities” as defined in that section. MLPFS also relies on the exemptions found in section 8.5 [Trades through or to a registered dealer], in paragraphs (a), (b) and (f) of subsection 8.18(2) [International dealer], and in section 8.21 [Specified debt] of NI 31-103 to provide limited trade execution services in respect of securities of Canadian issuers.

 

8.             MLPro does not provide trade execution services.

 

9.             “Prime Services” provided by the Filers principally consists of the following: (a) settlement, clearing and custody of trades; (b) financing of long inventory; (c) securities borrowing and/or lending pursuant to a securities lending agreement or delivering securities on behalf of a client pursuant to a margin agreement, in each case, to facilitate client short sales; and (d) reporting of positions, margin and other balances and activity. For greater clarity, Prime Services do not include execution of trades in securities.

 

10.          The Filers provide or wish to provide Prime Services in the Jurisdictions to Institutional Permitted Clients (the Prime Services Clients).

 

11.          In the case of a Prime Services Client that is an investment fund subject to Part 6 of National Instrument 81-102 Investment Funds (NI 81-102), the custodianship requirements in Part 6 of NI 81-102 would only permit the Filers to provide the Prime Services to the investment fund as a sub-custodian of the investment fund in respect of portfolio assets held outside Canada.

 

12.          MLPFS offers Prime Services to Institutional Permitted Clients for fixed income securities.

 

13.          MLPro offers Prime Services to Institutional Permitted Clients for equities and other non-fixed income securities.

 

14.          Prime Services Clients seek Prime Services from the Filers in order to separate the execution of a trade from the clearing, settlement, custody and financing of a trade. This allows the Prime Services Client to use many executing brokers, without maintaining an active, ongoing custody account with each executing broker. It also allows the Prime Services Client to consolidate settlement, clearing, custody and financing of securities in an account with the Filers.

 

15.          The Filers’ Prime Services Clients directly select their executing brokers. The Filers do not require their Prime Services Clients to use specific executing brokers through which Prime Services Clients must execute trades. Prime Services Clients send trade orders to the executing broker who carries out the trade. The executing broker will be an appropriately registered dealer or a person or company relying on an exemption from dealer registration that permits such executing broker to execute the trade for Prime Services Clients.

 

16.          The Filers provide the Prime Services after the execution of the trade, but any commitment to provide financing or to lend or borrow securities in relation to a trade may be made prior to the execution of the trade. The executing broker will communicate trade details to a Prime Services Client and the applicable Filer or Filer’s clearing agent, as applicable. A Prime Services Client will also communicate trade details to the applicable Filer. For trades executed on a Canadian marketplace, the applicable Filer will typically need to clear and settle the trades through a participant of the Canadian depository, clearing and settlement hub, CDS Clearing and Depository Services Inc.

 

17.          The Filers exchange money or securities and hold the money or securities in an account for each Prime Services Client. If a Filer is clearing and settling the trade through a clearing agent, the Filer’s clearing agent exchanges money or securities and holds the money or securities in an omnibus account for the Filer, which in turn maintains a record of the position held for the Prime Services Client on its books and records.

 

18.          On or following settlement, the Filers provide the other Prime Services as set out in paragraph 9.

 

19.          The Filers enter into written agreements with all of their Prime Services Clients for the provision of Prime Services.

 

20.          On September 2, 2011, in CSA Staff Notice 31-327 Broker-Dealer Registration in the Exempt Market Dealer Category, the Canadian Securities Administrators (CSA) stated that they had concerns with firms applying for registration in and with firms registered in the category of exempt market dealer (EMD) who were carrying on brokerage activities, including trading listed securities. In light of these regulatory concerns, firms applying for registration were instead registered in the restricted dealer category with terms and conditions. The interim restricted dealer registrations were time limited and were intended to allow applicants to engage in limited activities while the CSA reviewed the activities of firms registered in the category of EMD and restricted dealer.

 

21.          MLPFS was registered as an EMD in the provinces of Alberta, British Columbia, Ontario and Quebec and was subject to the requirements of NI 31-103. MLPro was registered as a restricted dealer in the provinces of Alberta, British Columbia, Ontario, and Québec, and its registration was subject to a sunset clause. As a restricted dealer, MLPro was subject to the requirements of NI 31-103.

 

22.          On February 7, 2013, in CSA Staff Notice 31-333 Follow-up to Broker-Dealer Registration in the Exempt Market Dealer Category, the CSA stated that they would be publishing amendments to NI 31-103 that would prohibit exempt market dealers from trading in a security if the security is listed, quoted or traded on a marketplace and if the trade in the security does not require reliance on a further exemption from the prospectus requirement (the Rule Amendments). The CSA stated that restricted dealers conducting brokerage activities in accordance with the terms and conditions of their registration would have their registration and any related exemptive relief extended to the date the Rule Amendments came into effect.

 

23.          The Rule Amendments came into effect on July 11, 2015. At that time, MLPFS agreed to surrender its EMD registration and MLPro’s registration in the category of restricted dealer expired. Since the implementation of the Rule Amendments, only investment dealers that are dealer-members of the Investment Industry Regulatory Organization of Canada (IIROC) or firms relying on an applicable exemption from the dealer registration requirement are permitted to engage in trading in a security if the security is listed, quoted or traded on a marketplace and if the trade in the security does not require reliance on a further exemption from the prospectus requirement in the Jurisdictions.

 

24.          MLPFS relies on the international dealer exemption under section 8.18 of NI 31-103 in Alberta, British Columbia, Manitoba, New Brunswick, Newfoundland and Labrador, Northwest Territories, Nova Scotia, Ontario, Prince Edward Island, Québec and Saskatchewan to provide Prime Services in respect of “foreign securities” as defined in section 8.18 of NI 31-103.

 

25.          MLPro relies on the international dealer exemption under section 8.18 of NI 31-103 in Alberta, British Columbia, Ontario and Québec to provide Prime Services in respect of “foreign securities” as defined in section 8.18 of NI 31-103.

 

26.          The Filers are not registered under NI 31-103, are in the business of trading, and in the absence of the Exemption Sought, cannot provide the full range of Prime Services in the Jurisdictions in respect of securities of Canadian issuers without registration, except as permitted under section 8.5 [Trades through or to a registered dealer], under the exemptions found in paragraphs (a), (b) and (f) of subsection 8.18(2) [International dealer], and under section 8.21 [Specified debt] of NI 31-103.

 

27.          The Filers are subject to regulatory capital requirements under the Securities Exchange Act of 1934 (the 1934 Act), specifically SEC Rule 15c3-1 Net Capital Requirements for Brokers or Dealers (SEC Rule 15c3-1) and SEC Rule 17a-5 Reports to be Made by Certain Brokers and Dealers (SEC Rule 17a-5). MLPFS has been approved by the SEC pursuant to SEC Rule 15c3-1 to use the alternative method of computing net capital contained in Appendix E to SEC Rule 15c3-1, and therefore files such supplemental and alternative reports as may be prescribed by the SEC. The Alternative Net Capital (ANC) method provides large broker-dealers meeting specified criteria, such as MLPFS, with an alternative to use mathematical models such as the value at risk model to calculate capital requirements for market and derivatives related credit risk. MLPFS, who uses the ANC method, must document and implement a comprehensive internal risk management system which addresses market, credit, liquidity, legal and operational risk at the firm.

 

28.          SEC Rule 15c3-1 also requires the Filers to account for any guarantee of debt of a third party in calculating its excess net capital. In particular, in the event that the Filers provide a guarantee of any debt of a third party, it will be required to deduct the total amount of the guarantee in calculating its net capital. MLPro does not guarantee the debt of any third party. MLPFS guarantees the debt of MLPro.

 

29.          SEC Rule 15c3-1 is designed to provide protections that are substantially similar to the protections provided by the capital formula requirements and specifically risk adjusted capital to which dealer members of IIROC are subject, and the Filers are in compliance with SEC Rule 15c3-1 and are in compliance in all material respects with SEC Rule 17a-5. If the Filers’ net capital declines below the minimum amount required, the Filers are required to notify the SEC and FINRA pursuant to SEC Rule 17a-11 Notification Provisions for Brokers and Dealers (SEC Rule 17a-11). The SEC and FINRA have the responsibility to provide oversight over the Filers’ compliance with SEC Rule 15c3-1 and SEC Rule 17a-5.

 

30.          The Filers are required to prepare and file a financial report, which includes Form X-17a-5 (the FOCUS Report), which is the financial and operational report containing a net capital calculation, and a compliance report annually with the SEC and FINRA pursuant to SEC Rule 17a-5(d). The FOCUS Report provides a more comprehensive description of the business activities of the Filers, and more accurately reflects those activities including client lending activity, than would be provided by Form 31-103F1 Calculation of Excess Working Capital (Form 31-103F1). The net capital requirements computed using methods prescribed by SEC Rule 15c3-1 are based on all assets and liabilities on the books and records of a broker-dealer whereas Form 31-103F1 is a calculation of excess working capital, which is a computation based primarily on the current assets and current liabilities on the books and records of the dealer. The Filers are up-to-date in their respective submissions of annual reports under SEC Rule 17a-5(d), including the FOCUS Report.

 

31.          The Filers are subject to regulations of the Board of Governors of the U.S.A. Federal Reserve Board (FRB), the SEC and FINRA regarding the lending of money, extension of credit and provision of margin to clients (the U.S. Margin Regulations) that provide protections that are substantially similar to the protections provided by the requirements regarding the lending of money, extension of credit and provision of margin to clients to which dealer members of IIROC are subject. In particular, the Filers are subject to the margin requirements imposed by the FRB, including Regulation T and under applicable SEC rules and under FINRA Rule 4210. The Filers are in compliance in all material respects with applicable U.S. Margin Regulations.

 

32.          The Filers hold customer assets in accordance with Rule 15c3-3 of the 1934 Act, as amended (SEC Rule 15c3-3). Rule 15c3-3 requires the Filer to segregate and keep segregated all “fully-paid securities” and “excess margin securities” (as such terms are defined in Rule 15c3-3) of its customers from its proprietary assets. In addition to the segregation of customers’ securities, SEC Rule 15c3-3 requires the Filers to deposit an amount of cash or qualified government securities determined in accordance with a reserve formula set forth in SEC Rule 15c3-3 in an account entitled “Special Reserve Account for the Exclusive Benefit of Customers” of such Filer at separate banks and/or custodians. The combination of segregated securities and cash reserve are designed to ensure that the Filers have sufficient assets to cover all net equity claims of its customers and provide protections that are substantially similar to the protections provided by the requirements dealer members of IIROC are subject. If the Filers fail to make an appropriate deposit, the Filers are required to notify the SEC and FINRA pursuant to SEC Rule 15c3-3(i). The Filers are in material compliance with the possession and control requirements of SEC Rule 15c3-3.

 

33.          The Filers are members of the Securities Investors Protection Corporation (SIPC) and, subject to the eligibility criteria of SIPC, Prime Services Clients’ assets held by the Filers are insured by SIPC against loss due to insolvency.

 

34.           Filers are in compliance in all material respects with U.S. securities laws. Subject to the matter to which the Exemption Sought relates, the Filers are not in default of securities legislation in any jurisdiction in Canada.

 

35.          The Filers submit that the Exemption Sought would not be prejudicial to the public interest because:

 

(a)           the Filers are regulated as broker-dealers under the securities legislation of the U.S., and are subject to the requirements listed in paragraphs 26 to 31,

 

(b)           the availability of and access to Prime Services is important to Canadian institutional investors who are active participants in the international marketplace,

 

(c)           the Filers will provide Prime Services in the Jurisdictions only to Institutional Permitted Clients;

 

(d)           the OSC has entered into a memorandum of understanding with the SEC regarding mutual assistance in the supervision and oversight of regulated entities that operate on a cross-border basis in the U.S. and Canada; and

 

(e)           the OSC has entered into a memorandum of understanding with FINRA to provide a formal basis for the exchange of regulatory information and investigative assistance.

 

36.          At the request of the Alberta Securities Commission, the Filer will not rely on subsection 4.7(1) of MI 11-102 to passport this decision into Alberta.

 

37.          The Filers are “market participants” as defined under subsection 1(1) of the Act. As market participants, among other requirements, the Filers are required to comply with the record keeping and provision of information provisions under section 19 of the Act, which include the requirement to keep such books, records and other documents as are necessary for the proper recording of business transactions and financial affairs, and the transactions executed on behalf of others and to deliver such records to the OSC if required.

 

Decision

 

The principal regulator is satisfied that the decision meets the test set out in the Legislation for the principal regulator to make the decision.

 

The decision of the principal regulator under the Legislation is that the Exemption Sought is granted so long as each Filer:

 

(a)           has its head office or principal place of business in the U.S.;

 

(b)           is registered as a broker-dealer under the securities legislation of the U.S., which permits each Filer to provide the Prime Services in the U.S.;

 

(c)           is a member of FINRA;

 

(d)           is a member of SIPC;

 

(e)           is subject to requirements over regulatory capital, lending of money, extension of credit and provision of margin, financial reporting to the SEC and FINRA, and segregation and custody of assets which provide protections that are substantially similar to the protections provided by the rules to which dealer members of IIROC are subject;

 

(f)            limits its provision of Prime Services in the Jurisdictions in respect of securities of Canadian issuers to Institutional Permitted Clients;

 

(g)           does not execute trades in securities of Canadian issuers with or for Prime Services Clients, except as permitted under applicable Canadian securities laws;


(h)           does not require its Prime Services Clients to use specific executing brokers through which Prime Services Clients must execute trades;

 

(i)            notifies the OSC of any regulatory action initiated after the date of this decision in respect of the Filer, or any predecessors or specified affiliates of the Filer, by completing and filing with the OSC Appendix “A” hereto within ten days of the commencement of any such action; provided that the Filer may also satisfy this condition by filing with the OSC within ten days of the date of this decision a notice making reference to and incorporating by reference the disclosure made by the Filer pursuant to U.S. federal securities laws that is identified in the FINRA BrokerCheck system, and any updates to such disclosure that may be made from time to time, and by providing notification, in a manner reasonably acceptable to the Director, of any filing of a Form BD ‘Regulatory Action Disclosure Reporting Page’;

 

(j)            submits the financial report and compliance report as described in SEC Rule 17a-5(d) to the OSC on an annual basis, at the same time such reports are filed with the SEC and FINRA;

 

(k)           submits audited financial statements to the OSC on an annual basis, within 90 days of the Filer’s financial year end;

 

(l)            submits to the OSC immediately a copy of any notice filed under SEC Rule 17a-11 or under SEC Rule 15c3-3(i) with the SEC and FINRA;

 

(m)          complies with the filing and fee payment requirements applicable to a registrant under OSC Rule 13-502 Fees;

 

(n)           files in an electronic and searchable format with the OSC such reports as to any or all of its trading activities in Canada as the OSC may, upon notice, require from time to time; and

 

(o)           pays the increased compliance and case assessment costs of the principal regulator due to the Filer’s location outside Ontario, including, as required, the reasonable cost of hiring a third party to perform a compliance review on behalf of the principal regulator.

 

This decision shall expire five years after the date hereof.

 

This decision may be amended by the OSC from time to time upon prior written notice to the Filers.

 

“Monica Kowal”

Vice-Chair

Ontario Securities Commission

“D. Grant Vingoe”

Vice-Chair

Ontario Securities Commission

 


APPENDIX “A”

 

NOTICE OF REGULATORY ACTION

 

1.             Has the firm or any predecessors or specified affiliates of the firm entered into a settlement agreement with any financial services regulator, securities or derivatives exchange, SRO or similar agreement with any financial services regulator, securities or derivatives exchange, SRO or similar organization?

 

Yes _____ No _____

 

If yes, provide the following information for each settlement agreement:

 

Name of entity

Regulator/organization

Date of settlement (yyyy/mm/dd)

Details of settlement

Jurisdiction

 

2.             Has any financial services regulator, securities or derivatives exchange, SRO or similar organization:

 

 

Yes

No

(a)           Determined that the firm or any predecessors or specified affiliates of the firm violated any securities regulations or any rules of a securities or derivatives exchange, SRO or similar organization?

___

___

(b)           Determined that the firm or any predecessors or specified affiliates of the firm made a false statement or omission?

___

___

(c)           Issued a warning or requested an undertaking by the firm or any predecessors or specified affiliates of the firm?

___

___

(d)           Suspended or terminated any registration, licensing or membership of the firm or any predecessors or specified affiliates of the firm?

___

___

(e)           Imposed terms or conditions on any registration or membership of the firm or predecessors or specified affiliates of the firm?

___

___

(f)            Conducted a proceeding or investigation involving the firm or any predecessors or specified affiliates of the firm?

___

___

(g)           Issued an order (other than an exemption order) or a sanction to the firm or any predecessors or specified affiliates of the firm for securities or derivatives-related activity (e.g. cease trade order)?

___

___

 

If yes, provide the following information for each action:

 

Name of entity

Type of action

Regulator/organization

Date of action (yyyy/mm/dd)

Reason for action

Jurisdiction

 

3.             Is the firm aware of any ongoing investigation of which the firm or any of its specified affiliates is the subject?

 

Yes _____ No _____

 

If yes, provide the following information for each investigation:

 

Name of entity

Reason or purpose of investigation

Regulator/organization

Date investigation commenced (yyyy/mm/dd)

Jurisdiction

 

 

Name of firm:

Name of firm’s authorized signing officer or partner

Title of firm’s authorized signing officer or partner

Signature

Date (yyyy/mm/dd)

 

Witness

 

The witness must be a lawyer, notary public or commissioner of oaths.

 

Name of witness

Title of witness

Signature

Date (yyyy/mm/dd)

 

This form is to be submitted through the Ontario Securities Commission’s Electronic Filing Portal:

https://www.osc.gov.on.ca/filings