Notice of OSC Rule: OSC Rule - 31-507 - SRO Membership - Securities Dealers and Brokers

NOTICE OF ONTARIO SECURITIES COMMISSION RULE 31-507
SRO MEMBERSHIP - SECURITIES DEALERS AND BROKERS

Notice of Rule

The Commission, has under section 143 of the Securities Act (Ontario) (the"Act"), made Rule 31-507 SRO Membership - Securities Dealers and Brokers(the "Rule").

The Rule and material required by the Act to be delivered to the Minister ofFinance were delivered on June 29, 2000. If the Minister does not approve theRule, reject the Rule or return it to the Commission for further consideration, theRule will come into force on December 1, 2000. If the Minister approves theRule, the Rule will come into force 15 days after it is approved.

Substance and Purpose of the Rule

The purpose of the Rule is to address certain regulatory issues that arise inconnection with oversight of securities dealers and brokers. The Rule requiresall securities dealers and brokers to be members of a self-regulatoryorganization recognized by the Commission (a "SRO") under section 21.1 of theAct. The Commission has recognized the Investment Dealers Association ofCanada (the "IDA") under section 21.1 of the Act. It is contemplated that theCommission will consider recognition of the Mutual Fund Dealers Association(the "MFDA") as a SRO under section 21.1 in late 2000 or early 2001. The Ruleconforms to the fundamental principle in paragraph 4 of section 2.1 of the Actunder which the Commission should, subject to an appropriate system ofsupervision, use the enforcement capability and regulatory expertise ofrecognized self-regulatory organizations.

The Rule is substantially similar in effect on all securities dealers and brokers asNational Policy Statement No. 49 ("NP 49") was on "national dealers".

The 1989 National Regulatory Working Group

In May 1989, the Canadian Securities Administrators (the "CSA") created theNational Regulatory Working Group, which tabled and made available to thepublic its Final Report entitled "Capital, Financial Reporting and AuditRequirements for the Securities Industry" in December 1989 (the "NRWGReport"). Among the recommendations contained in that report was arecommendation that would require certain dealers and advisers to becomemembers of a SRO and contribute to the Canadian Investor Protection Fund("CIPF"). This recommendation was partially adopted through theimplementation of NP 49. The NRWG Report recommendation that all dealersbe required to become members of a SRO is implemented through the Rule andproposed Rule 31-506 SRO Membership - Mutual Fund Dealers.

The NRWG Report made a number of recommendations to the CSA to deal withthe regulatory concerns expressed in the report relating to the lack of sufficientoversight of both dealers operating in multiple jurisdictions and advisers holdingproperty of their clients, particularly those advisers operating in multiplejurisdictions.

The CSA considered the recommendations, which included mandatorymembership in a SRO, formalization of relationships between the Canadiansecurities regulatory authorities and SROs, information sharing arrangementsbetween and among SROs and the Canadian securities regulatory authorities, alead regulator system of regulation for registrants where one regulatory bodywould have jurisdiction over all registrants, increased oversight of SROs by theCanadian securities regulatory authorities, introduction of new regulationsrelating to internal control procedures, risk-based capital, segregationrequirements and trade reporting, and implementing revised early warningreporting to the Canadian securities regulatory authorities. In addition, the CSAconsidered increased direct regulation of dealers and advisers by the CSA andrestricting the ability of registrants to hold client property.

Currently, the IDA is the only SRO recognized by the Commission. The IDA is aparticipating SRO in the CIPF, the industry funded investor compensation fund.CIPF covers losses of securities and cash balances, within prescribed limits,suffered by clients of a participating firm in case of that firm's insolvency.Regular levies assessed on firms finance CIPF. These levies are based on thefirm's gross revenues. The client loss coverage provided by CIPF is muchhigher than that afforded by the Ontario Contingency Trust Fund to whichsecurities dealers contribute.

The Rule was originally published for comment on October 3, 1997, revised andrepublished for comment on June 19, 1998, and revised and republished onApril 14, 2000.

Summary of the Rule

The Rule requires membership in a SRO recognized by the Commission. At thepresent time, the IDA is the only SRO recognized by the Commission formember regulation purposes. Membership in the IDA would require all memberdealers to make contributions to CIPF.

The Rule will become effective December 1, 2000. Applicants for registration asa securities dealer or broker after the effective date will be required to be SROmembers March 1, 2001. An existing securities dealer or broker registrant mustbecome a SRO member as of the date of their first renewal of their registrationfollowing March 1, 2001. An existing securities dealer or broker registrant mustalso provide the SRO with notice of its intention to make an application formembership by January 1, 2001.

The Rule stipulates that a securities dealer or a broker with a head office locatedin Ontario must be subject to the prime audit jurisdiction of the SRO recognizedby the Commission.

The Director may grant an exemption under the Rule.

Summary of Changes to the Rule

The 1998 publication of the Rule connected the date of membership to thesecurities dealer or broker financial statement filing date. The April 14, 2000publication changed the renewal of registration as the trigger date for SROmembership for existing registrants.

The Rule has also been changed to add a requirement that securities dealersand brokers that intend to become members of a SRO provide notice of theirintention to the SRO shortly after the Rule becomes effective. The final ruleincludes dates that were tentatively outlined in footnotes in the April 14, 2000publication. Those dates are outlined below.

Timing of the Rule

The Rule will become effective December 1, 2000. The Rule will apply to allapplicants for registration as securities dealers or brokers March 1, 2001.Existing registrants will be required to become members of a SRO as oftheir first renewal of registration following March 1, 2001 and no later thanMarch 1, 2002.

A securities dealer or broker that does not wish to become a member ofthe IDA as of the applicable date, must either surrender its registration orre-register in another category. Those securities dealers, for example, thatwould prefer to become mutual fund dealers and therefore be subject toproposed Rule 31-506 rather than this Rule, must re-register as mutual funddealers before their first renewal of registration after March 1, 2001.

Registrants should begin to plan for the transition under this Ruleimmediately. Registrants should be aware that the processing ofmembership applications at the IDA requires adequate review and may takesome time. The Director has the authority to grant exemptions from theRule and may also consider applications for temporary exemption incertain circumstances.

Summary of Written Comments Received by the Commission

Two comment letters were received in response to publication on April 14, 2000.The first letter, from the Toronto Stock Exchange (the "TSE") was strongly insupport of the Rule and believes that the Rule will address a "longstanding gapin securities regulation." The TSE believes that SRO membership will bring ahigher standard of investor protection through higher SRO requirements and theincreased resources that the SRO has available to it for regulation of securitiesdealers and registrants. The second letter was from a securities dealeroperating a day trading business. The securities dealer believes that as a resultof its unique business needs it would not fit easily into the IDA structure and, infact, IDA requirements are too inflexible to accommodate a day trading firm andwould impose prohibitive costs on the firm. The securities dealer alsoresponded to the 1998 publication for comment.

Authority for the Rule

The following sections of the Act provide the Commission with authority to adoptthe Rule. Paragraph 143(1)1 of the Act authorizes the Commission to makerules prescribing requirements in respect of applications for registration and therenewal, amendment, expiration or surrender of registration. Paragraph 143(1)2of the Act authorizes the Commission to make rules prescribing conditions ofregistration or other requirements for registrants or any category or subcategoryof registrant.

Alternatives Considered

The Commission considers increased reliance on the self-regulatory system tobe consistent with the purposes of provincial securities legislation. SROs canbring industry expertise to bear on members and can apply uniform standards ona consistent basis across provincial boundaries. They can react faster thangovernment agencies to changes in market conditions and to activities andtrends of concern. As the system under NP 49 has worked well since itsadoption in June 1993, the Rule extends the system to all securities dealers andbrokers. Under proposed Rule 31-506 SRO Membership - Mutual Fund 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 developing the Rule, the Commission has not relied on any significantunpublished study, report or other material.

Anticipated Costs and Benefits

There are substantial benefits involved in a self-regulatory organization systemof regulation. A self-regulatory organization system helps to ensure compliancewith regulatory requirements and also helps to provide consistent applicationand interpretation of the regulatory requirements.

Participants in the capital markets will benefit as additional levies are collectedas a result of increased membership in the CIPF to the extent that this providesan increased fund in the event of an insolvency of a member firm.

Clients of affected dealers will benefit from the protections afforded by a SROsystem and the availability of CIPF for those dealers that are not currentlyrequired to be members of a SRO and do not currently contribute to the CIPF.

The Rule will impose costs to dealers that are not currently members of a SROand do not currently contribute to the CIPF. These costs will include fees formembership in the SRO as well as the levies of CIPF which are based on thelevel of activity in the capital markets, i.e. gross revenues of the participant.Brokers already contribute to CIPF as a result of their membership in TheToronto Stock Exchange.

Based on experience to date under NP 49, the Commission believes that thebenefits of the proposed Rule justify the costs.

The Rule

The text of the Rule including the proposed changes follows, together withfootnotes that are not part of the Rule but have been included to providebackground and explanation.

Dated: June 29, 2000.

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 21.1 of theAct.

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

1.2 Primary Audit Jurisdiction - A securities dealer or a broker thathas its head office located in Ontario shall be subject to the primaryaudit 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 March 1, 2001 for an applicant forregistration as a securities dealer or broker.

2.2 This Rule shall be effective for a securities dealer on the renewalof registration for the securities dealer after March 1, 2001.

2.3 This Rule shall be effective for a broker on the renewal ofregistration for the broker after March 1, 2001.

PART 3 NOTICE TO SRO

3.1 Notice - Every registered securities dealer or broker that intendsto make an application for membership in a SRO pursuant to thisRule shall give the SRO written notice of its intention no later thanJanuary 1, 2001.

PART 4 EXEMPTION

4.1 Exemption - The Director may grant an exemption to this Rule, inwhole or in part, subject to such conditions or restrictions as maybe imposed in the exemption.

¹This Rule is new.

²A general definition rule has been adopted as Rule 14-501 Definitions. It containsdefinitions of certain terms used in more than one rule. Rule 14-501 also provides,among other things, that terms used in a rule and defined in Section 1 of the SecuritiesAct or subsection 1(2) of the Regulation will have the respective meaning given to themin the Securities Act or Regulation, as appropriate. A national definition rule has alsobeen adopted as Rule 14-101 Definitions. It contains definitions of certain terms usedin more than one National Instrument. National Instrument 14-101 also provides that aterm used in a National Instrument and defined in the statute relating to securities of theapplicable jurisdiction, the definition of which is not restricted to a specific portion ofthe statute, will have the meaning given to it in the statute relating to securities of thatjurisdiction. National Instrument 14-101 also provides that a provision in a NationalInstrument that specifically refers by name to a jurisdiction, other than the localjurisdiction shall not have any effect in the local jurisdiction, unless otherwise stated inthe provision.

³ The term "securities dealer" is defined in Rule 14-501 as "a person or companyregistered under the Act in the category of securities dealer".

⁴ The term "SRO" is defined in National Instrument 14-101 Definitions as "a self-regulatory organization, a self-regulatory body or an exchange". The Commission hasrecognized the Investment Dealers Association of Canada under section 21.1 of theAct.

⁵ The term "broker" is defined in Rule 14-501 as "a person or company registeredunder the Act in the category of broker".