On February 23, 2007, the Canadian Securities Administrators (the “CSA”) published proposed National Instrument 31-103 Registration Requirements (“NI 31-103”) for comment.1 NI 31-103 is a continuation of the CSA’s Registration Reform Project to harmonize, streamline and modernize the registration regime for dealers, advisers and underwriters across Canada. Approximately 267 comments were received from interested parties. The CSA reviewed these comments and on February 29, 2008, the CSA published a summary of the comments and provided feedback to the commentators. Additionally, NI 31-103, in its amended form, was again published for comment and this time it received approximately 309 comments. This probably makes NI 31-103 the most controversial change to Canadian securities laws short of proposing a national securities regulator. What is in this rule that that has sparked so many comments from dealers, advisors, underwriters, lawyers, accounts and investors as compared to any other rule the CSA has undertaken in its harmonization project?

Introduction of the “business trigger”
One of the principal changes proposed under NI 31-103 is the change in registration trigger. The current trigger is known as a “trade trigger.” A person2 must register as a dealer, advisor or underwriter with their local securities commission if they are engaged in an activity what fits within the definition of a “trade” under applicable securities legislation. However, under NI 31-103 the registration trigger will be changed to a “business trigger.”3 Under the business trigger, any person that is “in the business” of (i) trading in securities or (ii) advising in securities must be registered with their local securities commission. Factors that CSA members will consider when assessing if a person’s activities trigger the registration requirement under NI 31-103 include:

1. directly or indirectly holding oneself out as being in the business of the activity;4
2. acting in an intermediary capacity or as a market maker;5
3. directly or indirectly carrying on the activity with repetition, regularity or continuity; 6
4. being or expecting to be, remunerated or otherwise compensated for the activity;7 or
5. directly or indirectly soliciting others in connection with the activity.8

The sea change
Exempt Market Dealer (“EMD”)
One of the most significant changes is the implementation of the EMD registration category. A significant number of companies and individuals that have not been subject to any registration requirements will now have to file for registration as EMDs and will be subject to the new regulatory regime.9

EMDs that act as market interm-ediaries by facilitating the distribution of securities to “accredited investors” 10 will now require registration. Accredited investors are typically recognized as that class of investor that is distinguished from the general public because: (i) it is an institution, (ii) it receives a certain level of annual income11 or (iii) it has accumulated a certain level of net worth.12

Securities issuers may also have to be registered as an EMD if they (i) regularly trade in securities (ii) hold themselves out as being in the business of trading in securities, or (iii) employ or otherwise contract with persons to perform activities on the issuer’s behalf that are similar to those performed by a registrant. Mortgage investment companies will typically require registration due to the nature of their activities. Depending on the application of the business trigger factors to their business practices, venture capital companies may also have to register.

Because this registration category is new to every province except Ontario and Newfoundland and Labrador, capital market participants should review their business activities to see if they are caught by the business trigger rule and therefore required to register as an EMD once NI 31-103 comes into force. If registration is required, EMDs will have 12 months from the implementation date of NI 31-103 to complete their registration. Firms and individuals registered as limited market dealers (“LMDs”) will also have 12 months to complete and file a re-registration form, which is expected to be an abbreviated version of the existing registration forms.

EMD restrictions

New registrants should be aware that an EMD is only permitted to trade:

1. in securities that are distributed under an exemption from the prospectus requirement;14
2. securities that are distributed under a prospectus if the distribution may have been made under an exemption from the prospectus requirement;
3. in securities that, if the trade were a distribution, may have been distributed under an exemption from the prospectus requirement; and
4. on behalf of a client, any securities acquired by the client in circumstances described in clauses (a) to (c) above, if the trade is with a registered dealer.

New Regulatory Requirements
EMDs will be subject to a number of proficiency requirements, solvency requirements, financial record requirements and conduct rules. Conduct rules will include certain steps that EMDs must undertake to (i) know the investor client and (ii) determine the suitability of any particular investment for that client. EMDs will also be responsible for establishing procedures for holding client’s assets, compliance controls and complaint handling, conflicts of interest and referral arrangements. Many of these regulatory requirements will have a profound impact on the business operations of prospective EMDs. Prospective EMDs should review their current business practices and make the appropriate changes in preparation for NI 31-103. A summary of some of proficiency requirements, solvency requirements, financial record requirements and conduct rules is included below.

Fit and Proper Requirements
Proficiency
Every EMD acting as a dealing representative will have to have passed the Canadian Securities Exam or such other proficiency requirement as is recognized by the CSA.15 Individuals will have 24 months from the date they file their registration application to complete the EMD proficiency requirements.16 Where an individual completed the proficiency requirements more than 36 months prior to being registered as an EMD, the individual must have gained 12 months of relevant work experience during the 36 month period prior to the date the individual applied for registration. The CSA does not contemplate including a grandfathering clause in NI 31-103 for individuals that have been active in the securities industry without the requisite proficiency courses.

Solvency
A registered firm must ensure that its excess working capital, as calculated using Form 31-103F1 Calculation of excess working capital (“Form 31-103F1”), is not less than zero. For the purposed of completing Form 31-103F1, the minimum capital requirement for (i) an advisor is $25,000, (ii) a dealer is $50,000 and (iii) for an investment fund manager is $100,000. The excess working capital calculation must be completed within 20 days of month end. The applicable regulator must be notified as soon as practicable if the excess working capital is less than zero. Registered firms must also maintain a bond or insurance with a single loss limit in the highest of one of the following amounts:

1. $50,000 per employee, agent or dealing representative or $200,000, whichever is less;
2. one percent of the total client assets that the dealer handles, holds or has access to, or $250,000, whichever is less;
3. one percent of the dealer’s total assets, or $250,000, whichever is less;
4. the amount determined by an appropriate resolution of the board of directors of the dealer.

Financial Records
A firm must appoint an auditor and include a copy of its audited financial statements with its registration application. A registered firm must deliver its audited financial statements and a completed Form 31-103 to its regulator within 90 days of its year end. Interim financial statements must be delivered to the regulator within 30 days of the first, second or third quarters.

Exemption
EMDs that do not “handle, hold or have access to” client assets, including cheques and other instruments, are exempt from (i) the excess working capital requirement, (ii) bond or insurance requirement and (iii) the requirement to deliver audited financial statements to the regulator. The “handle, hold or have access to” definition of NI 31-103 has been highly controversial amongst prospective EMDs. “Handle, hold or have access to” is defined in the companion policy of NI 31-103 (the “Companion Policy”) to include situations where a dealer or adviser:

1. Holds client’s securities certificates or cash for any period of time;
2. has the authority (power of attorney) to withdraw funds or securities from client accounts;
3. accepts funds from clients (e.g. a cheque made payable to the registrant);
4. handles client cheques in transit (e.g. a cheque made payable to a third-party issuer);
5. accepts client’s funds from a custodian;
6. acts in the capacity of a trustee for clients;
7. has, in any capacity, legal ownership of, or access to, the client funds or securities;
8. has authority to debit client accounts to pay bills other than investment management fees.

In its current form, the exemption granted to EMDs is effectively non accessible. It is difficult to imagine a situation where an EMD will not at least “handle” a cheque as part of its normal business operations. For example, a typical private placement transaction involves an investor client delivering a cheque and a subscription agreement to an EMD, which in turn delivers that cheque and subscription agreement to the issuer. At the closing of the financing, the EMD performs the reverse function where the EMD then delivers the security certificate to the investor. Pursuant to the definition above, the EMD would be subject to the solvency, insurance and audit requirements for essentially performing a courier function by delivering the client’s cheque and subscription agreement to the issuer. The CSA has indicated that as a result of the comments received they are contemplating removing the “handle” portion of this definition from NI 31-103.17 It is important that prospective EMDs understand this exemption and review NI 31-103 when it is published in its final form. The application of this definition and the exemption will have significant implications on the costs associated with the operation of an EMD registered business.

Suitability
EMDs must take reasonable steps to ensure that before it makes a recommendation or accepts instructions from a client with regards to a proposed purchase or sale of securities that the proposed purchase or sale is suitable for the client with reference to the client’s (i) financial circumstances, (ii) risk tolerance, (iii) investment knowledge and (iv) investment needs and objectives. If a client instructs an EMD to buy, sell or hold a security which, in the EMD’s opinion, would not be suitable for the client, the EMD must inform the client of the EMD’s opinion19 and must not buy or sell the security unless the client instructs the EMD to proceed, notwithstanding the EMD’s opinion. EMDs are advised to ensure that they keep proper records with respect to all such instructions and be prepared to deliver them to the regulator in the event of a compliance review.

Compliance
EMDs must establish, maintain and apply a system of controls and supervision sufficient to (i) provide reasonable assurance to the firm that each individual acting on the firm’s behalf complies with securities legislation and (ii) manage the risks associated with the firm’s business in conformity with prudent business practices. The system of controls must be documented in the form of written policies and procedures. The policies and procedures should document what the registrant does, not what it would like to do. A policies and procedures manual should not be a “best practices” wish list, but a manual that provides guidance to the firm and its employees with respect to how the firm will conduct its internal business operations. The term “prudent business practices” should be viewed from the prospective of the business operations of the firm’s size and category of registration. Caution is advised when using an “off the shelf, one size fits all” policy and procedures manual, as this could enable the regulator to hold the firm to a standard of operations the registrant is not prepared to live up to.

EMDs should also be aware of two new individual registrant categories; the “ultimate designated person” (the “UDP”) and the “chief compliance officer” (“the CCO”). Both categories of registration are new requirements to the registrant regime, the purpose of which is to promote supervision of the firm’s compliance directed activities and for promoting compliance with securities legislation. NI 31-103 acknowledges that small firms may not employ sufficient staff to have the UDP and CCO function fulfilled by separate individuals and permits one individual to fulfill both of those functions where necessary.

Complaint handling and conflicts of interest and referral arrangements
EMDs are required to establish procedures to document and fairly respond to client complaints. EMDs are also required to use a dispute resolution service and to inform any complainant how to contact and use such service.20 Registrants are also required to take reasonable steps to identify any conflicts of interest that may exist within their operations and to disclose such conflicts of interest to their clients.
Referral arrangement must be in writing and its material terms must be disclosed to the client before an EMD accepts any client referral. Upon acceptance of the client referral, the EMD is responsible for completing the applicable “know your client” forms and the suitability analysis with respect to the proposed investment. Firms that have existing referral arrangements have 6 months to comply with this requirement after NI 31-103 comes in to force.21

Conclusion
NI 31-103 embodies a sea change for a vast number of participants in Canada’s capital markets. The CSA has indicated that they will not be republishing NI 31-103 for comment and hopes that it will come into force in the fall of 2009.22 EMDs, including existing LMDs, will be subject to a vast array of new regulatory requirements. While this article primarily addresses the issues facing a heretofore unregulated segment of Canada’s capital markets, the implementation of the business trigger principle in NI 31-103 can have significant effects on issuers, investors and other dealer or advisor registrants as well. Participants in Canada’s capital markets are advised to consult their lawyers, investment advisors or other professionals to understand whether NI 31-103 has any direct implications on their business or investment activities.

Brian Prill is an associate with the law firm of McLean & Kerr LLP in Toronto, Canada. He practices in the areas of securities law and corporate and commercial transactions, including mergers and acquisitions. Brian sits on the Board of Directors of the Limited Market Dealers Association of Canada / Exempt Market Dealers Association of Canada (the “EMDA/LMDA”) and is the Chairman of the NI 31-103 Comment Committee for the EMDA/LMDA. Brian was also a featured speaker at the Canadian Institute Conference on Registrations Reform that was held in Toronto on January 26-27, 2009.

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1. NI 31-103, companion policy, comments and comment summary and consequential amendments are available on the websites of the CSA members including www.lautorite.qc.ca www.albertasecurities.com www.bcsc.bc.ca www.gov.ns.ca/nssc www.nbsc-cvmnb.ca www.osc.gov.on.ca www.sfsc.gov.sk.ca.
2. A “person” includes an individual, partnership, unincorporated association, unincorporated syndicate, unincorporated organization, trust, trustee, executor, administrator or other legal representative.
3. At the time of writing, Manitoba is the only province that is not adopting the business trigger principle.
4. Merely holding oneself out as being willing to engage in trading or advising is sufficient to be engaged in the business of trading of advising in securities.
5. Acting in an intermediary capacity between a seller and a buyer of securities or making a market in securities constitutes trading for a business purpose.
6. Frequency of the activity is an indicator; however, the activity does not have to be the person’s sole of primary endeavor for that person to be in the business of trading or advising.
   
7. Carrying on an activity with no expectation of compensation may suggest that the activity is not for a business purpose.
8. Contacting others to solicit securities transactions or offer advice reflects a business purpose. Setting up a website to post information on investment opportunities, such as a bulletin board, might not be if the entity running the website has no role in any trades that take place between parties on the bulletin board.
   
9. See National Instrument 33-109 - Registration Requirements (“NI 33-109”) for the specific registration forms for EMDs. Form 33-109F4 is the registration form applicable to individuals and Form 33-109F6 is the registration form applicable to firms. LMDs registered in Ontario and in Newfoundland and Labrador will have to re-register with their securities commission once NI 33-103 is implemented, although, because of the LMDs prior registration, it is anticipated that the re-registration form will be an abbreviated version of the above.
10. See subsection 1.1 of NI 45-106 for a complete list of accredited investor categories.
    
11. For individuals this amounts to receiving in excess of $200,000 in each of the two most recent calendar years, or $300,000 when combined with a spouse’s income, and reasonably expects to exceed that income in the current calendar year.
    
12. For individuals, either alone or with a spouse, this net worth level means owning or beneficially owning in excess of (i) $1,000,000 in financial assets net of any liabilities or (ii) $5,000,000 in total net assets. Unlike the United States, an individuals cannot include the accumulated net worth in their home in the $1,000,000 financial asset calculation. For persons, other than an individual or an invest ment fund, the net asset threshold is $5,000,000.
    
13. At the Canadian Institutes Registrant Regulation Conference held on January 26-27, 2009 (the “CI Conference”), CSA representatives indicated that the transition period for EMD registration will be extended from 6 months to 12 months.
14. The EMD category of registration is modeled after the LMD category of registration that has existed in Ontario and Newfoundland and Labrador since 1998. Under this category of registration, LMDs are permitted to trade in securities pursuant to exemptions from the prospectus and registration requirements listed in subsections 2.43(1) and 3.9(1) of National Instrument 45-106 – Prospectus and Registration Exemptions (“NI 45-106”) and in subsection 5.2(1) of Ontario Securities Commission Rule 45-501 – Ontario Prospectus and Registration Exemptions (“OSC 45-501”). Subsection 2.43(1) of NI 45-106 lists 20 exemption categories that are available to market intermediaries that are registered as LMDs and subsection 3.9(1) lists another 2 exemption categories. Section 5.2(1) of OSC 45-501 lists a further 5 categories under which an LMD can act as a market intermediary.
    
15. CI Conference comments - CSA representatives indicated that other proficiency courses may be acceptable to the regulator. Market participants will have to wait until the final rule is released in order to determine what alternative courses will be acceptable and how the process of course recognition will be administered.
16. CI Conference comments - CSA is contemplating extending the proficiency time period to 24 months from 12 months.
    
17. CI Conference comments.
    
18. In addition, NI 31-103 contains a number of “relationship disclosure” requirements that the EMDs must comply with when a person first becomes a client of the EMD.
    
19. NI 31-103 also incorporates a new category of investor called the “permitted client,” which essentially includes a subset of sophisticated institutional investors that fall within the broader accredited investor definition. EMDs are exempt from having to undertake the suitability analysis with permitted clients.
    
20. The Limited Market Dealers Association of Canada / Exempt Market Dealers Association of Canada works with EMDs to assist them in con tacting many third party service providers for services like dispute resolution, insurance bonds and other services. There web site address is http://www.lmdacanada.com
21. CI Conference comments - this period will be extended from 3 months to 6 months.
    
22. CI Conference- CSA representative’s comments.