Introduction
On September 28, 2009, National Instrument 31-103 – Registration Requirements and Exemptions (“NI 31-103”) was proclaimed in force by the Canadian Securities Administrators (the “CSA”) and received Royal Assent in Ontario.  NI 31-103 is the result of five years of consultation among CSA members and market participants, including two separate comment periods on draft versions of NI 31-103.  The goal of the CSA was to harmonize dealer registration requirements across Canada. 

Unfortunately, NI 31-103 has not completely accomplished the CSA’s objectives for participants in the exempt market segment of the industry.  Because of a blanket order issued in the Northwestern Region  (the “Northwestern Order,” as set out below), we have two different regulatory regimes for exempt market participants in local jurisdictions in Canada. 

Under NI 31-103, all exempt market dealers (“EMDs”)  must be registered and are required to meet certain proficiency, solvency and compliance requirements.  EMDs in the Region are subject to the same regulatory requirements as EMDs in the Eastern Region.   However, under the Northwestern Order, exempt market participants in the Northwestern Region have the option to decide whether or not they want to register as an EMD.  In the Northwestern Region, non-registered exempt market participants (referred to as “exempt market intermediaries” or “EMIs”) can decide to operate under the Northwestern Order to avoid the regulatory costs associated with EMD regulation under NI 31-103.   The result is the potential for a divided system of registration consisting of EMDs in the Eastern Region and EMIs in the Northwestern Region.

This article discusses the basic regulatory framework laid out in NI 31-103, not the detailed regulatory provisions.  The purpose of this article is to illustrate some of the potential consequences of the lack of harmonization with respect to the requirements applicable to exempt market participants headquartered in the Eastern Region vis-à-vis exempt market participants headquartered in the Northwestern Region.

Regulatory Framework

The Business Trigger
NI 31-103 creates a harmonized approach to determining whether the activities of a market participant trigger the dealer registration requirement.  Pursuant to NI 31-103, anyone that is “in the business of trading or advising in securities” (the “business trigger”) must be registered as a dealer or an advisor.  The companion policy to NI 31-103 provides a non-exhaustive list of certain factors that will be considered when determining whether a market participant is “in the business of trading or advising in securities,” which factors include:
1. engaging in activities similar to a registrant;
2. intermediating trades or acting as a market maker;
3. directly or indirectly carrying on the activity with repetition, regularity or continuity;
4. being, or expecting to be, remunerated or compensated; and
5. directly or indirectly soliciting.

Northwestern Order
All market participants are subject to the business trigger with respect to determining whether registration is required.  However, in the Northwestern Region, the registration analysis does not stop there.  EMIs do not have to be registered so long as they:
1. confine their operations to the Northwestern Region;
2. notify the applicable commission that they intend to take advantage of the Northwestern Order; and
3. agree to comply with the terms and conditions of the Northwestern Order (see below).  
EMIs are also subject to certain marketing restrictions under the Northwestern Order.  EMIs can only sell securities under 4 of the 41 prospectus exemptions listed in National Instrument 45-106 – Prospectus and Registration Exemptions (“NI 45-106”), which include the: (i) accredited investor exemption (section 2.3), (ii) family, friends and business associates exemption (section 2.5), (iii) offering memorandum exemption (section 2.9), and (iv) minimum investment amount exemption (section 2.10).

EMIs must also comply with the following terms and conditions to take advantage of the Northwestern Order:
1. No registration: The Northwestern Order is only available to market participants that are not registered in any other category of registration in any other jurisdiction;
2. No suitability advice: EMIs are restricted to providing factual information about the security and the purchase agreement including: the features of the security, the risk of the investment, how the subscription agreement works and other items of a general factual nature; EMIs cannot use marketing materials that suggest general suitability or suitability for a particular kind or demographic of purchaser;
3. Risk acknowledgement: The purchaser must sign a risk acknowledgement form that is particular to the transaction and the inability of the EMI to provide suitability advice; this risk acknowledgement is in addition to the risk acknowledgement required under NI 45-106 or any other risk disclosure specific to the investment;
4. Not hold or have access to purchaser’s assets: EMIs who intend to rely on the Northwestern Order cannot hold or have access to the purchaser’s assets;  
5. Reporting: EMIs must file a report with the applicable commission within 10 days of relying on the Northwestern Order and update that report, if required, within 10 days of any subsequent transaction;
6. Recordkeeping: EMIs must keep records demonstrating their compliance with the conditions of the Northwestern Order including retaining the purchaser’s risk acknowledgement form for a reasonable period of time.

LMDs “Mapped Over” as EMDs
To facilitate the implementation of NI 31-103, all registrants were “mapped over” to their new registration categories. Consequently, LMDs registered in Ontario and Newfoundland & Labrador were re-categorized as EMDs, thereby creating the following requirements:
1.    EMDs headquartered in Ontario and Newfoundland & Labrador have to review, update and file their firm registration information on or before September 28, 2010 (Form 33-109F6).   
2.    EMDs headquartered outside Ontario and Newfoundland & Labrador will have to complete and file an initial registration with their principal regulator on or before September 28, 2010 (Form 33-109F6 plus supporting documentation).  Note that:
a.    There is no exemption to the requirement that EMD’s headquartered outside Ontario and Newfoundland & Labrador file an initial registration with the EMD’s principal regulator based on the fact that the EMD was registered as an LMD in Ontario or Newfoundland & Labrador,  
b.    NI 31-103 does provide those EMDs with a one-year transition period in which to file their initial registration, and
c.    EMDs with head offices in the Northwestern Region will have the option of suspending their registration as an EMD and continuing their operations as an EMI under the Northwestern Order.
3.    All other market participants, active in the exempt industry but not registered must file an initial registration with their principal regulator on or before September 28, 2010 (Form 33-109F6 plus supporting documentation). 

Requirements for EMDs
Registered EMDs are subject to a number of requirements under NI 31-103, including but not limited to: proficiency, solvency (which includes specific working capital, insurance and audited financial statement requirements), record keeping, know your client records (“KYC”), suitability analysis (which includes know your product requirements (“KYP”)), relationship disclosure, complaint handling, dispute resolution, trade confirmation and quarterly client statements. 

Many of the NI 31-103 requirements have transition periods ranging from 3 months (e.g. registration of the Chief Compliance Officer and the Ultimate Designated Person) to 24 months (e.g. implementation of a dispute resolution service).  Other requirements, such as KYCs, suitability analysis (including the KYP obligation) and record keeping, for example, took effect immediately upon NI 31-103 coming into force.   Delivery of annual audited financial statements and working capital calculations to the Ontario Securities Commission (the “OSC”) and delivery of certain client statements are two requirements that were originally omitted from the transition relief provisions of NI 31-103.  However, pursuant to an exemptive relief order issued September 28, 2009, there is now a one-year transition provision for EMDs with respect to the delivery of annual audited financial statements and working capital requirements to the OSC and a two-year transition period with respect to delivery of certain client statements.

Two Regimes in the Northwestern Region
Given the registration options created by the issuance of the Northwestern Order, EMDs with head offices in the Northwestern Region can be expected to review their business activities in the Eastern Region to determine if they are sufficiently profitable to justify the registration and compliance costs associated with NI 31-103.  These EMDs will have the option of deciding whether to:
1.    remain registered as an EMD and file an initial registration application with their principal regulator; or
2.    suspend their registration as an EMD. 

Competitive Advantages – EMDs vs. EMIs
From a marketing perspective, registered EMDs may have a competitive advantage over non-registered EMIs in that they will be able to sell any security that is distributed under any of the 41 prospectus exemptions available in NI 45-106.   EMDs can also expand their business operations to any other province or territory of Canada using the CSA passport system.   It is also important to note that while an EMI can sell securities of issuers and receive subscriptions from purchasers located within the Northwestern Region, EMIs are not registered to sell securities of issuers or receive subscriptions from purchasers located in the Eastern Region.  Conversely, EMDs can sell the securities of issuers and receive subscriptions from purchasers located in any jurisdiction in which the EMD is registered. 

Another important aspect of EMD registration is that EMDs will be required to meet certain proficiency, solvency and compliance requirements, which may have a certain appeal to issuers and investors.  On the other hand, EMIs are not required to meet any of these requirements.  This may cause issuers or investors to question whether EMIs have the appropriate credentials or oversight to handle any particular transaction.  They may also question whether the lighter regulatory regime under the Northwestern Order is the reason EMIs are prohibited from providing purchasers with any suitability analysis.  Consequently, the EMD registration under NI 31-103 may acquire a certain legitimacy that EMIs may not acquire under the Northwestern Order.

The advantages of non-registration for EMIs appear to be somewhat less than the EMD registration advantages discussed above.  Under the Northwestern Order, EMIs will not be subject to the registration or compliance costs associated with NI 31-103.  However, the price for that concession is that EMIs will have to restrict their operations to the jurisdictions and exemptions set out in the Northwestern Order.
Based on the foregoing, it appears that the advantages of registration may outweigh the advantages associated with non-registration.  EMIs are advised to evaluate the costs and benefits of operating in the larger Canadian market under the registration and compliance regime associated with NI 31-103 against costs and benefits of operating in the smaller Northwestern market under a lighter regulatory regime associated with the Northwestern Order.  EMIs are also advised to consider the impact on their market share, as EMDs may begin to compete with EMIs in the Northwestern Region by using the passport registration system.  One can reasonably expect that certain EMDs will take advantage of this system to become a national EMD with offices across the country, something an EMI cannot do.  
Who is the Gatekeeper in Syndication/Selling Group Arrangements?
A further issue created by the Northwestern Order arises in the context of a syndication or selling group arrangement (an “Arrangement”) between an EMD and an EMI regarding responsibility for collecting KYC information and conducting a suitability analysis with respect to purchasers who place their subscriptions with the EMI.  
1.    Issuer and Purchaser both Resident in the Northwestern Region
Under the Northwestern Order, the EMI is precluded from providing the purchaser with any suitability advice  and has no obligation to complete a KYC form.  Because the purchaser acquires the security through the EMI, the purchaser would not likely be considered a client of the EMD.  Additionally, the sale of the security through an EMI as part of an Arrangement does not appear to constitute a referral arrangement.   If the purchaser is not a client of the EMD under a referral arrangement, the EMD does not appear to have an obligation to complete a KYC form or undertake a suitability analysis.  As, arguably, neither the EMI nor the EMD in an Arrangement has responsibility for completion of a suitability analysis or the KYC form, one of the intended goals of registration harmonization, investor protection, appears to be compromised.

One could argue that the EMI risk acknowledgement form provides the appropriate measure of investor protection, as this form is intended to identify the risks of purchasing the security through an EMI.   When the EMI receives an executed EMI risk disclosure form from the purchaser, this would appear to fulfil the disclosure and record keeping requirements with respect to suitability for the EMI.  If the regulatory requirements for suitability are fulfiled for the EMI, one could further argue that the retention of a copy of this documentation by the EMD should fulfil the suitability and transaction record keeping requirements for the EMD, especially in the event the EMD’s principal regulator undertakes a compliance review of the transaction. 

Recommendations
EMDs contemplating an Arrangement with an EMI should consult their legal counsel and become aware of the EMI requirements.  EMDs should inform themselves of the interprovincial aspects of trades between issuers and purchasers residing in different jurisdictions of the Northwestern Region.  Where EMDs do enter into Arrangements with EMIs, EMDs should take steps to ensure that:
1.    their files contain adequate documentation of the Arrangement;
2.    they review and approve the EMI risk acknowledgment form prior to agreeing to the Arrangement;
3.    both the issuer and the purchaser reside in the Northwestern Region; and
4.    they include a copy of the Arrangement agreement, the EMI’s risk disclosure form and the purchaser’s signed acknowledgement in their files in preparation for any future compliance review. 

2.    One party in the Eastern Region and the other Party in the Northwestern Region
The analysis is simpler if either the issuer or the purchaser is outside the Northwestern Region, for example, an Ontario issuer and an Alberta purchaser.  Because one side of the trade takes place in the Eastern Jurisdiction (i.e. the issue of the security), registration is required for the dealer acting as intermediary on the trade for the Alberta investor (i.e. the purchase of the security).  Thus in an Eastern/Northwestern Region transaction, both parties to the Arrangement would have to be registered.

Recommendations
Prior to entering into an arrangement with a dealer in the Northwestern Region the EMD should confirm that the dealer in the Northwester Region is registered.  EMDs in the Eastern Region are advised to avoid syndication or selling group arrangements with EMIs because of: (i) the uncertainty surrounding who has the onus for KYCs and suitability analysis and (ii) the risks associated with a negative compliance review by the EMD’s principal regulator. 

Ironically, this result may help the CSA achieve its original harmonization objective.  EMIs may decide to register as EMDs because the profitability of being part of an Arrangement sufficiently offsets the perceived registration and compliance costs associated with NI 31-103.

Conclusion
The implementation of the Northwestern Order has stymied the efforts of the CSA to create a fully harmonized registration regime for exempt market participants.  Moreover, the Northwestern Order appears to have created a bifurcated regulatory regime with respect to exempt market participants in the Northwestern Region.  One result of having two regulatory regimes in the same jurisdiction may be a form of regulatory arbitrage as exempt market participants in the Northwestern Region examine which is the more profitable regulatory regime to operate under, the Northwestern Order or NI 31-103. 

Another result of the Northwestern Order may be reluctance: (i) on the part of issuers or investors to enter a transaction with an EMI or (ii) on the part of EMDs to enter into an Arrangement with an EMI.  The reluctance on the part of issuers or investors to enter into a transaction with an EMI may have the effect of inhibiting the formation of capital markets in the Northwestern Region.  In addition, the reluctance on the part of EMDs in the Eastern Region to enter into an Arrangement with an EMI in the Northwestern Region may have the effect of restricting the flow of capital between the Eastern Region and the Northwestern Region. 

It would also appear that the Northwestern Region may have a dual standard of investor protection: risk disclosure for transactions completed through an EMI versus a suitability analysis for transactions completed through an EMD.  By comparison, in the Eastern Region, under NI 31-103, there will only be one standard of investor protection. 

Unfortunately, the “light” regulatory system associated with the Northwestern Order may also have the negative effect of casting EMIs as the “black sheep” or “cowboys” of the industry.  This will likely become more evident as issuers and investors examine the lighter regulatory requirements of the Northwestern Order as opposed to the higher proficiency, solvency, compliance and disclosure requirements under NI 31-103. 

One would have hoped that the CSA would have reached a consensus with respect to regulation of exempt market participants in Canada.  However, absent a national regulator, it would appear that market forces will have to be the deciding factor in the creation of a truly harmonized registration regime for exempt market participants in Canada.

Brian Prill is a Partner at McLean & Kerr LLP, President of the Exempt Market Dealers Association of Canada and Corporate Secretary of Hudson River Minerals Ltd.  Brian’s practice focuses on corporate and securities laws transactions including capital financing, dealer registration and mergers and acquisitions.  Brian also serves on the Executive Committee of the  Business Law Section, the Securities Law Sub-Committee and the Natural Resources Section Executive of the Ontario Bar Association.