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Regulatory Outreach for Financial Filings: Carrot or the Stick?


The article was originally published in PCMA Private Capital Markets Magazine, Spring 2014

Read between the lines of the latest tome from the Ontario Securities Commission (OSC) and its’ message is clear: “Take a bite out of the carrot we’re offering, or risk the sting of the stick we carry.”

The carrot being dangled in front of Dealers, Portfolio Managers and Investment Fund Managers is a new emphasis on what the OSC calls outreach: online information, special seminars, education programs and a whole lot of cautionary tales now available in greater amounts than ever before.

The stick, of course, is the array of penalties at the OSC’s disposal should you be found guilty of the most common, or most egregious, filing deficiencies.

This warning - or offering - is contained in the rather thick 2013 Annual Summary Report put out by the OSC, which now directly oversees some 1,300 firms that trade or advise in securities or commodity futures.

This includes investment fund managers, exempt market dealers, portfolio managers and scholarship plan dealers. While the OSC also registers the 115 mutual fund dealers and 200 investment dealers these firms are principally overseen by their respective self-regulatory organizations being the Mutual Fund Dealers Association (MFDA) and of the Investment Industry Regulatory Organization of Canada (IIROC).

The OSC report is not exactly light bedtime reading. But it suggests you might avoid some sleepless nights if you take advantage of the outreach resources the OSC is now offering which include:

- A “registrant outreach” web page designed to enhance compliance awareness.

- Outreach seminars that convey practical knowledge and interpretations of financial reporting and regulatory capital matters, like the OSC seminars that were well attended last September.

- A new Registrant Resources Section of the OSC designed to provide easy, centralized access to the latest compliance materials.

The OSC is also offering some salient advice: it suggests that firms consider engaging an independent consulting or audit firm having the necessary compliance internal audit experience to assist with co-sourcing or outsourcing of an effective sales compliance audit regime. EMDs, especially those with limited time and resources, could likely use the help.

EMDs are required to comply with regulatory capital requirements, books and records requirements, and monthly and year end reporting and audit requirements. In other words, they need to have enough money on hand, the right records at their fingertips, the proper timetable for reporting, and the ability to be held accountable without worry. This can seem daunting for firms new to regulation, such as a newly approved registrant. But it can even be challenging for an experienced dealer with a rapidly growing clientele.

And you don’t want to risk your principal regulator deciding to wield the stick at his or her disposal: ongoing on site and desk financial compliance reviews to assess capital adequacy, and any penalties that might result.

Compliance reviews of registered firms are conducted on a continuous basis. In its report, the OSC noted that it takes a risk based approach to the firms selected for review. The key risk factors impacting selection include the most recent risk assessment questionnaire, the firm’s compliance history, complaints or whistle blowing tips or referrals form an SRO or other regulator. For an onsite review, a registrant should expect that senior management will be interviewed to update the regulators understanding of the business, reviewing the most recent annual and interim financial statements and excess working capital calculations, reviewing the annual compliance report to the registrant’s Board, assessing the overall compliance and supervision structure and follow up on corrective actions over past compliance deficiencies. In addition, the commissions are conducting “sweep reviews” which may involve reviews of specific topics or industry sectors. If you are a new firm, you should expect to be reviewed as the regulator would like to see these firms get off to a good start. Not surprisingly, large or “ impact “ firms are regularly reviewed.

Sweep reviews in 2013 targeted those firms with high value assets under management or administration, high number of dealing reps, securities custody practices, excess working capital calculation and capital market participation fee calculations. In addition, the OSC noted that it now regularly contacts registrant clients by phone as a regular part of its compliance review. New last year was also the emergence of “Mystery Shopping” whereby regulators will contact dealing reps to assess their compliance knowledge. All of this means that each firm needs to assess the rigor of their orientation and ongoing training programs, supervisory practices and record retention practices.

Based on my experience with other regulators in Canada and the US, firms should pay close attention to their regulatory compliance reports and remediate each finding as soon as practicable. On the next compliance review, you can expect your regulator will perform follow up audits on the status of remediation and expect that findings are corrected.

The OSC noted that 6% of its compliance reviews of all registered firms resulted in referrals to the OSC’s Enforcement Branch for investigation or suspension of registration. This is a welcome decrease from the 10 % referral/suspension rate in 2012 and 2011. While this statistic continues to be too a high a referral or suspension rate, the reduction suggests that many firms are paying close attention to enhancing their compliance practices.

The three fundamental criteria the regulators look at for determining continued suitability of a registrant for registration under NI 31-103 are integrity, proficiency and solvency. The OSC noted that compliance is a responsibility that extends to everyone in the firm, whether they are registered or not. The UDP and CCO have extremely important compliance roles as they are ultimately responsible for ensuring that and effective compliance system is in place. The OSC provided several best practices for firms to consider. At the end of the day, a firm must manage risk within its business to ensure that it has the right people doing the right things at the right times.

The OSC no longer provides reminders with respect to deadlines for filings. It is the responsibility of the firm to have a compliance structure in place that enables it to comply with all regulatory requirements. If a filing deadline is not met, it may affect a firm’s continued suitability for registration and may result in terms and conditions being imposed on the firm’s registration or suspension of registration. In addition, firms will incur late filing fees of $100 for each business day that the filing is late, to a maximum of $5,000 annually. Ouch, that hurts!

Registrants’ annual audited financial statements must be prepared using IFRS as required under NI 52-107 and Part 12, Division 4 of NI 31-103 sets out their financial reporting obligations. This requires EMDs to deliver their annual audited financial statements (and related calculation of excess working capital - the NI 31-103F1) within 90 days after their financial year end. The financial statements are required to be prepared on a non-consolidated basis (which IFRS refers to as “Separate Financial Statements”). The OSC noted that the annual audited financial statements must include a sentence indicating that the financial statements are prepared in accordance with the financial reporting framework specified in Section 3.2(3)(a) or for foreign firms, section 3.15 of NI 52-107 and a description of the financial reporting framework used. This added sentence should also be referenced in the auditor’s report.

Thankfully, starting in February 2014, the Form 31-103F1 Calculation of Excess Working Capital (Form 31-103F1) must be filed electronically. The OSC notes that some firms are not accurately calculating their excess working capital on Form 31-103F1. When calculating excess working capital (EWC), registered firms should use the accrual basis of accounting, not the cash basis of accounting- and this includes the interim monthly financial statements. From EWC, a firm should exclude any current assets that are not readily convertible into cash, such as prepaid expenses and security deposits with service providers. The definition of what constitutes “readily convertible into cash”, in my experience, is often one the toughest judgment calls for both management and its independent auditor.

The OSC also notes that it is concerned with firms that include in working capital any accounts receivables, especially those due from related parties, which are not readily convertible to cash. Accounts receivables that are not realizable in to cash in a prompt and timely manner should be excluded from the excess working capital calculation. The OSC suggests that where a firm believes that related party receivables could be promptly received, the firm should maintain on file documentary evidence to support this assertion. Acceptable evidence could include audited financial statements of the related party or a bank statement supporting that the related party has cash available at that time. This guidance is welcomed as the determination is a challenge. It’s my experience that SROs such as IIROC and the MFDA provide a more rigorous definition of what is an allowable asset (i.e. working capital) for regulatory capital purposes.

The OSC noted that registrants need to deliver to it a copy off all executed subordinated loan agreements. If the agreement is not delivered to the OSC, then it will not be considered subordinated for purposes of the EWC calculation. The CSA has specifically addressed this issue in its December 5, 2013 suggested revisions to NI 31-103. Don’t forget that before you repay any subordinated debt, you may also notify the regulator of this before it is repaid. That notice is due 10 days before repayment. The regulator may request further documentation to demonstrate that the EMD continues to have excess working capital.

The OSC noted some instances where a market risk deduction(i.e. a margin/haircut deduction from working capital) has not been made for the value of securities held by the registrant. Each security held is assigned a market risk margin rate as set out in Schedule 1 of 31-103F1. However, if you are an active proprietary trader be careful with the margin rules, Unlike IIROC’s inventory margin rules, there are no capital offset rules for hedged short positions, options and warrants. Firms are reminded to provide supporting documentation of the market risk calculation as part ofthe annual and interim financial statement filings.

The OSC notes that registered firms are required to know their capital position at all times. Many people are surprised to find that the capital required is not only the $50,000 cash in the bank. Sufficient liquid assets are required to cover other working capital requirements (e.g. accounts payable and accrued liabilities), FIB insurance deductibles, market risk and guarantees, if any. Thus, I like to suggest that an EMD maintains liquid assets of at least$75,000 to $100,000 dependent on the nature of the business.

What should you do in the unfortunate event your EMD reports a capital deficiency? As Form 31-103F1 does not have early warning indicators (as you find with other SROs), capital deficiencies do arise. It’s important that an EMD has contingency plan to deal with these rare situations. A capital deficiency must be resolved on a timely basis, usually within 48 hours. Thus, it’s important that financial statements and EWC calculations be prepared and reviewed by management on a timely basis.
The OSC notes that EWC cannot be less than zero for more that2 consecutive days. The OSC should be contacted immediately to explain the details of the deficiency, be provided a copy of the calculation EWC and related supporting documentation, outline the plan to resolve the deficiency and steps to avoid its recurrence and finally, provide evidence of how the deficiency was resolved (cash injections and copies of the executed subordination agreement or share capital issued).After a capital deficiency is resolved, the OSC notes that it will either recommend terms and conditions be placed on an EMD’s registration (e.g. filing for a period the monthly financial reports and the Form 31-103 F1) or provide a warning letter to the registrant.

Keep your own firm in mind while you take the time to review the report for the OSC, and be open to its advice, or help from other professionals. One great place to start is by attending the PCMA’s Annual CFO Education Series: Financial Regulatory Reporting Certificate Program. It is being held in Calgary, Vancouver and Toronto in Fall 2014, and it’s where we review insignificant depth your financial regulatory requirements. It might be a good use of your time. And along with other refreshments, we also serve carrots.