Further comment on the CSA “PROPOSALS TO ENHANCE THE OBLIGATIONS OF ADVISERS, DEALERS, AND REPRESENTATIVES“
In 2012 we were led to believe that the CSA was looking to introduce a fiduciary type best interest standard into the Canadian retail financial services market. The CSA referred to a “statutory fiduciary duty” which “would likely support a private law cause of action for damages by a beneficiary against a fiduciary…The principal question is whether advisers and dealers should have an obligation to act in the best interests of their clients when providing advice to them. “
The current CSA Consultation states that its best interest standard is not a fiduciary duty and would not interfere with existing client/registrant relationships. The standard would be a standard of care and operate as a principle. The CSA document did not explain the reasoning behind the framing of the rule but it may have left some clues.
My attention was drawn to the fact that the “best interest standard” was to be inserted into the existing obligation to “deal fairly, honestly and in good faith”.
“A regulatory best interest standard would require that a registered dealer or registered adviser shall deal fairly, honestly and in good faith with its clients and act in its clients’ best interests, and that a representative of a registered dealer or registered adviser shall deal fairly, honestly and in good faith with his or her clients and act in his or her clients’ best interests.”
When we talk about “deal fairly” just what are we talking about? If we wanted to be specific about it we would need to go back to the 1930/45/66/1978 Ontario Securities Acts and attendant Securities Commission rules and interpretation.
This is not as easy as it sounds. Unlike the US, there is surprisingly little information in Canada on the history of regulation of advising versus dealing/broking categories. We know that there are two main CSA registration categories, advising representatives and dealing representatives and that the main area of issue today lies with dealing representatives or salespersons subjected to the lesser suitability standard and who are not considered, under current or proposed regulation, to have fiduciary type advice giving responsibilities. Indeed, even those advising on a non discretionary basis, under the advising representative category, are not accorded this status.
With respect to the relevance and importance of the phrase “deal fairly” in current regulation, a fair dealing model came out of 1930s US legislation and SEC/legal rulings. This operational model for broker/dealers was divorced from that of advice via the 1940s Investment Advisors’ Act.
The SEC in its “Guide to broker dealer registration” defines the duty of fair dealing and thus also uses the term “deal fairly”:
“Broker-dealers owe their customers a duty of fair dealing. This fundamental duty derives from the Act’s (1934 Securities Exchange Act) antifraud provisions mentioned above. Under the so-called “shingle” theory, by virtue of engaging in the brokerage profession (e.g., hanging out the broker-dealer’s business sign, or “shingle”), a broker-dealer represents to its customers that it will deal fairly with them, consistent with the standards of the profession. Based on this important representation, the SEC, through interpretive statements and enforcement actions, and the courts, through case law, have set forth over time certain duties for broker-dealers. These include the duties to execute orders promptly, disclose certain material information (i.e., information the customer would consider important as an investor), charge prices reasonably related to the prevailing market, and fully disclose any conflict of interest.”
It is notable that the duties under the representation to “deal fairly” do not include that of providing advice. In “The Professional Obligations of Securities Brokers Under Federal Law: An Antidote for Bubbles?” Ramirez (2002) wrote:
“Focusing specifically upon the regulation of the securities broker-dealer profession, Roosevelt stated that his legislative proposal was animated by a “broad purpose of protecting investors” and to provide for “better supervision” of securities exchanges. The goal of the Act was therefore to establish “a minimum standard of fair dealing” on securities exchanges. The ’34 Act was essentially an attempt to make capitalism more durable by making “intelligent adjustments,” rather than an attempt to “destroy” the market mechanism for allocation of capital. Thus, for example, the ’34 Act focuses upon disclosure obligations rather than having the government approve securities for sale to the public.“”
“In re Duker 1939 the Commission stated “Inherent in the relationship between a dealer and [its] customer is the vital representation that the customer will be dealt with fairly and in accordance with the standards of the profession.”‘”
Again we have a reference to fair dealing that focuses on the mechanics of the market as opposed to the provision of advice. In “SEC Shingle Theory: Continuing Viability; Continuing Questions”, Franklin Ormsten wrote:
“The shingle theory holds that when a broker hangs out its shingle to do business it impliedly represents that it will deal fairly with its customers and in accordance with industry standards. The theory had its origins in an early SEC administrative case. In re Duker & Duker, 6 SEC 386, 388 (1939). Most often the theory is applied to the concept of fair pricing and full disclosure. An early and important case, Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), cert. denied, 321 U.S. 786, illustrates this.”
With respect to “deal fairly” we have again a reference to the Shingle Theory, with respect to broker/dealer accountability and representation of service. In this particular reference we see that a very early stage the representation to “deal fairly” was in respect of fair pricing and full disclosure and had little to do with the provision of advice.
Likewise, from “Fiduciary Obligations of Broker-Dealers and Investment Advisers” Arthur B. Laby (2010) wrote:
”In a series of dealer cases decided around the time the Advisers Act was passed…the SEC established an enhanced standard of conduct for dealers and brokers. The Commission held that even when a firm was transacting with a customer as a dealer, it undertook to act on the customer’s behalf and, therefore, the relationship was similar to agency….The SEC referred to the trust and confidence customers reposed in the firm….stating that exploitation of the customer’s trust contravened a duty of fair dealing. Thus began the Commission’s development of a theory of liability for broker dealers, which came to be called the “shingle” theory. The SEC first applied the shingle theory in the context of a dealer charging excessive mark-ups. It was called the shingle theory because the broker-dealer firm was hanging out its shingle, offering to act on the customer’s behalf, and therefore should be subject to enhanced duties. The shingle theory was tested and affirmed by the Second Circuit in Charles Hughes & Co. v. SEC. Under the shingle theory, the SEC did not impose strict fiduciary duties on broker-dealers. Rather, the standard applied by the Commission was that the brokers’ conduct be reasonable under the circumstances. A reasonableness requirement, however, falls short of the best interest standard required of a fiduciary.”
“Later, the Commission expanded the shingle theory to apply to a wide variety of cases when brokers held themselves out as experts and induced customers to rely on their expertise. The theory was applied to a broker, who by making stock recommendations, impliedly represented that he or she had adequate information to recommend the particular issue…..”
And from a footnote taken from Hanley V SEC 1969 “A securities dealer occupies a special relationship to a buyer of securities in that by his position he implicitly represents he has an adequate basis for the opinions he renders.”
So we have the “fair dealing” frame with respect to disclosure and fair pricing gradually extending to areas such as suitability as the scope of broker/dealer responsibilities expands. But this remains a frame where advice is incidental to the transaction.
My point here is that there is a clear lineage with respect to the term “deal fairly”/”fair dealing” in the US which raises questions over the use of the term “deal fairly” with respect to Canadian registrant obligations in the CSA consultation. While there is a dearth of immediately available references to decipher the Canadian lineage and intent, references to the 1945 and the 1966 Ontario Securities Act state they were likely influenced by US legislation at the time. If this is the case then there is also a likelihood that the root of the current obligation is also similarly influenced.
In “A Thesis Regarding The Measurement of Damages As A Result of Misrepresentation In A Prospectus” McNally W and Cotton B wrote” :
“It has been suggested that the Kimber Committee Report, and the subsequent Ontario Securities Act, 1966 were largely influenced by the Securities Act of 1933 and the Securities Exchange Act of 1934 in the United States. The Securities Act of 1933 primarily required that a company issuing securities to the public disclose all material facts relating to the company and to the securities then being issued. One year later the Securities Exchange Act of 1934 was enacted which broadly prohibited any person from engaging in fraudulent activity in connection with the purchase or sale of securities.”
What is lacking in Canadian regulation is clarity with respect to the legal importance of the differentiation of advice provided by advisors and advice provided by advisers, as well as the advice provided by advisers under non discretionary accounts vis a vis advisers operating discretionary accounts. While in the US the development of a rationale for enhanced regulation of advice is well noted in legislation, legislative intent, regulation and case law, this is not the case in Canada. I am no securities lawyer but I am quite surprised at the lack of clarity and evidence of clear lineage with respect to both advice based and sales based registration in Canada.
Indeed, the framing of the revised obligation of registrants to “deal fairly, honestly and in good faith with his or her clients and act in his or her clients’ best interests” suggests to me that the best interest standard is being tacked onto a frame that is still unable to accommodate the advice based model that the retail financial services industry has become. It is not just a question of introducing a best interest standard but perhaps the Securities Acts themselves need to be rewritten. Clearly “dealing” as in “deal fairly” is still a foundation of securities markets, but advice has built upon it.
The current frame lacks a clear definition of advice relative to a sales or dealing relationship and is thus unable to clearly define the boundaries of either. As the CSA consult clearly states, the proposed standard and new targeted reforms will retain the existing client/registrant relationships. These are relationships that do not recognise the status of the advice provided by registrants.
Perhaps our regulators surmised that because the phrase “deal fairly, honestly and in good faith” references a frame that is not considered to be one that naturally supports a fiduciary type advice based relationship, but that of the transaction (i.e. fair dealing), that the standard would not be confused with a fiduciary standard. A best interest standard rooted in “fair dealing” might therefore be assumed to tighten the transaction distribution route as opposed to the advice distribution route. Its roots are more likely to be the 1934 US Securities Exchange Act than the 1940s Investment Advisors Act.
I wish I could be clearer as to the roots and rationale behind current Canadian securities regulation as I lack the evidence to fully prove either.