Education Centre

Mortgage Syndication – What’s Going On?

By: Gregory M. Colford, CCO, Fundscraper Capital Inc. (FSCO: 12859)

To borrow from Churchill, mortgage syndication in Ontario is “a riddle, wrapped in a mystery, inside an enigma”. Mortgage syndicators are waiting with bated breath to see what finally comes from the recent interventions of two competing regulatory bodies into their market.

Mortgage syndication has generally been the regulatory roost of the Financial Services Commission of Ontario (“FSCO”) (soon to become the Financial Services Regulatory Authority of Ontario).

Nearly a year ago (March 8, 2018) the Canadian Securities Administrators (the “CSA”), representing each of the security regulatory authorities across the country (including the Ontario Securities Commission, or “OSC”), dropped a series of proposed changes that would see the OSC assume responsibility for the oversight of mortgage syndication in the Province of Ontario.

The reasons were twofold:

First, it was to harmonize the rules of mortgage syndication across the country. In Ontario mortgages are currently exempt from securities law and the oversight of the OSC. Once the changes are adopted, there will no longer be exemptions from securities law anywhere across Canada and the placement of mortgage security would have to comply with the rules governing the private and public investment markets.

Second, at the time the amendments were announced, the mortgage syndication market was in turmoil, leaving many inexperienced investors exposed to questionable deal offerings made into the market by overly aggressive promoters.

The new rules are thought not to come into force until late in the Spring of 2019, if not early summer. It is further anticipated that the mortgage brokerage community will be given an extra year to comply. “Whew” could be heard whistled through the mortgage syndication community – two more years! Well, not quite.

I. SOME BACKGROUND

Who are the mortgage syndicators?

Mortgage syndicators are generally mortgage brokers who are regulated by FSCO. In Ontario, only mortgage brokers (and their agents) are allowed to deal in or advise upon mortgages (there are exemptions for the banks, trust and insurance companies, the Crown, etc.). Given the proximity to market, mortgage brokers are the natural “syndicators”. The job of the mortgage syndicator is to initiate, promote and organise the syndicate.

What is a “syndicated mortgage”?

“syndicate”, by definition, is a self-organised group of people. A syndicated mortgage is mortgage where there are two or more persons acting as lenders. The lenders have a direct beneficial interest in the underlying mortgage. It is attractive to be part of a syndicate as the investor (who now becomes a lender) is sharing the risk of being repaid by the borrower with other investors/lenders of like mind. A “syndication” is often organized as an agency arrangement where one member of the syndicate will be charged with various administrative duties that may include being a “title trustee” for the group. Another form may be where syndicate members participate through a mortgage participation agreement that will recognize each member’s interest in the underlying mortgage and who has what duties to the others with respect to the administration of the mortgage. What is common in all syndicate arrangements is the immediacy the investor has to the mortgage – there is no one other than the title trustee between the investor and the mortgage!

The job of the mortgage syndicator

It is the job of the mortgage syndicator to knit the syndicate together. The mortgage syndicator will charge a fee reflecting his or her costs of originating the syndicate and the cost of services the syndicate bears and for which the syndicate has agreed to reimburse the syndicator. Being a mortgage syndicator can be a very profitable undertaking as the syndicator’s fees may include managing and administering the mortgage. In many cases the syndicator will also hold an interest in the mortgage.

The old regulatory environment

The regulatory environment at the time the OSC introduced its proposed changes was then relatively light. The syndicator had to prepare and circulate a basic disclosure document that described the brokerage, its relationship to the borrower, if any, what interests the brokerage might have in the transaction, its fees, etc. The second part of the disclosure form set out information about the transaction itself. If construction was involved, an addendum was added.

The forms were completed by the broker/syndicator and delivered to the investor to sign. The investor was given two days to back out of a deal unless the investor waived. The waiver was generally part of the syndicator’s package. Once the disclosure documents were completed and signed, the brokerage held one copy and the investor the other. Nothing was filed with FSCO. The broker would report the syndication in its annual information return to FSCO.

II. THE PROPOSED CHANGES

How the CSA intends to change the business of mortgage syndication

The first major proposed change is that mortgage syndications are no longer exempt from the Securities Act (Ontario) and for reasons described below this is ground breaking.

The mortgage syndicator will now only be able to choose between distributing the syndicated product in the (i) public markets pursuant to a prospectus filed and reviewed by the regulatory authorities (highly unlikely given costs!!) or (ii) private markets under the rules governing “private placements”. Mortgage syndicators will likely do the latter, yet it won’t be without its challenges.

  1. First, anyone who sells in the private markets has to be registered with the regulators. The proposed rules suggest that mortgage brokers will eventually have to be registered in some limited capacity that assures the regulator they are competent to assess their client’s suitability to invest in the mortgage product offered by the syndicator. This means the syndicator is likely going back to school! The OSC rules governing KYC (“know-your-client”) and its sister obligation KYP (“know-your-product”) are extensive and very much unlike what the ordinary mortgage broker/agent is exposed to in their licensing exercises.
  2. Second, they will have to learn the rules that govern the exempt securities market. These rules are generally set out in a document referenced as National Instrument 45-106 and its ancillary companion policies and notices. The rules are extensive and complicated. An investor is no longer simply a “purchaser” – the purchaser is now a “Permitted Client”, an “Accredited Investor”, an “Eligible Investor” or an “Ineligible Investor”, who, notwithstanding he or she is ineligible, can still be an investor! And the hair is split further as the legislation introduces minimum subscribers, dealer exemptions, etc.
  3. Third, syndicators will now have to determine how he or she will package and sell their product. Will he or she use an offering document? Will a term sheet suffice? Can they use a glossy advertisement? In addition, syndicators will have to figure out who in their office will be able to talk about the mortgage syndication opportunity to potential investors. It is likely only the syndicator’s staff who have been registered with the OSC will be able to speak to the investment with potential subscribers.
  4. Fourth, where an offering document is being prepared by syndicators and they hope to rely on the “offering memorandum exemption” available in the private investment market, they will have to comply with the additional disclosure guidelines for offering memoranda used for mortgages that are being syndicated.
  5. Fifth, syndicators will have to report. Currently mortgage syndicators are not required to report their trades. Under the new rules, mortgage syndicators will have to report their trades to the regulator within 10 days of the trade date and pay fees accordingly. If an offering memorandum is used and the corresponding exemption is employed by syndicators to market their products, the document (and any marketing material) will have to filed on the System for Electronic Document Analysis and Retrieval (“SEDAR”) for the entire world to view!
  6. Sixth, the syndicator now acquires additional statutory liability under the Securities Act (Ontario) and the regulatory oversight of the most activist regulatory body in Canada, the OSC. It is the job of the OSC to oversee and regulate the activities of the capital markets and any cursory glance of the business pages will tell the reader the OSC is quite active in that endeavor. Now that mortgage syndication has come under its auspices, mortgage syndicators will be paid the same attention the new kid gets when stepping into the classroom the first day.

It is expected that the OSC will impose a registration requirement that will require mortgage brokers to successfully complete some series of courses that will eventually evidence their competence to solicit and sell in the exempt market.

Though the new rules are expected to come into place sometime late spring/early summer 2019, there has been no definitive word as of February 11, 2019, when the new rules will be published and their effective date set.

III. MORE CHANGES AND WHAT TO DO ABOUT THEM

Yes, traditional mortgage syndicators have a hill to climb, but they likely have two years. In the meantime breathe easy and engage an expert advisor.

Well, maybe not too soon.

The day the earth shook!

Within a month of the CSA announcing its changes, FSCO released its intent to overhaul the rules governing mortgage syndication. In the words of one mortgage syndicator, “FSCO has now mandated I give my clients a colonoscopy before concluding their purchase. If we did this to people buying cars, we’d all be driving bicycles!”

Into a relatively barren regulatory environment FSCO let loose a web of policies and procedures to haphazardly cover the decades old lacuna left by benign neglect that scarred the market. Supplementing the simple Form 1 disclosure documents, FSCO rolled out a KYC protocol in the Form 3 series of disclosure documents that would intimidate a Canadian chartered bank! The Form 3 series is seemingly designed to address the unique risk profile of “unqualified” mortgages. Where the OSC thinks it may take a year or two to bring the mortgage brokerage community into line, FSCO thought a fistful of months adequate. Instead of adopting the seasoned approach of the CSA, FSCO created a one-size-fits-all solution from which no market participant is exempt. The ensuing confusion and the abrupt cessation of market activity was not surprising. The new rules were described at the time of their introduction as “transitional”, yet as at the date mentioned above, no one knows how long transition is going to be or to what degree the regulators are cooperating.

For example, FSCO replaced the Form 1, 1.1 and 1.2 with 55 pages of additional forms (Form 3, Form 3.1 and Form 3.2) for the bulk of syndicate mortgage product (also known as “non-qualified” transactions)!

However, the existing Forms 1, 1.1 and 1.2 continue to apply and must be used for mortgages funded by one lender and for “qualified” syndicated mortgages (which are generally first charge residential mortgages representing no more than 90% LTV). Here’s a simplified chart to let you know which forms are required for what kind of mortgage product:

FSCO Form Requirement
Mortgage Type Form 1, 1.1, 1.2 Form 3, 3.1, 3.2
“Non-Qualified” NO YES
“Qualified” YES NO

The Form 3 is the old check-box style KYC form: an inventory of a potential subscriber’s assets and collection of his or her investment intents. The form is completed by the subscriber and is intended to be relied upon by the mortgage broker/agent when making his or her suitability assessment of the subscriber for the investment. That suitability assessment is the focus of the Form 3.1.

For the uninitiated, which unfortunately is a rather large group, the Form 3.1 asks the broker/agent to make critical assessments and draw conclusions they have never been trained to do. FSCO appears to assume suitability assessment is an instinctive exercise that should be no more difficult than pulling balloons out of the air!

The Form 3.2 sets out the information requirements FSCO will now require of any offering document tabled to investors in a syndicated offering. The disclosure requirement is akin to an “offering memorandum” in securities law and the broker is required to certify that it is accurate to the best of his or her knowledge. The drafting exercise would challenge the average Bay Street lawyer. FSCO overnight moved an entire industry out of your mother’s Volkswagen Beetle into Elon Musk’s SpaceX rocket ship.

The new mortgage syndication rules became effective July 1, 2018, the same day many syndicators governed by FSCO gave up business.

Surviving Compliance

The choice that mortgage syndicators have today is embrace the changes imposed by FSCO now or wait and see what the OSC will require. To embrace the FSCO regulatory regime today will involve significant cost and client interruption. Further, there is no guarantee that once the OSC publishes its rules the syndicator will not have to go back and revisit what they have just put in place. If the syndicator chooses to wait it out, he or she will likely lose business.

What’s the answer?

Retain a private market intermediary today to carry out mortgage participation transactions that comply with the Securities Act (Ontario) instead of the Mortgages, Brokerages, Lenders and Administrators Act (Ontario) thereby circumventing FSCO’s transitional rules today.

In Ontario private market intermediaries are referred to as “Exempt Market Dealers”. Exempt market dealers (“EMDs”) are fully registered securities dealers who engage in the business of trading in prospectus exempt securities (which soon will include syndicated mortgages!), or any securities to qualified exempt market clients.

As described by the Private Capital Markets Association of Canada“EMDs are subject to full dealer registration and compliance requirements and are directly regulated by the provincial securities commissions. EMDs are required to meet all dealer obligations which include: educational proficiency, capital and solvency, insurance, audited financial statements, KYC, KYP, trade suitability, compliance systems, record keeping, client statements, trade confirmations, disclosure of conflicts of interest and referral arrangements, etc. The EMD category of registration exists in all provinces and territories of Canada.”

Whereas a “syndicate” is a self-organized group, an EMD or a promoter who retains an EMD, will represent a group organized by a third party. In the area of mortgages, it is common to organize groups under mortgage investment corporations (“MICs”), mortgage trusts (“Trusts”), or limited partnerships (“LPs”) whose sole business is investing in mortgages. In any of these examples, the EMD is not selling syndicated interests of mortgages, but rather shares in a MIC, units in a trust or limited partnership interests in a limited partnership.

The mortgage broker retains a critical role as, even with all the changes, only a mortgage broker can deal/trade in mortgages (with the exceptions described above). MICs, Trusts and LPs each require a mortgage broker to buy and sell mortgages on their respective behalves. In this construct the mortgage syndicator can continue advising on mortgages, but it is the EMD who has the responsibility for qualifying the investors and providing the independent investment advice that marks “best practice” for the OSC.

The EMD is practised at compliance. What might be foreign to the mortgage syndicator is second hand to the EMD. The primary function of an EMD to assess the suitability of the investor for the product in question beginning with the very first assessment, is the investor qualified (or permitted at law) to make the investment in the first place!

IV. YOUR SOLUTION – FUNDSCRAPER CAPITAL INC. (“FUNDSCRAPER”)

At Fundscraper we’re registered with FSCO as a mortgage brokerage and with the OSC as an EMD in the Province of Ontario as well as British Columbia, Alberta, Quebec and Prince Edward Island. We have spent the last two and a half years perfecting our online compliance procedures with the full expectation of the changes happening today in the mortgage syndication market. We discovered that by creating an interactive online environment we can greatly reduce the costs of compliance while delivering best-in-practice solutions. Once we qualify investors, we apply computer-generated algorithms to their investment decisions to assess suitability of investment and flag common investment risks. A qualified investor can begin our process and complete a subscription within twenty minutes from their tablet and desktop and, soon, their phone.

At Fundscraper we also enhance distribution by making available, if a client so chooses, a product offering to a much larger educated audience than the client would have access to alone. Fundscraper is able to show syndicators how they can continue profitably in business and give them the comfort that between them and the regulator stands a seasoned platform that will shield them and provide protection for their investors. Having Fundscraper as a trusted partner puts the mortgage syndicator back in business.

Once the new OSC rules are in place mortgage syndicators will have to do the following:

  1. It will be imperative that all interactions with clients and potential clients be properly documented. All of a syndicator’s communications with investors are subject to possible audit by the OSC.
  2. Syndicators will have to be careful with soliciting! Solicitation is considered “trading”under the rules of the OSC. Every time a subscription package is delivered, it is considered a solicitation for investment. Today, unless otherwise exempt, only persons registered with the securities regulatory authorities like Fundscraper are entitled to “solicit”.
  3. Investors will have to be qualified under the new rules before they are permitted to subscribe. Systems like what Fundscraper employs will have to be in place that give the regulator comfort that assessments are being properly executed.
  4. If disclosure documents like an offering memorandum or confidential information memo are being used, then there are reasonable disclosure obligations that that must be addressed. If employing the “offering memorandum exemption” under the Securities Act (Ontario), likely to be the most popular with syndicators, then there are very rigorous disclosure obligations.
  5. Suitability is everything. Understanding what “suitability” means is the art of the EMD. Determining whether an investment is suitable or not for a particular investor means the EMD will either recommend or not recommend the investment for the potential subscriber and is willing to defend that recommendation before the OSC! The regulator will make the EMD accountable for the suitability assessment made. Our system generates suitability reports based on the information a potential subscriber provides and flags issues of concern the dealer ought to attend with the potential subscriber.
  6. Don’t miss any checkboxes! Completeness is the cornerstone of protection – for both the investor and the dealer. Fundscraper’s online environment makes it impossible to skip a box.
  7. As described above, syndicators under the new rules will have to file reports of each syndication and pay a fee! If the syndicator is late, the fine is $100 a day!
  8. Always prepare for an audit; always prepare to be sued. Fundscraper papers your trail.
  9. Though it is not yet determined, once mortgage syndication falls under the auspices of the OSC and registered “dealers” or “restricted dealers” are required to carry out the solicitation and trade, those parties may now be subject to the Financial Transactions and Reports Analysis Centre of Canada (“FINTRAC”) reporting requirements of securities dealers like EMDs. Currently, mortgage brokers are not required to file the CSA Reporting Form for complying with the monthly suppression of terrorism and Canadian sanctions reporting obligations under certain federal provisions. This may change. At Fundscraper we have fully automated this exercise.

Fundscraper is today’s solution.

ABOUT THE AUTHOR

Gregory Colford
Gregory Colford

PRINCIPAL BROKER, EXECUTIVE VICE-PRESIDENT & CHIEF COMPLIANCE OFFICER

Gregory Colford, JD, CIM, was a senior partner at Heenan Blaikie LLP, once one of Canada’s ten largest law firms. Over his 12 years at Heenan Blaikie LLP, he headed the Toronto Securities Department, the Corporate Services Department, the Precedent Committee, the Legal Opinion Precedent Committee, and was the Toronto representative on the firm’s Stock Trading Committee. Through the course of his practice, he brought many companies to the public capital markets and advised extensively on corporate governance, board integrity, and market compliance.  He was also the co-founder of Carlisle Capital Structures Corporation and helped the company grow to over $1 billion CAD in AUM of mortgage securities on behalf of a top tier Ontario pension fund.