This is the second part of a two-part article. If you have not read Part I, feel free to check it out here: Should I Register as a Dealer To Talk About My Product? | Part I
Where an issuer elects to embark on any kind of advertising campaign, it is imperative that the issuer involve legal counsel to ensure that the fine line between advertising and advising is respected.
“Well, I want subscribers!!”
So, what do asset managers do if they want subscriber conversion? They pursue one of three options: (i) they hire a registered dealer, (ii) make an application to the regulatory authority to become a registered dealer (referenced as a “captive dealer”) themselves, and, (iii) recently, a third option has become available: an asset manager may have a “connected” dealing representative (generally an employee of the asset manager who is qualified to be a “dealing representative”) sit on the desk of a securities dealer and process only those trades of the asset manager.
Hiring a Registrant
Hiring a registered dealer is a pretty straightforward higgling exercise. The asset manager determines what they need and then shops around for the best price. The purpose of hiring the dealer is to “off load” the regulatory burden (and the concurrent liability) that attaches to solicitation for trading, namely, subscriber assessment and suitability determination.
The scope of the retainer will be determined by the services required by the asset manager. Many managers simply require a dealer to process subscribers. The dealer therefore provides an execution function: the dealer will validate the identity of the subscriber, next qualify that the subscriber can legally subscribe into the offering, then assess the suitability of the investment for the subscriber, and finally assist the subscriber with completing their investment. Afterwards the dealer will work with the manager to prepare the Report of Exempt Distribution the manager is required to file 10 days following the date of the trade.
The retainer may be much broader. It may include soliciting new clients, providing services, curing prior deficiencies, etc.
The asset manager will often coordinate their promotional activities with the dealer. For example: persons who have become interested in an asset manager’s product because of the advertising may be invited by the asset manager to leave their contact information with the dealer so the dealer can reach out and actively solicit the interested party. If the asset manager is speaking at a conference, the dealer may be in attendance to answer questions investors might have that go beyond product description (e.g., “Does this product pay a coupon?” is a question the asset manager can well answer). A question such as “Is this a good investment for me?” should only be answered by a licensed dealer.
The dealer has two jobs: first, confirm the proposed subscriber is actually qualified to participate in the exempt market and, secondly, assess whether the investment is suitable for the proposed subscriber. Suitability assessment is the key undertaking of the dealer. A dealer cannot be agnostic/indifferent as to whether a deal is suitable or not for a proposed investor – the dealer has to make a finding of suitability!
It is with respect to suitability assessment that most issuers fail in the eyes of the regulator. As conflict is so apparent, the presumption is that it cannot be done in a properly disinterested fashion.
Retaining the independent securities dealer is the issuer’s best regulatory prophylactic.
Issuers are sometimes motivated to obtain their own licenses for a variety of reasons. The issuer may perceive a cost saving by pulling all the execution work inside. Issuers are also concerned about losing control over their clients. There is a concern that notwithstanding a ‘exclusivity’ agreement, an arms length dealer will market other products to their clients, woo their clients away to other issuers or simply not provide the client service the issuer expects. The issuer will therefore seek to become registered with the regulatory authority to advise on security. In Ontario, this is most frequently in connection with exempt market security and the registration sought is the “exempt market dealer” registration. This is the simplest category.
There is a terrific amount of work, time and cost that must be invested for this registration. The issuer first has to staff the proposed “registrant”. It will need an “Ultimate Designated Person”, a “Chief Compliance Officer” and a “Dealing Representative”.
The UDP is the person who is ultimately responsible for compliance. This would typically be the President/CEO of the shop. The UDP generally has no defense for non-compliant behavior. Though there are no prerequisites to becoming a UDP, the regulatory authority applies rigorous review of any individual who promotes him or herself as a potential UDP.
The CCO does have to have certain qualifications before being considered for approval by the regulatory authority. The individual must have passed the Canadian Securities Course or Exempt Market Products Exam, the Partners, Directors Officers Exam or the CCO’s Qualifying Exam and have 12 months of relevant securities industry experience. The DR has to have at least successfully completed the Canadian Securities Course or Exempt Market Products Exam.
Next it will have to have on hand $50,000 at all times to meet the capital sufficiency requirements required of the regulation. EMDs have unique insurance requirements in Ontario that must be had in hand with its ordinary insurances.
Once everything is in hand and the requisite documents are filed, it may take anywhere from four to eight months to be issued a license if the regulator has no unresolved issues.
Being a “captive” dealer effectively binds to the asset manager all of the liabilities that the dealer bears for subscriber assessment and suitability. If the captive dealer miscues, then the regulatory liability will generally spiral right up to the asset manager. In too many instances, it is not simply the captive dealer that is suspended, but the entire organization.
The costs to organize the proposed registrant can range anywhere from $50,000 to $75,000.
The costs to organize the proposed registrant can range anywhere from $50,000 to $75,000.
“Yikes! What’s the Third Option?”
In the last couple of years, the regulatory authorities have begun to permit issuer-connected dealer representatives (“ICDR”). An ICDR is a dealing representative who is connected with one issuer only and registered with a registrant. Generally, an ICDR is an employee of the issuer who has taken and passed the courses necessary to be a dealing representative. The issuer negotiates with a dealer “desk space” for the ICDR. A fee will be determined between the dealer and the issuer that will compensate the dealer for overseeing the activity of the ICDR. The dealer will (or should) impose a strict code of oversight over the ICDR with which the issuer will have to agree.
The dealer will likely be required to implement a rigorous system of control and supervision whereby all communications by the ICDR with customers, potential customers, finders and referral agents, other than in-person meetings, be conducted on e-mail servers, telephonic and other electronic communications owned and operated by the dealer that will record and permit the dealer to monitor all interactions. The dealer will also have to insist on what amounts to a veto right in regard to any marketing materials used by the ICDR while working under the dealer.
At the end of day the issuer ends up with the worst of both worlds: it is now paying a dealer a “desk fee” (in the place of commissions, etc.) and still risks the possibility of being shut down if their own ICDR screws up! The ICDR brings back all the regulatory liability to the doorstep of the issuer and the issuer is paying a dealer for it!
There is, in this author’s opinion, a misguided notion many asset managers have that being registered is some sort of miracle salve they can rub all over to keep those nasty regulators at bay, like DEET during blackfly season in Algonquin Park! This is false. The issuer who elects to be a dealer, either through registration or by way of an ICDR increases its regulatory liability. The implicit presumption will always be the subscriber’s best interest will be second to the issuer’s. Retaining an independent securities dealer will always be the better practice and, in many instances, likely cheaper.
Yes, a private issuer can advertise its wares. The ordinary rules governing advertising of any kind apply in the securities industry: be truthful, do not mislead. Advertising crosses the line into advising when the focus shifts from general product promotion to individual subscriber conversion. It’s a fine line. Retain the advice of qualified legal counsel to help discern the difference. An independent exempt market securities dealer like Fundscraper Capital Inc. can always assist developing and deploying effective marketing campaigns to promote product offering and attract qualified subscribers for whom the offering is suitable.
For more information, contact us at www.fundscraper.com.