Oversight of Self-Regulatory Organizations
November 3, 1998
by Toni Ferrari
One of the Ontario Securities Commission's ("OSC") strategic directions is to push down direct regulation of registrants to self-regulatory organizations ( "SROs"). This is because SROs can help regulators to achieve regulatory objectives more
efficiently and effectively. Because the regulator remains ultimately responsible for the regulation of market intermediaries, it is important that we develop an effective oversight programme for SROs. Accordingly, one of the OSC's priorities for fiscal 1999, as published, is
"to develop and implement an effective programme of oversight for SROs, including the new SRO for mutual fund dealers".
Today, I will be speaking to you about how the OSC conducts SRO oversight. I will start by reviewing the definition of an SRO and the powers of the Commission under the Securities Act (Ontario) (the "Act"). I will state some of the
objectives of SRO oversight and I will describe the different mechanisms we use for effective oversight, including the recognition process; regular reporting and ongoing communication; the by-law review and approval process; and compliance examinations of the SRO. Finally, I will talk a bit about how the OSC
can rely on the work of others to make SRO oversight more efficient and effective.
Definition and Powers of the Commission
The Act defines an SRO as a company
that represents registrants and is organized for the purpose of regulating its members and their representatives, with a view to promoting the protection of investors and the public interest.
Section 21.1 of
the Act gives the Commission the power to recognize an SRO, and to impose terms and conditions on that recognition. The section also gives the Commission broad powers to oversee the SRO. Specifically, the Commission is able to make any decision with respect to any by-law, rule, regulation, policy,
procedure, interpretation or practice of a recognized SRO.
Objectives of SRO Oversight
The objectives of SRO oversight are to identify deficient SRO operational performance at an early stage and ensure that corrective measures are implemented; to ensure effective communication between SROs and the OSC; and to periodically
review the SRO's member compliance monitoring, and the handling of complaints, investigations and settlements of disciplinary matters. SRO oversight should not interfere with or attempt to micro-manage the work of the SRO. Rather,
the objective is to validate reliance on the SRO for the
functions which we have delegated to it. An outcome of effective oversight should be clear communication of the regulator's expectations. This will place the SRO in a better position to meet those expectations.
Mechanisms for Effective Oversight
The Recognition Process
The Investment Dealers Association of Canada ("IDA") is the only recognized SRO in Ontario. It is anticipated that the Mutual Fund Dealers Association will apply for formal recognition once it is up and running. For today, I will limit my
discussions to the supervision of the IDA.
For years the IDA was treated informally as an SRO. The IDA was formally recognized as an SRO on October 31, 1995 pursuant to section 21.1 of the Act.
The recognition process is an important one. It helps set clear standards which must be met
by the SRO prior to exercising its delegated authority. The recognition process for the IDA was quite rigorous and included an examination of the IDA's compliance and enforcement capacities and operations to ensure it had effective resources; and a review of the IDA rules, including its constitution, by-laws,
regulations and policies, to ensure that the rules were justified according to the recognition criteria.
Through the recognition process, the Commission was able to impose terms and conditions on the recognition of the IDA. The terms and conditions imposed on the IDA require that:
the IDA maintain adequate staff resources and an appropriate internal reporting structure to be able to perform compliance and enforcement functions;
the IDA obtain Commission approval prior to making any fundamental changes to its organizational structure which affect its self-regulatory functions;
the IDA cooperate generally with the Canadian Investor Protection Fund ("CIPF"), the Commission and other regulators, and that the IDA advise other self-regulatory organizations to which a member is subject of any breach of the rules;
public disclosure be made of disciplinary and settlement hearings; and
the IDA keep any trade association or lobbying activities structurally separated from its self-regulatory operations. Examples of these activities include any representations made to governments regarding such issues as industry fee structures, ownership and
foreign participation in the securities industry.
Where staff had concerns with some of the IDA's procedures, the recognition process resulted in the IDA undertaking corrective action.
Ongoing Reporting and Communication
Once the recognition process is complete, the regulator should perform oversight of the SRO on an ongoing basis. One of the mechanisms for ongoing supervision is regular reporting and communication. This mechanism is important so that the
regulator can ensure that the SRO continues to meet the recognition criteria.
The IDA's conditions of recognition set out many items which the IDA must report on to the Commission. For example, there is a requirement that the IDA report to the Commission certain situations where its members are non-compliant. There is also a requirement to
report to the Commission regularly on investigations and complaints. The IDA must report any material changes in financial or operational compliance programmes or enforcement programmes. Notices to members and interpretations of rules must be copied to the Commission. On an annual
basis, the IDA must report on its staff complement by function; it must provide its budget and audited financial statements and a copy of its annual report; and it must submit a self-assessment of the IDA's performance of its self-regulatory responsibilities. This self-assessment is a very useful document as
the IDA must make recommendations for improvement in areas which they themselves have identified as weaknesses.
In addition to regular reporting, OSC staff must ensure that the lines of communication remain open with the SRO. To this end, staff meet regularly with IDA staff.
By-law Review Process
Another mechanism for supervision of an SRO is the by-law review process. The IDA's conditions of recognition set out a formal process for development of new rules. Generally speaking, all new rules or rule amendments must be:
approved by the Commission prior to implementation;
published for comment;
accompanied by statements outlining the rule's nature, purpose and effect;
accompanied by a statement that it is in the public interest to make such rules; and
justified by reference to the permitted purposes set out in the recognition criteria.
According to the recognition criteria, the IDA can only make rules for specific permitted purposes such as:
to ensure compliance with Ontario Securities Law;
to promote investor protection;
to facilitate an efficient capital-raising process;
to facilitate free and open competition in the securities industry;
to provide for the administration of the affairs of the IDA;
and other permitted purposes.
The recognition criteria states that rules shall not permit unfair discrimination among customers, issuers, dealers or others. Also, rules should not impose any burden on competition that is not necessary or appropriate. When the IDA submits a proposal for a new
rule or rule amendment, it is OSC staff's job to ensure the proposal meets the permitted purposes of rules under the recognition criteria. OSC staff submit a recommendation to the Commission as to whether the rule should be approved. If the ongoing communication process I
spoke about earlier is working well, then OSC staff should be aware of new rules that are under development at the IDA, and any significant issues staff has with the rule should be addressed early on.
Oversight Through Compliance Examinations
A very important tool for effective oversight is performing compliance examinations of the SRO and its members. Section 20 of the Act gives the Commission the powers to perform compliance reviews of market participants, which
includes SROs. Compliance reviews include inquiry into and examination of the books, records and documents of the market participant.
To date, the OSC has performed compliance reviews of the IDA's enforcement and compliance functions as part of the recognition process. However, no
comprehensive compliance examination has ever been performed. We are planning to change this, and have allocated significant resources in 1999 to do just this. Ongoing monitoring through compliance reviews was contemplated as part of the recognition process. In fact, one of the IDA's conditions of
recognition is the requirement to cooperate and assist with any review of the self-regulatory functions conducted by the Commission, or by a party appointed by the Commission.
The objectives of a compliance review of the IDA include:
to determine compliance with the terms and conditions of the IDA's recognition, and the undertakings signed in connection thereto;
to ensure that the IDA continues to have appropriate procedures and resources to do the job;
to ensure that the IDA's core regulatory functions, such as Registration, Compliance, Enforcement and Policy, are being performed in a manner that results in appropriate and consistent enforcement of Ontario Securities Law and IDA
to identify any weaknesses in the above; and
to report weaknesses to the IDA and the Commission, including a plan for action and follow up.
Some examples of the work that would be done include:
reviewing IDA examination programmes to ensure that they are designed to test compliance by members with all relevant IDA and OSC rules;
reviewing a sample of IDA compliance and enforcement files to assess whether all issues have been identified, and whether appropriate action was taken by the IDA; and
reviewing applications for exemptions from IDA rules to ensure that the discretion used by the IDA was appropriate and consistent.
There are many more steps, but in the interest of time, I won't list them all. There is however, one procedure that's worth mentioning. The OSC plans to conduct examinations of IDA member firms on a very selective basis as part of its SRO oversight programme. The
objective of this would be to compare the regulator's results to those of the SRO as a means of assessing the effectiveness of the SRO's compliance reviews. In the U.S., the Securities and Exchange Commission includes as part of its supervision programme for the National Association of Securities Dealers
("NASD") the performance of joint examinations of NASD member firms. This is certainly an alternative we are considering.
Relying on the Work of Others
Finally, I want to talk about how the OSC can and does rely on other organizations to assist in the oversight of the IDA. One of these organizations is the CIPF. In July of 1991, the Canadian Securities Administrators ("CSA") signed an agreement with CIPF
in an effort to reduce the burden of oversight. In the agreement, CIPF agreed to perform oversight procedures on member's financial compliance activities. As part of this, CIPF agreed to establish minimum standards. These minimum standards were presented to and approved by the Commission in March, 1995, and
include standards imposed on dealers, such as capital, insurance, books and records and segregation requirements; and standards imposed on SROs, such as field examinations and reporting obligations to CIPF. In addition, CIPF agreed to perform financial examinations of SRO member firms on a rotational basis to
ensure member firms and SROs are complying with the minimum standards. CIPF currently completes examinations of anywhere from 5 to 10% of members each year. Such examinations include a review of the SRO's working paper files. CIPF also reviews all monthly, quarterly and annual financial reporting of member
firms. Finally, CIPF reviews all deficiency letters issued by SROs to member firms, and member responses, to ensure that all deficiencies have been addressed appropriately, and to ensure consistency among SROs in dealing with deficiencies.
In the agreement with the CSA, CIPF agreed to report to the CSA on the results of the above oversight activities. In Ontario, this reporting has been mainly informal. As part of our efforts to develop effective oversight procedures, we will be looking to formalize
such reporting so that we can establish greater reliance on the work of CIPF in the area of SRO oversight.
Our other partners in the area of SRO oversight are the other Canadian securities regulatory authorities, or the "CSA". To further improve the efficiency and effectiveness of SRO oversight, the CSA should develop a consistent approach to supervision of
SROs, and should rely on each other's work wherever possible. In the case of a national organization like the IDA, mutual reliance amongst the CSA can make the process much more efficient. In recognition of this fact, we are in the process of setting up a CSA committee to coordinate IDA oversight. The
committee has not yet had its first meeting, but some of the things the committee might be doing include developing a consistent approach to the approval of new rules and rule amendments; developing a consistent approach to the examination of IDA functions; ensuring consistency in the type of information
required to be reported by the IDA to each regulator; and developing a mechanism for relying on each other's work. If successful, the work of this committee would not only make oversight of the IDA more efficient, but would also assist the IDA in dealing with regulators through the implementation of
In conclusion, I just want to reiterate that an effective SRO oversight programme is essential as the regulator is ultimately responsible for the regulation of market intermediaries. Again, the objective of SRO oversight should
not be to interfere with or micro-manage the work of the SRO. Rather,
the objective is to validate reliance on the SRO for the functions which we have
delegated to it. Finally, an important outcome of SRO oversight should be to foster a good working relationship with
the SRO, which includes clear communication of our expectations as regulators.