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Bulletin #0427-C

Compliance
Significant Financial Compliance Deficiencies Noted During On-site Examinations of Members

Contact: Laura Milliken
BULLETIN #0427 – C
Director, Financial Compliance
March 22, 2010
Phone: 416-943-5843

E-mail: lmilliken@mfda.ca

MFDA Bulletin

Compliance

For Distribution to Relevant Parties within your Firm and Audit Firm


Significant Financial Compliance Deficiencies Noted During On-site
Examinations of Members

The MFDA Compliance Department conducts on-site examinations of all Member firms’
financial reporting and operational processes to ascertain whether they comply with the
applicable MFDA Rules, Policies and Notices.

The MFDA previously issued Bulletin #0056 that included common financial compliance
deficiencies noted during on-site examinations. Since then, the MFDA has also issued a number
of Notices and Bulletins providing additional guidance on specific financial compliance
requirements.

The purpose of this Bulletin is to highlight the more serious financial compliance deficiencies
identified during MFDA staff’s on-site examinations of all Members, which may have resulted in
material capital implications leading to Members triggering capital deficiencies or other early
warning tests. Often, the cause of the deficiencies arise as a result of a firm not adequately
managing or considering the capital implications of significant changes in their business such as:
back office system conversions; business expansions through acquisitions or amalgamations;
offering new products for distribution; or investing the firm’s own capital in new or different
investment products.

Significant Deficiencies that Could Impact Any Dealer Level

Incorrect Margin Rate Applied to Securities Owned

Requirement:
The capital formula requires a margin deduction to be taken for market risk associated with the
firm’s securities owned and sold short. Depending upon the nature of investment held by the
Member (e.g. GIC, equity mutual funds, money market mutual funds), inherently different
market and liquidity risks exist and, therefore, different margin rates are to be respectively

applied. The margin rates that apply to mutual funds relate to only mutual funds qualified by
prospectus for sale in any province of Canada.

Issue Identified:
ƒ Member invests in hedge funds which are not qualified by prospectus and incorrectly
applies a margin rate of 50% of the market value of the funds rather than 100%.

Capital Implications:
ƒ Risk Adjusted Capital (“RAC”) is overstated by the difference between the margin
reported by the Member and the amount that should have been calculated and reported on
Statement B line 9 of the Form 1 – Financial Questionnaire and Report (“Form 1”).

References:
ƒ Rule 3.5.1
ƒ Form 1 – Notes and Instructions to Schedule 1

Securities not Held at Acceptable Securities Locations

Requirement:
Each Member is required to ensure that all securities and other investment products held for the
Member at external locations be held at acceptable securities locations, regardless of whether
they be the firm’s own investments or client investments held in nominee name of the dealer. In
order for the location to be considered “acceptable”, the location itself must be appropriate and a
compliant custodial agreement must be in place.

Issues Identified:

ƒ A compliant custodial agreement is not executed with mutual fund company or financial
institution where the Member’s own investments and/or nominee name client assets are
held.
ƒ Member’s own investments are held in a custodial account that is in the name of a related
or affiliated company.
ƒ The prescribed custodial agreement has been executed by the fund manager or financial
institution; however, the terms of the agreement do not extend to the specific investment
product (e.g. GIC, mutual funds) held for the Member.

Capital Implications:
ƒ 100% of the market value of securities and investment products not held at acceptable
securities locations must be reported as a capital deduction on Statement B line 11 of the
Form 1.

References:
ƒ Rule 3.3.3(b)
ƒ Member Regulation Notices MR-0058 and MR-0063
ƒ Custodial Agreement Listing (https://mfda.ca/regulation/forms/CustodialAgreements.pdf)
ƒ Form 1 – General Notes and Definitions
ƒ Form 1 – Statement B Notes and Instructions

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Incomplete Reporting on Form 1

Requirement
:
Each Member is required to report its financial position and operating results to the MFDA on a
monthly and annual basis in the prescribed form. This includes ensuring all accounts in the
Member’s general ledger, back office trading system, and other appropriate accruals are
adequately reconciled and completely reported on the Form 1.

Issues Identified:

ƒ Guarantees provided by the Member for lending facilities entered into by related or
affiliated companies are not reported on Statement B line 7.
ƒ Suspense and error account balances (e.g. cash balances, security positons) are not being
identified and/or reported.

Capital Implications:
ƒ Impact of non-reported balances on Form 1

References:
ƒ Form 1
ƒ Rule 3.5.1
ƒ Rule 5.1

Significant Deficiencies Impacting Level 3 and 4 Dealers Only

Trust Bank Accounts not Reconciled to Back Office System

Requirement:
Each Member is required to reconcile all its trust accounts, according to its own records to third
party banking information/statements on at least a monthly basis and report the value of
unresolved differences on Statement B line 13.

Issues Identified:
ƒ Member incorrectly reports the same balance according to the trust account statement on
Statement A lines 2 and 23 without reconciling the trust account statement to its back
office system reflecting client cash held.
ƒ Member performs a system conversion but does not establish adequate controls to ensure
the client cash reported in the trading system continues to reconcile with the third party
trust account information.

Capital Implications:
ƒ Where client cash according to Member records is not reconciled/verified against third
party information on a monthly basis, the difference is considered to be adversely
unresolved. A capital deduction equal to the value of the client cash according to the
Member’s records not verified/reconciled to a trust account statement must be reported
on Statement B line 13 of the Form 1.
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References:
ƒ MFDA Policy No. 4 – Internal Control Policy Statement 4
ƒ Form 1 – Statement A and Statement B Notes and Instructions

Incomplete Reporting on Form 1

Requirement
:
Each Member is required to report its financial position and operating results to the MFDA on a
monthly and annual basis in the prescribed form. This includes ensuring all accounts in the
Member’s general ledger, back office trading system, and other appropriate accruals are
completely reported on the Form 1.

Issue Identified:

ƒ Trust accounts which are not included in the Member’s general ledger are not being
identified and reported.

Capital Implications:
ƒ Impact of non-reported balances on Form 1.

References:
ƒ Form 1
ƒ Rule 3.5.1
ƒ Rule 5.1

Significant Deficiencies Impacting Level 4 Dealers Only

Nominee Name Client Assets not Reconciled to Third Party Information on a Monthly
Basis

Requirement:
Each Member is required to reconcile all client nominee name assets, according to its records, to
third party information on at least a monthly basis and report the value of any unresolved
differences on the Form 1. The reconciliation is required to be completed by the filing due date
of the financial report (i.e. 20 business days for monthly filings). This process is required for all
assets (i.e. mutual funds, GICs, segregated funds) held on behalf of clients but registered in the
name of the Member.

Issues Identified:
ƒ Member is performing a monthly reconciliation process for nominee name assets;
however, the system is actually comparing third party information to the same third party
information (i.e. FundSERV records are actually being compared to FundSERV records)
rather than to Member records. This issue has arisen as a result of the back office system
being incorrectly set up or used to capture and compare Member internally generated
records to third party records.
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ƒ Member completes monthly reconciliation of all its nominee name assets to third party
records; however, it is not completed by the due date of the financial report.
ƒ Member commences the distribution of nominee name GIC business to its clients but
inadvertently does not establish internal controls to capture this new line of business in its
monthly reconciliation processes.
ƒ Member expands its business by acquisition or amalgamation but does not properly
establish internal controls to ensure the acquired business is subject to the same monthly
reconciliation process.

Capital Implications:
ƒ Where nominee name assets according to Member records are not reconciled against
third party information on a monthly basis, the nominee name positions are considered to
be adversely unresolved. A capital deduction equal to the market value of the nominee
name assets plus the applicable margin rate on the assets must be reported on Statement
B line 12 of the Form 1.

References:
ƒ MFDA Policy No. 4 – Internal Control Policy Statement 4
ƒ Member Regulation Notice MR-0051
ƒ Form 1 – Statement B Notes and Instructions

DM # 198831v1

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