To illustrate some of the issues associated with
conflicts of interest, let us examine a case study involving
the sale by an exempt market dealer of debt securities
issued by a related issuer.
An exempt market dealer and an issuer are typically
related when the same individuals manage both entities. In
some cases, the EMD is specifically set up to distribute the
securities of the related issuer, which may be a business or
a family of investment funds.
The securities commissions have identified a
disproportionate rate of compliance deficiencies among
EMDs that distribute the securities of related issuers.
They have given notice that they will focus compliance
attention on such dealers and will take enforcement
action when the dealers are found to be acting contrary
to securities legislation.
The case study is based on an actual enforcement
case involving an exempt market dealer.
Two brothers owned and managed a group of
companies comprising a used-car dealership, a finance
company and an exempt market dealer. The finance
company provided car loans to the customers of the
used-car dealership. How did it get the money with which
to make the car loans? By raising money from investors in
the form of high-yield debt instruments distributed on the
exempt market through the related EMD.
In the words of one witness, the various companies
were “all one organization… getting cars, leasing cars and
financing the leasing of those cars.”
What were the issues in this case?
Loan by the Finance Company to the Used-car Dealer
First, the finance company lent a large sum of money
to the used-car dealer to finance the inventory of cars. The
loan was unsecured and did not carry interest, which was
an inappropriate use of investors’ money.
Secondly, the non-interest bearing loan to a related
party constituted a conflict of interest which the exempt
market dealer was under an obligation to disclose to its
clients. However, at no time was the existence of the loan
disclosed to them.
Financial Condition of the Finance Company
Thirdly, the finance company was making losses. Its
financial condition was actually worse than indicated by
its accounting losses. All the car loans to the customers
of the used-car dealership were subprime loans. A large
sum of money was tied up in accounts receivable, most of
which were overdue and probably uncollectible. However,
no provision had been made for bad debts.
The EMD was under an obligation to disclose to its
clients the risks associated with the financial condition of
the finance company. However, no disclosure was made.
Fourth, the EMD did not take into account the risks
associated with the financial condition of the finance
company when recommending its securities to clients. It
therefore failed to discharge its suitability obligation.
Fifth, the marketing materials of the finance company
which the EMD made available to its clients were
misleading in many respects and consequently in breach
of securities legislation, which prohibits the making of
false statements about any matter that a reasonable
investor would consider relevant in deciding whether to
buy a security.
Source of Payments by the Finance Company
Finally, the finance company apparently repaid its
loans and made interest payments to its investors on the
due dates. However, the EMD was unable to explain the
source of the money used by the finance company to
service its loans.
Decision of the Securities Commission
The irregularities came to light in the course of two
compliance reviews by Staff of the securities commission.
At the end of the second review, Staff recommended the
suspension of the EMD’s registration.
The securities commission took into account the
issues we have just discussed. It concluded from the
EMD’s pattern of conduct that it lacked the integrity
required of a registered firm, and decided to suspend
its registration. It did not matter to the commission that
some of the issues implicated the finance company rather
than the EMD because both companies were owned and
managed by the same individuals and their businesses
were inextricably linked.
For more information contact:
Andre Fok Kam
The information in this article is based on the Ethics for
Exempt Market Dealer Representatives course offered by
IFSE Institute: www.ifse.ca.
1.Hodgkinson v. Simms ((1994) 3, S.C.R. 377)