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As online securities trading has grown rapidly over the past several years, particularly in the United States, Canadian brokers and stock exchanges have been struggling to compete cost-effectively with their U.S. counterparts. Many Canadian “retail” investors have turned to U.S. online brokers to handle their trading in foreign and interlisted Canadian securities, due to faster execution times, better service and lower commissions. Although there are securities law constraints on foreign brokers dealing with Canadian residents, many U.S. online brokers will accept Canadian accounts, even though they are not licensed as broker-dealers in Canada. There does not appear to be much that the Canadian regulators can do to stop foreign online brokers from dealing with Canadian clients, short of bringing regulatory action against the Canadian clients themselves. INDUSTRY APPLICATION FOR REGULATORY RELIEF In response to this predicament, a group of Canadian online and discount brokers made a formal application in August 1998, seeking relief from Canadian regulatory requirements that were restricting their ability to compete cost-effectively with foreign online firms. In particular, this industry group urged the Canadian securities regulators to eliminate the know-your-client and suitability obligations for online or discount brokerage accounts where no advice is given to clients. Canadian online and discount brokers argued that this would speed up execution and reduce transaction costs without undermining investor protection. KNOW-YOUR-CLIENT AND SUITABILITY RULES The know-your-client and suitability obligations have been cornerstones of Canadian investor protection for many years. Historically, these rules have compelled licensed securities brokers to collect information regarding a client’s investment objectives when an account is opened. Brokers must then evaluate each individual trade for the client’s account, to ensure that it is “suitable” for the client, based on the initial information collected. Strict adherence to these requirements has enhanced investor confidence in the public markets and has advanced Canada’s reputation as a fair place to invest and raise capital. Recent changes in technology and the way in which securities are traded in the retail markets have raised serious questions for Canadian regulators as to whether the rules should be maintained, particularly for online and discount brokers where orders are not being solicited. INDUSTRY ASSOCIATION AND STOCK EXCHANGE SUPPORT In response to the application brought by the Canadian online firms, the Investment Dealers’ Association of Canada (IDA) and the Canadian stock exchanges formed a working group to consider the issue of direct retail access within the context of Canada’s suitability rules. This working group of self-regulatory organizations (SROs) concluded that the current suitability rules in Canada should be amended to allow brokers to offer a type of “order-entry only” account in which customers could make and execute their own investment decisions without trade-by-trade suitability reviews by their brokers. This would eliminate the undue delay resulting from the requirement that brokers manually evaluate each client order for suitability before executing it. In a broad sense, this proposal was consistent with U.S. regulations that only impose a suitability obligation on brokers for securities transactions recommended by the broker. SPECIAL PARAMETERS FOR ONLINE AND DISCOUNT BROKERAGE ACCOUNTS The SRO working group developed a set of parameters within which it recommended that online and discount brokers might operate “order-entry only” accounts without assessing suitability on a trade-by-trade basis. These parameters included the following: � The client would have to agree to maintain an order-entry only account and acknowledge responsibility for any profits or losses as a result of investment decisions made in that account. � The broker would not be permitted to provide tailored investment advice or “recommendations” to holders of order-entry only accounts. � All order-entry only account transactions would have to be “unsolicited.” � Full-service brokers would be permitted to offer both full-service and order-entry only accounts to clients, provided that the full-service and order-entry only accounts were offered through separate divisions of the firm, with a clear distinction between the nature of the services provided by each division. � After-the-fact reviews would be carried out on a daily and monthly basis to allow the broker to intervene where the client incurred mounting losses in the account. INVESTOR PROTECTION CONCERNS Despite the efforts of the SRO working group to develop a responsible approach to the problem faced by online and discount brokers in Canada, the provincial securities commissions in Canada have been unable to reach a consensus that would see them implement the recommendations of the SRO working group. A variety of investor protection concerns has interfered with the consensus-building exercise that is a prerequisite to any national securities regulatory action in Canada. One significant regulatory concern relates to the recommendation that full-service brokers would be permitted to offer order-entry only accounts as well as traditional advisory services. This could result in clients having advisory as well as discount or nonadvisory accounts with the same broker, potentially leading to client confusion about the nature of the services being provided. As well, there is concern that it will be difficult to determine what constitutes a recommendation when a full-service firm offering both types of accounts is broadly disseminating investment advice through web site publications, newsletters and research reports. Clients maintaining order-entry only accounts will inevitably be able to access and use this kind of information, particularly if they are able to maintain both types of accounts at a particular brokerage firm. The SRO working group concluded that the key issue in determining whether information dissemination would constitute a recommendation is whether the information is pushed out to particular clients or targeted members of the public by the broker. However, as long as a brokerage firm is pushing out the information to particular clients or members of the public in support of advisory account services, there is nothing to prevent clients or the investing public from acting on this information by using an order-entry only account with the same firm. From the regulators’ perspective, this might mean that substantially all trading of securities would gravitate to order-entry only accounts where the client could obtain faster execution at a lower cost, because orders need not be intercepted for trade-by-trade evaluation as to suitability. TIMETABLE FOR RESOLUTION With the industry group’s formal application fast approaching the second anniversary of its filing without a ruling, the Canadian securities regulators are under considerable pressure to provide some measure of relief for Canadian online and discount brokers, even if it is an interim solution. There is a risk, however, that the provincial securities regulators will not act in concert, with the result that the rules will not be consistent across Canada. Even if consensus can be reached, it is unlikely that the amended rules will go as far as the industry and the SRO working group have been seeking or recommending. This means that Canadian clients may continue to find that foreign online brokers are able to provide a more user-friendly service at a lower cost than their Canadian counterparts. Mark J. DesLauriers is a partner and co-head of the corporate finance group in the Toronto office of Osler, Hoskin & Harcourt.

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