confused man

It is good to see the Canadian Investor Protection Fund (CIPF) board weigh in on the CSA’s review of self-regulation, given the CIPF’s integral role in the Canadian self-regulatory system. In its paper, the CIPF has restricted its comments to answering one key question: Should the CIPF remain as an independent body or should it be integrated into a future SRO?

The CIPF protects, within prescribed limits, client assets held by IIROC-registered firms in the event of a firm’s insolvency, in addition to managing the CIPF Fund for compensating client losses and administrating insolvencies of troubled IIROC firms. The CIPF coordinates closely with IIROC to ensure it obtains prompt notice from IIROC of a troubled situation possibly requiring compensation payments to clients through the CIPF Fund.

The CIPF paper describes the benefits of integrating the CIPF compensation fund into a consolidated SRO. The obvious cost savings come from shared infrastructure and operating efficiencies. Perhaps more importantly, significant benefits could be realized from the exchange of information and perspectives — and close ongoing staff collaboration — across the integrated operations of a consolidated SRO.

The CIPF paper raises serious caution, however, on the disadvantages of integrating with a regulator. The paper warns of the the risk of the compensation fund’s and regulator’s mandates drifting together, particularly under regulatory and political pressure in crisis situations. If a regulated firm faces financial difficulties, for example, the compensation fund could overstep its mandate, extending and expanding compensation to the assets of the troubled firm and its affiliates in order to stabilize investor confidence and calm the marketplace.

The risk of widening the scope of the compensation fund’s mandate, however, can be limited. First, the responsibilities and obligations of asset coverage should be well delineated through documentation and precedent to prevent merger creep.

The CIPF paper referred to a court ruling between the SEC and the U.S. Securities Investor Protection Corporation (SIPC) fund that brought more clarity on the limits of insurance coverage. The court did not uphold the SEC’s authority to compel SIPC coverage for investors who fell victims to Stanford’s Ponzi scheme. In another case, the UK Financial Services Compensation Scheme compensated clients of the FCA-regulated Woodford Equity Income Fund up to the maximum threshold following the firm’s collapse. Although these situations occurred with an independent standalone compensation fund, similar outcomes would have likely happened with an integrated fund-regulator structure given clear delineation of responsibilities for client compensation.

Second, an effective governance structure for the SRO body can be implemented to oversee and manage the defined mandates of the SRO and its responsibilities and its compensation fund. While it is possible that political pressures may override detailed responsibilities for client compensation defined in a mandate, such circumstances would be exceptional.

The complications of integrating the CIPF compensation fund into an SRO could be mitigated by well-defined responsibilities for client compensation and good governance. However, in the context of the current deliberations on SRO consolidation, the priority for the CIPF should be harmonization and integration of the two compensation funds in the investment industry: the CIPF for IIROC dealers and MFDA IPC for MFDA mutual fund dealers. The CIPF paper does not address this. Once this is done, the integration of the combined compensation funds into a consolidated SRO could follow.