The Mutual Fund Dealers Association has issued a notice that warns firms and their reps against selling exempt securities where they have a direct or indirect interest.

The MFDA says that its staff has become aware of situations where clients of MFDA members have been sold exempt securities of non-arm’s length issuers such as: shares or debentures in corporations owned by members or reps; promissory notes issued by entities related or connected to dealers or reps; securities guaranteed directly by the member; investments in limited partnerships where reps act as general partner or manager; and, other ventures such as investments in land developments, factoring corporations and mortgage investments.

“MFDA staff is of the opinion that the practice of selling exempt securities of issuers in these and similar situations cannot generally be done in accordance with the requirements of [its rules],” the notice says.

The notice points out that in cases where dealers or rep have a significant interest in securities or other products being sold to clients through the MFDA member “there is a material conflict of interest that… must be addressed by the exercise of responsible business judgment influenced only by the best interests of the client.”

It notes that provincial securities legislation requires certain disclosure for the sale of securities of a related party by way of prospectus. But, with exempt securities, the MFDA says that there are additional factors that must be considered and “disclosure alone will not be sufficient to address the conflict”.

Concerns include the fact that exempt securities are not reviewed by any securities commission prior to issue, and are not subject to the same types of controls and disclosures as securities sold by prospectus. Therefore, “even where there is disclosure of the inherent conflict to clients, it is the view of MFDA staff that there will be few circumstances where [dealers or reps] would be able to demonstrate that the conflict has been adequately dealt with through the exercise of responsible business judgment influenced only by the best interests of the client.” It adds that this view is consistent with that of some of the securities commissions.

It also stresses that transactions with respect to such securities cannot be structured as referral arrangements to avoid conflict concerns. “The use of a referral structure does not address the conflict issue,” it adds.

The notice adds that exceptions may apply to: exempt securities that are issued or guaranteed by an appropriately regulated financial institution such as a Schedule I or II chartered bank, credit union or trust company; and, securities managed by related investment counsel/portfolio managers.