Is Flexible Regulation Better for the Canadian Securities Markets?

Over the last few decades, we have witnessed changes in the way securities markets are regulated. New technologies and innovations have enabled various stakeholders and actors to contribute to this new governance. In this paper, I will explain the differences between the new flexible regulatory approach and the more traditional approach, with a focus on the benefits of the former and how it has been implemented in the Canadian securities markets. In order for flexible regulation to work, regulators and the regulated need to collaborate and come together to solve problems as opposed to only using a top-down model. The focus must be on outcomes in addition to process. Principles must guide registrants on how to exercise their best judgment to achieve outcomes that safeguard the integrity of the capital markets. Flexible regulation allows registrants to adapt to changing circumstances, solve problems as they arise and measure effectiveness.

Flexible Regulation Approach v Traditional

Cristie Ford states that we now live in a more complex, interconnected and globalized world; we must tailor our responses to these times, and not to earlier ones.^[1] Private sector innovation coupled with the right regulatory tools that engage the private market, reflect what some scholars have referred to as a complementarity approach, which neither delegates regulatory authority nor relies wholly on top-down approaches or belt-and-suspenders style duplication. Regulators and the private market work in tandem, each expending their resources according to their relative strengths.^[2]

Traditional approaches to regulation tend to focus on past examples of misconduct, while failing to anticipate future problems. In the aftermath of the Great Depression, most western countries were concerned with building a strong, positive state presence in response to the devastation caused to the economy.^[3] Then President Franklin Delano Roosevelt established the New Deal. This was widely understood as one of the most significant events in American politics in the 20^th century. As Bruce Ackerman has described:

. . . [a] half-century ago, our legal system was reeling under one of the greatest shocks in its history. Although America had experienced many depressions before, it had never confided political power to a leadership so evidently willing to respond by questioning the legitimacy of laissez faire itself.^[4]

President Clinton stated that the New Deal helped to restore our Nation to prosperity and defined the relationship between our people and their Government for half a century….That approach worked in its time. But we today, we face a very different time and very different conditions….the era of big government is over.^[5]

In a flexible approach, regulators can specify an objective, but then allow firms to self-evaluate and develop a set of internal rules that are consistent with achieving the regulators objectives. Government, industry and society share responsibility for achieving policy goals through a reflexive approach which is process-oriented and tailored to local circumstances. As Orly Lobel explains, the Renew Deal (21^st century) v. the New Deal (20^th century), is more negotiated rule making with audited self-regulation, performance-based rules, decentralized and dynamic problem solving, disclosure regimes, and coordinated information collection^[6]. Lobel also states that stakeholders now have more voice in the regulatory process as opposed to the old model that was a one-size-fits-all approach.

Julia Black sums up the changes to regulatory approaches perfectly: The most that can be drawn from existing research is that markets and law are in a reflexive relationship in which each influences the other, often in uncertain and unpredictable ways driven by dynamics that are not yet fully understood.^[7]A traditional regulatory model tends to be a formal top-down hierarchy, whereas a flexible approach is a more informal horizontal network, which is more integrated. In a flexible approach, all information is considered over a longer period of time and shared with regulators. This can also be called Ex-post (reactive, defensive) vs. Ex-ante (proactive).

Flexible Regulation and the Canadian Securities Market

In the Canadian securities market, a more principles-based approach to compliance and trading supervision has been recently introduced. Dealer members now have more flexibility in developing policies, procedures and systems of control that better address their particular compliance risks. No one supervisory system is appropriate for all market participants. There are differences in firms sizes, business lines, locations and jurisdictions in which they operate. Effective compliance can be achieved in a variety of ways. The Investment Industry Regulatory Organization of Canada (IIROC) now requires its dealer members to create a firm-specific risk-profile, detailing the firms greatest threats and risks depending on its business lines and exposure. Further, IIROC expects market participants are to have compliance policies and procedures designed reasonably to address compliance risks based on their size and the nature of businesses in which they are involved.

IIROC has recently granted greater flexibility to market participants in developing policies and procedures that better address their particular compliance and supervision risks, as well as technologies that are available to them. They have completely removed the Minimum Supervision standard and adopted a principles-based approach. The intention of the regulatory amendments is not to lessen the requirements and expectations of trading supervision, but rather to move away from a one-size-fits-all approach. Recent changes in market structure, technological advances in trading, as well as increased knowledge of compliance and supervisory professionals, have all contributed to the change from a prescriptive minimum supervision to a principles-based approach to supervision. These amendments have not lessened the supervision obligations of market participants, instead they have improved the framework for participants to identify and address higher-risk areas and activities.

Now that each market participant in Canada must develop, implement and maintain a risk-based supervisory system that identifies and prioritizes those areas that pose the greatest risk of violations of requirements, it will enable the participant to focus its review on the areas that pose a higher risk of non-compliance. The frequency of review and sample size used in reviews must be commensurate with the following, among other things:

• The participants size (considering factors such as revenue, market share, market exposure and volume of trades);
• The participants organizational structure;
• Number and location of the participants offices;
• The nature and complexity of the products and services offered by the participant;
• The number of registrants assigned to a location;
• The disciplinary history of registered representatives or associated persons;
• The risk profile of the participants business and any indicators of irregularities or misconduct i.e. red flags ^[8]

Many other jurisdictions have also made amendments to supervisory obligations: the US under FINRA rules and the UK under MiFID. Having a more flexible approach to regulation does not change the fact that participants will do whatever is necessary to protect their reputational damage. Sanctions and enforcement actions are always publicly disseminated amongst industry peers.

I believe that having custom tailored surveillance systems that are designed to keep firms compliant will benefit the industry overall and allow regulators to expend their resources in a more focused and effective manner and align market participants incentives with regulatory objectives.

Flexible Regulatory Approaches in an Enforcement Context

Flexible regulation should make enforcement more effective. For instance, if resources are focused on high-risk areas, regulation should be more effective in preventing violations. A decline in enforcement cases may be an indicator that a proactive approach is working (enforcement is reactive). Also, if the number of cases decline, more resources will be available to thoroughly investigate more egregious violations.

Firms that have had previous disciplinary proceedings, warnings or sanctions regarding their compliance supervisory systems are subject to more frequent regulatory examinations. This will prompt firms to adapt new procedures, which will avert future enforcement actions.

With a view to more effectively using investigative resources and encourage firms to improve their compliance practices to avert future enforcement actions, IIROC has recently proposed two new alternative forms of disciplinary action^[9]. One is a new Minor Contravention Program (MCP) under which an approved person or dealer member would agree to the imposition of a sanction for rule contraventions that are deemed minor. The MCP would provide a more efficient means to resolve cases that cannot be adequately addressed by way of a Cautionary Letter, but do not warrant formal disciplinary action. A key feature is that the sanction would be fixed at $2,500 per contravention for an approved person and $5,000 for a dealer member. Also, by agreeing to the MCP Notice, the approved person or dealer member would not be subject to a formal disciplinary record, and therefore would not be required to disclose it under disciplinary history on an application for registration. However, IIROC staff could rely on the admission at a future disciplinary proceeding against the approved person or dealer member. The second proposed alternative is the use of Early Resolution Offers. This would help to expedite settlement agreements to promote the efficient resolution of cases, increase the application of the IIROC Staff Policy Statement on Credit for Cooperation, encourage firms to take remedial measures and address investor harm through voluntary acts of compensation. These two changes in enforcement reflect a flexible approach to regulation.

Developing a strong working relationship with regulators is important in creating a culture of compliance that works to protect the integrity of the capital markets. A policing and enforcing approach only serves to strengthen the defences of the firms, which feel that they have their backs up against the wall. This will not have any social benefit and will dramatically increase compliance costs for the wrong reasons. A greater number of enforcement actions does not necessarily translate into improved compliance among firms. In a flexible regulatory approach, enforcement actions should only be pursued if there is strong evidence that the registrant has not shown any effort to self-supervise and educate the actors within the firm. Firms will tend to be much more collaborative in becoming proactive and working with regulators to deter wrongdoing.

John Armour states that there must be trust between market participants and regulators, otherwise they will be less forthcoming if regulators use the information provided by the market participants for future enforcement action. Regulators must also trust the participants in order to continue to grant the flexibility to design and implement customised systems and controls.^[10]