The Incorporation Conundrum for Investment Advisors

April 2024 Legal Moment

An ongoing topic of discussion in the financial services market is whether a sole proprietor investment advisor is permitted to incorporate under the Investment Industry Regulatory Organization of Canada (“IIROC”) regime.

The respective regulatory bodies for lawyers and doctors, and for financial advisors licensed by the Mutual Fund Dealers Association of Canada (“MFDA”), all permit the establishment of personal or professional corporations to operate their businesses, often subject to certain regulations and limitations. However, the ability of IIROC regulated advisors to incorporate is not entirely clear.

Investment advisors are feeling left out as they cannot benefit from enhanced tax efficiencies of incorporation, for example, by diverting the commissions received from their dealers into a corporation that is taxed at the lower corporate tax rate. Further, they cannot take advantage of other methods of using a corporation to control their earned income or generate investment income from funds they choose to retain within the corporation.

On the other hand, complete protection from personal liability would potentially expose the investment  advisors’ clients to significant risk. Physicians and lawyers, for example, are permitted to incorporate but are not permitted to avoid personal liability for professional errors or negligence. Regulators under the IIROC regime, with their concerns for protection of the general public, would also wish to prevent advisors being afforded personal liability protection.

A. Legal Position

As per IIROC Rule 1201(2) (Definitions), an ‘Approved Person’ is defined as follows:

“An individual approved by IIROC under the IIROC requirements to carry out a function for a Dealer Member, namely, the following individuals:

Associate Portfolio Manager, Chief Compliance Officer, Chief Financial Officer, Director, Executive, Investment Representative, Portfolio Manager, Registered Representative, Supervisor, Trader, or Ultimate Designated Person. ”

Generally, investment advisors fall under the category of ‘Registered Representative’, which in turn is defined as:

“An individual approved by IIROC to trade, or advise on trades, in securities, options, futures contracts, or futures contracts options with the public in Canada, on the Dealer Member’s behalf, including where that individual deals only in mutual funds or only with institutional clients.”

IIROC Rule 2551(7) (Individual Approval) explicitly provides:

“An Approved Person must not accept, nor allow an associate to accept, directly or indirectly, any pay, wages, salary, fees, gratuity, advantage, benefit or other consideration from any person other than the Dealer Member, its related companies, or affiliates for any Dealer Member related activities carried out by the Approved Person.”

The foregoing analysis signifies that IIROC rules may not, at this stage, allow investment advisors to incorporate a corporation, which would be tantamount to such advisors indirectly accepting payments from a source that is not a Dealer Member.

Investment advisors need to be mindful of the fact that any contravention of the IIROC Rules, securities  legislation or requirements relating to trading or advising in respect of securities, commodities contracts or  derivatives can expose them to IIROC investigation and enforcement proceedings, resulting in a range of sanctions, commensurate with the contravention in question, including fines up to $5 million per contravention, disgorgement, conditions imposed on approval or membership, suspensions, and barriers to membership.  There can also be significant related legal and administrative costs associated with any contravention hearing.

B. Regulatory Position

Canadian Securities Administrators (“CSA”) formed a working group to conduct a detailed review of the existing framework for the industry’s self-regulating organizations, namely IIROC and MFDA. CSA produced a ‘Position Paper 25-404’, dated August 03, 2021, setting out the CSA’s position and intention to allow such incorporation in the future, as part of wider discussions to merge IIROC and MFDA. As per our discussions with the IIROC officials, such merger is anticipated to occur by the end of 2022, but nothing can be said with certainty at this stage, given the political considerations attached to such decision making.

C. Conclusion

We are advising our investment advisors’ clients to err on the side of caution, as incorporation may not be advisable at this stage, from a legal or regulatory perspective. This is also the position of IIROC representatives. Given the anticipated timing for a potential MFDA and IIROC merger by the end of this calendar year, we are advising our clients to defer this decision for a year to see what the combined regulations of an amalgamated entity might permit. If a client decides to continue with incorporation (which many IIROC-regulated advisors have already done), it will be at the sole risk of the advisor, fully informed as to the potential consequences.

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