CSA Staff Notice: 81-304, 33-303 - Trust Accounts for Mutual Fund Securities

CANADIAN SECURITIES ADMINISTRATORS' STAFF NOTICE 33-303,
81-304TRUST ACCOUNTS FOR MUTUAL FUND SECURITIES

Purpose

The purpose of this notice is to communicate the views of staff of each of the CanadianSecurities Administrators on compliance with section 12 of National Policy Statement No.39 ("NP 39"), which deals with commingling of money, by mutual fund dealers andsecurities dealers (collectively the "dealers"). In conducting compliance field reviews, staffhave noted certain inappropriate practices related to the use of trust accounts. This noticeis intended to assist dealers in complying with section 12 of NP 39 and to set out staff'sviews on the minimum internal controls appropriate to ensure dealers meet theserequirements.

Section 12 of NP 39 sets out requirements for the proper handling of client money duringthe period the dealer holds such money pending either investment in mutual funds or, inthe case of proceeds of redemption, delivery to the client (the "holding period"). An integralpart of section 12 is the requirement that dealers maintain a trust account. The primaryfunction of this trust account is to segregate money owned by clients relating to mutualfund purchases and redemptions from the dealer's own assets and other businessactivities. Segregation safeguards client assets by reducing the opportunity for loss to theinvestor during the holding period.

The revised versions of proposed National Instrument 81-102 Mutual Funds and proposedCompanion Policy 81-102CP, which are expected to replace NP 39 and which werepublished for comment on March 19, 1999, incorporate the position of staff set out below.

Designating a Trust Account

Section 12 of NP 39 requires that dealers maintain interest-bearing trust accounts. NP 39does not define the term "trust account" nor does it describe how such an account is to beestablished or maintained. Dealers have indicated that some financial institutions arereluctant to provide trust account services and hesitate to label and administer accountsopened to hold client funds as trust accounts. Staff are of the view that dealers areresponsible for ensuring that client funds retain their character as trust funds while ondeposit with financial institutions.

At the time of opening a trust account, a dealer should advise the financial institution inwriting that the account is established for the purpose of holding client funds in trust andthat the account should be labelled as a "trust account". The dealer should also advise thefinancial institution in writing at the time of opening the trust account that the money in theaccount is not to be withdrawn, including by means of electronic transfer, by any personother than authorized employees of the dealer and that the money in the trust account maynot be used to cover shortfalls in any other accounts of the dealer.

Commingling of Funds

Section 12 of NP 39 requires that a dealer separately account for money received for thepurchase or the redemption of mutual fund securities. The dealer shall not comminglesuch money with other assets of the dealer or with money held in trust for the purchase orthe sale of other types of securities. The dealer must maintain separate accounts, whichmay also be designated as trust accounts, for clearing trades in other types of securities.In the past, staff compliance examinations have revealed that some dealers havecommingled money relating to mutual funds with money relating to other securities, suchas guaranteed investment certificates, treasury bills and segregated funds. This practiceis contrary to the requirements of section 12.

 

Dealers should have appropriate internal controls in place to ensure that client moneyrelated to mutual fund purchases or redemptions continues to be separately accounted for,segregated from other business transactions and held in trust. These controls shouldinclude identifying the bank account in the general ledger of the dealer as a trust accountfor mutual fund clients so that employees and management who have authority to directcash transactions are aware of the purpose of this money. The dealer should maintainadequate staff to process purchase and redemption cheques and should ensure that itsstaff are properly trained. Staff are of the view that good internal controls will minimizeerrors and commingling of funds.

Allowable Expenses against Trust Account Interest

Section 12 of NP 39 states that dealers should not use any money received for investmentin mutual funds to finance their own operations. Costs associated with client cheques thatare returned due to insufficient funds to cover a trade (i.e. NSF cheques) should be borneby the dealer and should not be offset by interest income earned in trust accounts. Staffare of the view that it is inconsistent with the nature of a trust account for service chargesor any other fees or expenses to be paid out of funds held in a dealer's trust account.

Advancing Funds to Clients

Staff have identified instances where dealers have advanced funds to clients to covertrades until cash is received. This type of "bridge financing" exposes the registrant to addedbusiness risk that may not be contemplated in the dealer's calculation of its requiredcapital. If a dealer follows the practice of advancing funds to clients, it should adjust itscapital calculation on a regular basis by implementing the cash account rule used by theself-regulatory organizations. In no circumstances should such funds be paid out of a trustaccount maintained pursuant to section 12 of NP39. Dealers should report to staff andremedy any capital deficiencies immediately.

Staff have also identified the practice of "lapping" as a form of bridge financing. Lappingoccurs as a result of the timing between the trade date and the settlement date. Clientfunds held for unsettled trades are used to settle other client trades that do not haveadequate funds to cover such trades. Staff consider this practice by dealers to be aninappropriate use of client trust funds and the practice, if followed, should be discontinuedimmediately.

Reconciliations and Internal Controls

All dealers participating in the distribution of securities of a mutual fund have a duty toinvestors to ensure that money has been invested appropriately and on a timely basis. Thedealer must ensure that it is adequately organized and that there are adequate facilitiesand procedures to fulfill this obligation.

Ensuring appropriate and timely investing of money is most effectively done by reconcilingthe trust account to the trading and accounting records of the dealer on a timely basis.Reconciliation will ensure completeness and accuracy of all cash transactions whencompared to trading and accounting records. Reconciliations should be performed at leastmonthly. Where the volume of transactions is large, it may be appropriate to performreconciliations more frequently, such as weekly or daily.

It is important that dealers review reconciliations and clear reconciling items on a timelybasis. This review ensures accuracy of cash transactions and acts as an additional controlover the trust account. Dealers should also ensure that there is adequate segregation ofthe accounting, cash and review functions for the trust account(s) in order to ensure thatinternal controls are effective.

Securities legislation requires that dealers maintain adequate books and records necessaryto record properly their business transactions and financial affairs. Reconciliations andsupporting documents that evidence review and clearing of items are an integral part of adealer's business records.

Requirements in British Columbia

Certain of the requirements of NP 39 set out above are also imposed on dealers underBritish Columbia securities legislation. Section 57(2) of the British Columbia SecuritiesRules (the "Rules") requires dealers to deposit clients' free credit balances into a trustaccount immediately upon their receipt by the dealer. Any interest earned on these fundsmust accrue to the credit of clients.

Section 58 of the Rules requires that any subscriptions or prepayments held by dealers forclients pending investment must be held in a trust account for clients separate from thetrust account referred to above and must be segregated from the dealer's own assets. Anyinterest earned on these subscriptions or prepayments must accrue or be paid to the creditof the clients or, at the option of the dealer, the mutual fund (where these subscriptions orprepayments relate to the purchase of mutual fund securities).

Proposed amendments to the Rules, which were published for comment in the BritishColumbia Securities Commission's Weekly Summary on March 19, 1999, clarify thatcertain requirements set out in sections 57 and 58 of the Rules do not apply if a registrantis a member of certain self regulatory organizations or if a registrant complies with the trustaccount provisions set out in proposed National Instrument 81-102.

Questions

Please direct any questions to:

Wayne Alford	Alberta Securities Commission	(403) 297-2092
Doug Brown	Manitoba Securities Commission	(204)945-2548
Terry Ford	Saskatchewan Securities Commission	(306) 787-5876
Mark Gallant	Registrar of Securities, Prince Edward Island	(902) 368-4552
Elaine Anne MacGregor	Nova Scotia Securities Commission	(902) 424-4592
Ross McLennan	British Columbia Securities Commission	(604) 899-6685
Renée Piette	Commission des valeurs mobilières du Québec	(514) 940-2199
Susan Powell	Department of Government Servicesand Land, Newfoundland and Labrador	(709) 729-4189
Richard Roberts	Registrar of Securities, Government of the Yukon	(867)667-5225
Donne Smith, Jr.	Office of the Administrator, NewBrunswick	(506) 658-3060
Irene M. Tsatsos	Ontario Securities Commission	(416) 593-8223
Katharine Tummon	Registrar of Securities, Governments ofthe Northwest Territories and Nunavut	(867)873-7490

Dated May 14, 1999