12.2 Scope of this Section

In this section the expression "market intermediaries" generally includes those who are in the business of managing individual portfolios, executing orders, dealing in or distributing securities and providing information relevant to the trading of securities.

Regulation for the various types of intermediaries should address entry criteria, capital and prudential requirements, ongoing supervision and discipline of entrants, and the consequences of default and financial failure.

The oversight of market intermediaries should primarily be directed to the areas where their capital, client money and public confidence may most be put at risk. ⁴² These include the risks that:

• incompetence or poor risk management may lead to a failure of due execution, a failure to obtain due settlement or a failure to provide adequate advice;
• breach of duty may lead to misappropriation of client funds or property, the misuse of client instructions for the intermediary's own trading purposes ("front running" or trading ahead of customers), manipulation and other trading irregularities, or fraud on the part of the intermediary or its employees;
• the insolvency of an intermediary may result in loss of client money, securities or trading opportunities, and may reduce confidence in the market in which the intermediary participates.

12.3 Licensing and Supervision

The licensing ⁴³ and supervision of market intermediaries should set minimum standards for market participants and provide consistency of treatment for all similarly situated intermediaries. It should also reduce the risk to investors of loss caused by negligent or illegal behaviour or inadequate capital. The licensing process should require a comprehensive assessment of the applicant and all those who are in a position to control or materially influence the applicant. The licensing authority should have the power to reject applications that do not meet the standards set.

The licensing authority should also have the power to withdraw or suspend the license or otherwise sanction the licensee whenever the entry criteria are not fulfilled.

Changes of control or material influence should be made known to the competent authority in order to ensure that its assessment on the intermediary remains valid. The regulator should be empowered to withdraw a licence or authorization where a change in control results in a failure to meet relevant requirements.

The following matters should be the subject of consideration:

• Regulation should set conditions of entry that make clear the basis of participation. The entry conditions should be consistently applied and need not be determined by the regulator, but where for example it is the responsibility of a self-regulatory organization, the process should be subject to appropriate oversight by the regulator.
• Regulation should determine whether participation in the market by an intermediary should be based upon a demonstration of appropriate knowledge, resources, skills and ethical attitude (including a consideration of past conduct). ⁴⁴
• The regulator should have the authority to refuse licensing of an intermediary if these requirements have not been met.
• There should be an initial capital requirement for securities firms as a condition of entry into the market. This ensures that the owners of the business have a direct financial stake in the business. The capital requirement should be maintained and should be the subject of periodic reporting to the regulator or competent SRO. The ongoing capital requirement should be directly related to the nature and amount of business undertaken by an intermediary. The financial position of the intermediary should be regularly audited by independent auditors.

To ensure that continued licensing remains appropriate, there should be a requirement for periodic updating of relevant information and a requirement for reporting material changes in circumstances affecting the conditions of licensing.

To enable investors to better protect their own interests, the regulator should ensure that the public have access to relevant information concerning the licensee, such as the category of license held, the scope of its authorized activities, the identity of senior management and those authorized to act in the name of the intermediary. ⁴⁵

12.4 Capital Adequacy ⁴⁶

The protection of investors and stability of financial systems are increased by an adequate supervision of ongoing capital standards.

Capital adequacy standards ⁴⁷ foster confidence in the financial markets and should be designed to allow a firm to absorb some losses, particularly in the event of large adverse market moves, and to achieve an environment in which a securities firm could wind down its business over a relatively short period without loss to its customers or the customers of other firms and without disrupting the orderly functioning of the financial markets. Capital standards should be designed to provide supervisory authorities with time to intervene to accomplish the objective of orderly wind down.

A firm should ensure that it maintains adequate financial resources to meet its business commitments and to withstand the risks to which its business is subject. Risk may result from the activities of unlicensed and off balance sheet affiliates and regulation should consider the need for information about the activities of these affiliates.

A capital adequacy test should address the risks faced by securities firms judged by reference to the nature and amount of the business undertaken by the firm.

12.5 The Conduct of Business Rules and Other Prudential Requirements ⁴⁸

Market intermediaries should conduct themselves in a way that protects the interests of their clients and helps to preserve the integrity of the market. ⁴⁹

The management of a market intermediary should bear primary responsibility for ensuring the maintenance of appropriate standards of conduct and adherence to proper procedures by the whole firm. This includes the proper management of the risks associated with the business of the intermediary. ⁵⁰ Regulation should not be expected to remove risk from the market place, ⁵¹ but it should ensure that there is proper management of that risk. Periodic evaluation of risk management processes within a regulated entity is appropriate. SROs and third parties, such as external auditors, may be used to assist in this process.

Instances of operational breach can occur despite the existence of internal procedures designed to prevent the relevant misconduct or negligence. It is not practical for the regulator to oversee adherence to those internal procedures on a day to day basis. That is the responsibility of the senior management of the intermediary. Senior management must ensure that they are able to discharge that responsibility. They must themselves understand the nature of the firm's business, its internal control procedures and its policies on the assumption of risk. They must clearly understand the extent of their own authority and responsibilities. They must have access to all relevant information about the business on a timely basis and have available to them all necessary advice on that business and on their own responsibilities. That information must also be available to the regulator upon request.

The details of the appropriate internal organization of a firm will vary according to the size of the firm, the nature of its business and the risks it undertakes but generally regulation of market intermediaries should adhere to the following standards.

• Integrity and Diligence - A firm should observe high standards of integrity and fair dealing and should act with due care and diligence in the best interests of its customers and the integrity of the market.
• Terms of Engagement - A written contract of engagement with a customer will generally be necessary and appropriate. A firm should similarly be ready to provide a customer with a full and fair account of the fulfillment of its responsibilities to the customer.
• Information About Customers - A firm should seek from its customers any information about their circumstances and investment objectives relevant to the services to be provided. Policies and procedures should be established which ensure the integrity, security, availability, reliability and thoroughness of all information, including documentation and electronically stored data, relevant to the firm's business operations. Where the activities of an intermediary extend to the giving of specific advice, it is of particular importance that the advice be given upon a proper understanding of the needs and circumstances of the customer: a matter generally encompassed in the rule of conduct that the intermediary must "know your client".
• Information for Customers - A firm should make adequate disclosure to its customers, in a comprehensible and timely way, of information needed to make a balanced and informed investment decision. It may be necessary for regulation to ensure disclosure in a particular form where products carry a risk that may not be readily apparent to the ordinary investor. Recruitment and training should ensure that staff who provide investment advice understand the characteristics of the products they advise upon. ⁵²
• Customer Assets - Where a firm has control of or is otherwise responsible for assets belonging to a customer which it is required to safeguard, it should arrange proper protection for them (for example, segregation and identification of those assets) in accordance with the responsibility it has accepted. These measures are intended to: provide protection from defalcation; facilitate the transfer of positions in cases of severe market disruption; prevent the use of client funds for proprietary trading or the financing of an intermediary's operations; and assist in orderly winding up upon the insolvency of an individual firm should that be necessary.
• Market Practice - A firm should observe high standards of market conduct, and it should also comply with any relevant law, code or standard as it applies to the firm. The firm's compliance with all applicable legal and regulatory requirements as well as with the firm's own internal policies and procedures should be monitored by a separate compliance function that reports directly to senior management in a structure that makes it independent from operational divisions.
• Operational Controls - Effective policies and operational procedures and controls in relation to the firm's day-to-day business operations should be established. The "effectiveness" of those operational procedures and controls should be evaluated in the light of whether they serve reasonably to ensure:
1. an effective exchange of information between the firm and its clients, including required disclosures of information to clients;

2. the integrity of the firm's dealing practices, including the treatment of all clients in a fair, honest and professional manner;

3. the safeguarding of both the firm's and its clients' assets against unauthorized use or disposition;

4. the maintenance of proper accounting and other applicable records, and the reliability of the information; and

5. compliance with all relevant legal and regulatory requirements;

6. appropriate segregation of key duties and functions, particularly those duties and functions which, when performed by the same individual, may result in undetected errors or may be susceptible to abuses which expose the firm or its clients to inappropriate risks.
• Conflicts of Interests - A firm should try to avoid any conflict of interest arising but, where the potential for conflicts arise, should ensure fair treatment of all its customers by proper disclosure, internal rules of confidentiality or declining to act where conflict cannot be avoided. A firm should not place its interests above those of its customers.
• Proprietary Trading - There should be clear policies within the firm covering the circumstances in which proprietary trading is permitted. The regulator should obtain information about a regulated firm's own proprietary trading and determine that the firm's net capital is adequate in relation to the risk associated with its proprietary trading. The information provided should be sufficient to allow for an understanding of the overall business and risk profile of a firm and its affiliates. It should also allow for the regulation of margin trading and the detection of conflicts of interest or manipulative practices.

12.6 Action in the Event of Financial Failure of an Intermediary ⁵³

Failure of an intermediary may have systemic consequences.

The regulator should have a clear plan for dealing with the eventuality of failure by market intermediaries. The circumstances of financial failure are unpredictable so the plan needs to be flexible.

The regulator should attempt to minimize damage and loss to the investor caused by the failure of an intermediary. A combination of actions to restrain conduct, ensure that assets are properly managed and provide information to the market may be necessary.

Depending upon the prevailing domestic bank regulatory model, it may also be necessary to cooperate with banking regulators, and if the domestic arrangements require it, insolvency regulators. As a minimum position, the regulator should have identified contact persons at other domestic and key foreign regulators.

12.7 Supervision of Intermediaries

Regulation should ensure that there is proper ongoing supervision with respect to market intermediaries. ⁵⁴

Regulation should provide for:

• Powers of Inspection - The right to inspect the books, records and business operations of a market intermediary should be available to a regulator to ensure compliance with all relevant requirements, even in the absence of a suspected breach of conduct. There must be complementary requirements for the maintenance of comprehensive records.
• Powers of Investigation and Enforcement - The full range of investigatory powers and enforcement remedies discussed in this document, at Section 8, should be available to the regulator or other competent authority in cases of suspected or actual breach.
• Discipline and Revocation - There must be a fair and expeditious process leading to discipline and, if necessary, suspension or revocation of a licence.
• Discipline and licence revocation could be delegated to an acceptable SRO but only with regulatory oversight and not on an exclusive basis.
• Complaints - There should be an efficient and effective mechanism for the resolution of investor complaints.

12.8 Investment Advisers

Investment advisers are those principally engaged in the business of advising others regarding the value of securities or the advisability of investing in, purchasing or selling securities.

If an investment adviser also deals on behalf of customers, the capital and other operational controls discussed above as applicable to other market intermediaries also should apply to the adviser. If the adviser does not deal, but is permitted to have custody of client assets, regulations should provide for the protection of client assets, including segregation and periodic inspections (either by the regulator or an independent third party).

In regulating the activities of investment advisers, the regulator may elect to place emphasis on the substantive licensing criteria, and the capital and other requirements recommended for regulation of other market intermediaries in Sections 12.3 - 12.6. Alternatively, the regulator may opt for a disclosure based regime designed to permit potential advisory clients to make an informed choice of advisers.

At a minimum however, the regulatory scheme selected should contain the following elements:

• a licensing regime that is sufficient to establish authorisation to act as an investment adviser and to ensure access to an up to date list of authorised advisers;
• bars against the licensing of persons who have violated securities or similar financial laws, or criminal statutes during a specified time period preceding their application;
• record keeping requirements;
• clear and detailed requirements setting out the disclosures to be made by the adviser to potential clients, including: descriptions of the adviser's educational qualifications, relevant industry experience, disciplinary history (if any), ⁵⁵ investment strategies, fee structure and other client charges, potential conflicts of interest, and past investment performance (if relevant). Disclosure should be required to be updated periodically and as material changes occur;
• rules and procedures designed to prevent guarantees of future investment performance, misuse of client assets, and potential conflicts of interest;
• inspection and enforcement powers;

There are investment advisers who neither deal on behalf of clients nor hold client assets nor have custody of client assets nor manage portfolios, but who only offer advisory services without at the same time offering other investment services. In this case it may be sufficient if the market intermediaries on whose services these investment advisers advise are adequately licensed according to the principles stated above; therefore, separate licensing of the investment adviser may not be strictly required.