PrefBlog

The regulators have decided I don’t pay enough tax, so in accordance with CSA Staff Notice 31-338 Guidance on Dispute Resolution Services Client Disclosure for Registered Dealers and Advisers that are not members of a Self-Regulatory Organization I have joined the Ombudsman for Banking Services and Investments and, more importantly, paid my OBSI Portfolio Manager Membership Fee. Assiduous Readers will be relieved to learn that since this fee is not actually charged by a Securities Commission, I do not expect it to be included when the various commissions discuss the rate of increase in regulatory fees.

I haven’t had a single complaint in the fourteen years I’ve run my own shop, and none in the eight years before that during which I was with Greydanus, Boeckh & Associates, Inc., but who knows? Tomorrow there might be a flood.

Procedures for clients with complaints are detailed on the Hymas Investment Management Inc. website under the heading "Complaints".

PrefInfo has been updated to 2014-6-8.

As always, finding an error will win you a PrefLetter … just let me know about it and if I agree it’s an error, you’ll get a free copy!

I’m more of a portfolio manager than a financial planner, so it was only recently that I learned of Flaherty’s little-known legacy for a largely forgotten minority:

The RDSP is a cousin of the Registered Retirement Savings Plan (RRSP) but tweaked to fit the needs of those with physical, developmental and psychiatric disabilities.
…
Under the program, money can be set aside for a person with a disability (by family or the person him– or herself) and investments accrue tax-free; the RDSP is much like a RRSP, except withdrawals can begin at age 45. For example, the parent of a 15-year-old who puts $200 a month into the plan would provide her with an additional $2,500 a month by age 65. Also, the rules are such that her other income, such as disability benefits, would not be clawed back as a result.
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What distinguishes it from a RRSP is that the federal government also makes a contribution, like it does with the Registered Education Savings Plan, but far more generous. Those eligible for a RDSP can get a grant of up to $3,500 a year, and low-income parents can receive an additional Disability Savings Bond of up to $1,000 annually.
…
The main knock on the program is that it takes a lot of paperwork – which is the reality with any program with eligibility. In this case, a person’s disability has to be so severe that they qualify for a Disability Tax Credit.

The main Revenue Canada web page which has links to Eligibility Requirements:

You can designate an individual as beneficiary if the individual:
•is eligible for the disability tax credit (DTC);
•has a valid social insurance number (SIN);
•is a resident in Canada when the plan is entered into; and
•is under the age of 60 (a plan can be opened for an individual until the end of the year in which they turn 59).The age limit does not apply when a beneficiary’s RDSP is opened as a result of a transfer from the beneficiary’s former RDSP.

… and links to grant information and savings bonds:

An RDSP can get a maximum of $3,500 in matching grants in one year, and up to $70,000 over the beneficiary’s lifetime. A grant can be paid into an RDSP on contributions made to the beneficiary’s RDSP until December 31 of the year the beneficiary turns 49.

The amount of the grant is based on the beneficiary’s family income. The beneficiary family income thresholds are indexed each year to inflation. The income thresholds for 2013 are as follows:

Amount of CDSG grant when family income is $87,123 or less:
•on the first $500 contribution—$3 grant for every dollar contributed, up to $1,500 a year.
•on the next $1,000 contribution—$2 grant for every dollar contributed, up to $2,000 a year.

Amount of CDSG grant when family income is more than $87,123:
•on the first $1,000 contribution—$1 grant for every dollar contributed, up to $1,000.

… and the savings bonds part …

A Canada disability savings bond (bond) is an amount paid by the Government of Canada directly into an RDSP. The Government will pay bonds of up to $1,000 a year to low-income Canadians with disabilities. No contributions have to be made to get the bond. The lifetime bond limit is $20,000. A bond can be paid into an RDSP until the year in which the beneficiary turns 49.

The amount of the bond is based on the beneficiary’s family income. The beneficiary family income thresholds are indexed each year to inflation. The income thresholds for 2013 are as follows:
•$25,356 or less (or if the holder is a public institution), the bond is $1,000;
•between $25,356 and $43,561, part of the $1,000 is based on the formula in the Canada Disability Savings Act;
•more than $43,561, no bond is paid.

This doesn’t really have a lot to do with preferred shares, I agree. But while I don’t consider myself to be a financial planning specialist, I do know more about financial matters than most people … and I’d never heard of this. Right off the top of my head, I knew of two families who might be eligible.

So … I decided this needed some more publicity, and this is it.

IIROC has announced the release of the hearing panel’s decision on the vindication of David Berry.

The decision is nine pages long; about half of it is interesting:

¶ 38 Berry was a highly successful trader of preferred shares. By the time of his termination in 2005, he commanded more than 60% of the preferred share market in Canada. His income had soared to $15 million a year. In fact, he was so successful that his supervisors asked Compliance to be particularly vigilant, and presumably they were.

¶ 39 What made him so successful? His counsel suggests that, in part, it was “because he was willing to take more risks than his competitors, including by taking short positions.” The evidence supports this view. Indeed, there were recurring arguments about this between him and the syndication desk. Berry would want to short some new issue and Syndication, perhaps being more risk-averse, didn’t. So he did it by himself in the 08 account.

That’s a nice “perhaps”. Perhaps more risk-averse, certainly. Perhaps being too dumb, or too disingenuous, to realize or admit that a particular new issue was grossly overpriced. That’s another perhaps.

But … shorting shares! Gasp! What does IIROC’s counsel have to say about that, I wonder?

¶ 49 New issue shares can be shorted. This does not constitute, as enforcement counsel submitted, “creating shares out of the ether.” Underwriters are generally allowed to over-allot new issue shares to satisfy demand, and that is accomplished by shorting the security: see, for instance, IDA Syndicate Practices Handbook, p. 10, which provides that in preferred and equity financing

… the syndicate manager is authorized, in its discretion, and in compliance with applicable laws and regulations, to purchase and sell securities of the issuer in the open market, for long or short account, at such prices as the syndicate manager may determine, and to overallot underwritten securities, and may liquidate any such position.
(Emphasis added.)
The only caveat to this provision is that “at any time such positions do not exceed 15% of the underwriting obligation.

¶ 50 The rule cited above clearly states that this type of overallotment may be done by the “syndicate manager.” This excludes Berry, but he is not charged with violating Syndicate policies, which he may well have, but on which we pass no judgment. We note, however, that prior to his dismissal, his employer had no written syndication process policies or procedures.

¶ 51 IIROC recognizes that shares could be sold short, but only when there is demand. In our view, Berry’s sales to clients constituted demand. Berry represented to his clients the availability of a new issue and clients understood that they were buying a new issue. He therefore, on behalf of his firm, made a commitment to deliver new issue shares, and what he sold, long or short, were new issue shares. That he “ran his own parallel new issue book,” as enforcement counsel suggests, we do not disagree with but, once again, he is not charged with violating syndication procedures.

¶ 52 Finally, IIROC submits that clients did not know that they were purchasing against shorts. True, but clients never know that they are buying from a short seller, and there is no requirement to disclose this to a purchaser.

So there you have it. No case at all, just garbage hoked up by a pack of lawyers and regulators who have absolutely no clue about markets and care less.

The whole thing reflects very poorly on Scotia, and illustrates the reasons behind Canada’s productivity problems relative to the US. David Berry had a good idea: making markets – even poor ones – in preferred shares was a lot more profitable than acting as agent. Also, keep your clients happy. So he applied his idea.

I understand there is a very fundamental difference in atmosphere between Canadian and US brokerages. If you have a good idea at a US brokerage, you bring it up with your supervisor – maybe some others as well – and try to get some resources to develop it, whether that’s capital, or legal time, or whatever. The common organizational response to such an initiative is along the lines of: “OK – we’ll let you have the capital. If it all works out, you’ll get rich. If it really works out, you’ll get stupid-rich. If it doesn’t work out, you’re fired.” A lot of ideas don’t work out … but a lot of them do.

At a Canadian brokerage, such an idea goes to committee. It meets sometime next year, I think.

And at Scotia, apparently, if you do your job too well, a pack of useless jealous nonentities will attempt to destoy your career. It is outfits like Scotia who are responsible for the poor productivity in Canada relative to the US.

As a parting note, there is this section in the ruling:

¶ 56 But, as enforcement counsel pointed out in his opening statement, Berry sometimes “engaged in trading for his institutional clients that bypassed the syndication process.” We agree – and have already said so – that in so doing Berry ran a parallel book, an undertaking that may have been in contravention of syndication rules and practices. But, we repeat, that is not what he is charged with, and it would, therefore, be inappropriate to make any further comment on this aspect.

¶ 57 UMIR Rule 7.7(5) does not cover this behaviour. It refers to the solicitation of purchase orders for a distributed security. What Berry did, when using the 08 account, was identical with what he did when following the syndication rules: he solicited expressions of interest (tantamount to an order). Only here, some of the shares came from stock already in the account, while others were obtained later when the short position was covered. Clients did not suffer: the price they paid was the price fixed by the syndicate and no commission was charged.

I don’t know if there’s any ‘statute of limitations’ for charges of running a parallel book. If not, then we may see Scotia dragging out this idiotic process even further.

I am pleased to pass on the following notice of an Advocis event:

A Hard Look at Regulation – January 31, 2013
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PD Days – $65 for Chapter members; $75 member late registration; $120 for non-members
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Regulators control more and more of how you do business. This important PD Day will provide perspectives on: how Advocis is working to mitigate regulatory creep; an Ontario MPP’s perspective on financial regulation; the morality of self-regulation; a financial company executive’s view; and that of a national financial journalist. If you value your livelihood, come out to this Advocis PD Day.
…
Hampton Inn – 100 Coventry Road, Ottawa
…
1:15 PM – 2:15 PM The Regulatory Impact on Insurance Companies and the Products They Offer – James Hymas, CFA, BSc, President, Hymas Investment Management

James Hymas CFA BSc is President of Hymas Investment Management and specializes in the analysis of dividend paying companies. With many published articles, James writes for Advisor’s Edge and other publications. His talk will focus on dubious economic and investment assumptions behind rule changes.

A disciplinary panel has dismissed the IIROC charges against David Berry!

In a ruling Tuesday, a panel of the Investment Industry Regulatory Organization of Canada (IIROC) said the self-regulatory body “has failed to make out its case against the Respondent, and the charges, are, therefore dismissed.”
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IIROC has spent more than seven years on the matter and had already reached a $640,000 settlement with Scotia Capital in early 2007. After Scotia admitted liability, a panel approved the settlement.

At that time IIROC said “we are pleased that Scotia Capital recognized in this settlement that, even though supervision was not an issue, it would not be appropriate to retain profits generated by the wrongdoing of its employees.”

The three person panel, chaired by the Hon. Fred Kaufman, determined this week that there was, in fact, no wrongdoing. And contrary to what was said in early 2007 about supervision not being an issue, the panel also determined that Mr. Berry’s supervisors were likely aware of the activities in question.

“The preponderance of evidence suggests that they did, although this is denied by James Mountain, the head of institutional equity,” said the panel.
…
The panel spent time discussing the “atmosphere” which existed at Scotia towards the end of Mr. Berry’s employment. “It is clear that serious issues, mostly relating to his compensation, had arisen.”

I’ve been following the Berry affair with great interest: see, for example, the post Toronto Life Article on David Berry. In a nutshell, Berry was a preferred share trader who recognized – and I mean, he really recognized – the value of liquidity. He was the only guy on the street who would call a market on preferreds and back that up to the extent that his capital permitted. The markets he called were pretty damn lousy … but the lack of exchange-based liquidity and the intense desire of the buy-side to get a $250,000 preferred share trade done in less than double the time of a $25,000,000 stock trade ensured that a lot of people accepted his lousy markets – and we’re talking like, occasionally $1.00 off the last price! But if you wanted to move 25,000 shares, and you wanted to move them NOW, there was only one place to do it.

So those trades made money for Scotia, and the more money he made the more capital he was allocated and the bigger the inventory he could carry and the more money he made.

Until Scotia – as far as I’m able to tell, and this is apparently backed up by an insider willing to testify – decided he was making too much money and, when he made difficulties about modifying his contract so he would make much less money, decided to get him.

An army of lawyers and accountants were put on the case, and his trades were subjected to such intense scrutiny that Jesus Christ Himself wouldn’t have passed muster.

And all they found was garbage. I’ve read the IIROC statement of allegations. Picayune t-crossing that nobody in their right mind would consider caring about. However, this didn’t stop Scotia management from weeping and wailing about the dreadful sins of their rogue employee and not only fired him, but attempted to destroy his career by going to IIROC for confirmation that terrible, terrible things had happened.

And now IIROC has confirmed that, in fact, nothing terrible happened at all.

I’ll post more when the IIROC decision is on-line. For now, there’s a Barry Critchley column from last October that I missed at the time:

But he may have been too successful: documents obtained by the Financial Post suggest that even as Mr. Berry was earning millions of dollars for the bank in 2004, it was seeking outside legal opinions on the ramifications of renegotiating his contract to stop paying him so much.
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In the fall of 2004, Mr. Berry was head of the preferred share trading desk at Scotiabank’s securities division, then known as Scotia Capital. In each of the two prior years, he’d earned $15-million, when CEO Rick Waugh earned $7.37-million and $8.58-million. And he had much to be pleased about: his group had just completed another highly profitable year, meaning a healthy boost to the bonus pool of the firm’s institutional equities group. He was set to receive almost $10-million in compensation, thanks to a “direct-drive” contract that awarded him essentially 20% of the profits he earned for the bank, minus his $125,000 annual salary plus expenses, up to $15-million.
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Three months later, or in late April 2005, Berry still hadn’t signed the contract. In May 2005, RS (the regulatory precursor to IIROC) issued a warning letter to Mr. Berry (though no formal proceedings were commenced) and started a “routine, scheduled trade desk review at Scotia.”

By the end of June 2005, Berry had been terminated with his group having chalked up about $43-million in net income. One year later Mr. Berry filed a $100-million claim alleging constructive and wrongful dismissal. In turn, the bank has filed a statement of defence and counterclaim.

Let’s hope he soaks Scotia for every cent of that $100-million. Maybe give them a $50 discount if Rick Waugh delivers the cheque personally.

And, just to ensure that this post has something to do with the actual preferred share market, let me highlight some numbers: He made about $15-million annually, and his pay was (roughly) 20% of the desk’s profits. Liquidity has a value – as we were reminded yesterday.

Many will remember that when Omega Preferred Equity Fund was closed to new investors, it was also announced that National Bank would be starting a new fund with in-house management.

It’s here, but it seems to be operating very quietly!

The portfolio management firm is Fiera Sceptre Inc., which has a “strategic alliance” with and is partly owned by National Bank, as announced in February. The portfolio manager is Catherine Payne:

Catherine Payne is a member of the Active Fixed Income team and is responsible for managing certain corporate bond, high yield bond, preferred share and convertible bond portfolios.

Ms. Payne has 19 years of industry experience and has been with the firm and a predecessor since 2003. Prior experiences include positions as Portfolio Manager, Senior Credit Analyst, and Assistant Vice President at major Canadian investment management, credit rating and brokerage firms.

Ms. Payne graduated from the University of Toronto with a Bachelor of Commerce (BComm). She later received the Chartered Financial Analyst (CFA) designation.

As is usually the case, there is lots of chatter about experience and not a line about performance.

There are four classes to the fund, three of them with an estimated MER of 1.50%, the F-Class with an estimate of 50bp. I am fascinated to see that NBC510, the Deferred Sales Charge option, pays the salesman a 5% commission on the sale with a trailer to follow. I’m in the wrong business!

According to the Globe and Mail Fund Quote the fund was 64% in cash on October 31, which I presume had more to do with start-up frictions than long-term asset allocation goals.

I’ll keep an eye on the fund and report its performance together with those of my other competitors.

DBRS has announced that it:

has today published updated versions of two Canadian structured finance methodologies:

— Stability Ratings for Canadian Structured Income Funds
— Rating Canadian Split Share Companies and Trusts

Neither of the methodology updates resulted in any meaningful changes and as such, neither publication has resulted in any rating changes or rating actions.

The new methodology institutes a formal procedure for Reviews:

Rating actions taken on the preferred shares of an issuer are based on the following guidelines:

• • If the downside protection available falls outside the expected range by a signifi cant amount for two consecutive months, the preferred shares may be placed Under Review with Negative Implications to indicate the high likelihood of an impending downgrade.
• • After a rating has been placed Under Review with Negative Implications, it maintains its status until one of the following scenarios occurs:
  • – If the downside protection fell outside expected levels for two consecutive months subsequent to the rating being placed Under Review with Negative Implications, then the preferred shares will likely be downgraded. The revised rating level will depend on the path of downside protection levels during the Under Review period, as well as on other factors such as changes in the dividend coverage available and the credit quality of the portfolio.
  • – If the downside protection levels are consistent with the then-current rating for two consecutive months subsequent to being placed Under Review with Negative Implications (likely due to an increase in downside protection), the Under Review status will likely be removed with a confi rmation of the rating.
• • If the downside protection indicates that an upgrade is warranted for four consecutive months, then the
  transaction will likely be upgraded. The revised rating level will depend on the path of downside protection levels during the previous four months, as well as other factors such as changes in the dividend coverage available and the credit quality of the portfolio.

They’re still using VaR based on one-day drops:

Volatility Rating

• • DBRS analyzes the historical volatility and performance of the portfolio’s underlying securities to estimate the likelihood of large declines in downside protection.
• • Historical performance data for a defi ned period is used (normally ten years).
• • Daily returns are annualized; only negative returns count as potential defaults.
• • A probability of default is calculated that will yield a one year VaR at the appropriate dollar-loss amount equating to the downside protection available.
• • The probability of default is linked to a long-term rating by using the one-year default rates from the DBRS corporate cumulative default probability table.
• • The long-term rating is converted to a preferred share rating using a notching assumption that the preferred shares of a company should be rated two notches below the company’s issuer rating.

A Diversification adjustment has been formalized:

• • Portfolios with greater diversifi cation will generally exhibit less volatility and a lower probability of a large decline over time.
• • As the diversifi cation of a portfolio by industry and by number of securities decreases, the diversification factor applied will increase.
• • See the Downside Protection Adjustments for Portfolio Diversification table in this methodology, which shows the adjustment factor for varying levels of diversification.

The Cash Grind is treated as an adjustment:

• • Higher capital share distributions increase the grind on the net asset value (NAV), which results in the portfolio requiring to earn a certain percentage return from capital appreciation (the percentage grind) to cover the amount that portfolio expenses and distributions exceed dividend income.
• • The percentage grind will have less of a negative effect if there is an asset coverage test preventing capital share distributions once the NAV drops below a certain value.
  • – A higher NAV cut-off value will provide greater protection to the preferred shares.
• • A longer transaction term increases the cumulative effect of any
  grind on the portfolio.

• • The methodology shows the impact of capital share distributions on the maximum preferred share rating.
  • – More aggressive distribution policies and asset coverage tests will result in notching below the maximum preferred share rating (see the Impact of Capital Share Distributions on Initial Ratings table in this methodology).

They had this to say about option writing strategies:

DBRS views the strategy of writing covered calls as an additional element of risk for preferred shareholders because of the potential to give up unrealized capital gains that would increase the downside protection available to cover future portfolio losses. Furthermore, an option-writing strategy relies on the ability of the investment manager. The investment manager has a large amount of discretion to implement its desired strategy, and the resulting trading activity is not monitored as easily as the performance of a static portfolio. Relying partially on the ability of the investment manager rather than the strength of a split share structure is a negative rating factor.

Fair Canada has announced:

FAIR Canada will be receiving funding from the Ontario Securities Commission (the OSC) and the Investment Industry Regulatory Organization of Canada (IIROC). The OSC has committed to funding FAIR Canada in the amount of $500,000 per year for a two-year period. IIROC will be contributing $350,000 per year over two years. The funds come from money collected by the regulators from monetary sanctions and settlements.

“On behalf of staff and the Board of Directors of FAIR Canada, I want to express my appreciation and gratitude to the OSC and IIROC for making use of their enforcement/restricted funds to finance our work representing the interests of investors and consumers of financial services,” said Ermanno Pascutto, Executive Director of FAIR Canada. “There is very little funding available for consumer groups in Canada and the use of these funds for this purpose will benefit both the investing public and the Canadian financial markets.”

The funding will also benefit Ermanno Pascutto, a former Executive Director and head of staff of the Ontario Securities Commission (OSC) in the 1980′s, but that part’s played down. Other staff members are

• Ilana Singer, a former Senior Advisor, International Affairs at the OSC
• Marian Passmore, a former Associate Director in the Regulatory Affairs Group at Advocis
• Lindsay Speed, who interned and completed her articles at a leading national law firm, but does not appear to have worked for them after articling

Notables on the board of directors include:

• Stanley Beck, a former Chair of the Ontario Securities Commission
• Stan Buell, who was appointed to the Ontario Securities Commission Investor Advisory Panel in 2010
• Neil de Gelder, a past Executive Director of the British Columbia Securities Commission
• Claude Lamoureux who serves on the board of the OSC Investor Education Fund
• Dawn Russell, a former Public Governor of the Canadian Investor Protection Fund

Well, it certainly is nice that the regulators will be getting a fresh and independent perspective on regulation from the ex-regulators who they’re funding, isn’t it?

I have previously published an article regarding the provenance of FAIR’s prior funding tranche, titled IIROC’s Slush Fund. In the press release announcing the launch of FAIR Canada, it was stated:

The Boards of the IDA and RS, which recently merged to form the Investment Industry Regulatory Organization of Canada (IIROC) have approved one time start up funding from their discretionary and restricted funds to create FAIR.

Well, maybe two times. But who’s counting? Anyway, it’s nice to see that current funding totaling $850,000 annually is less than the original rate:

The Organization has agreed to establish the Canadian Foundation for the Advancement of Investor Rights (FAIR). The Organization is committed to funding the foundation over a three-year period to a maximum of $3,750 [thousand]. As at March 31, 2009, the remaining commitment is $1,922 [thousand].

FAIR’s expenses in 2011 and 2010 were $924,067 and $933,455, respectively … but they still had working capital of over half a million on 2011-6-30.