At the PCMA CCO workshop series in Fall 2013, there was an
in-depth discussion of product due diligence and KYP requirements
presented by Peter Dunne and Brian Koscak of Cassels Brock &
Blackwell. They explained the difference between product diligence
and knowing your product highlighting the heightened legal context
in which the review and due diligence is conducted.
In general, I recommend that dealers examine three broad
areas relating to product due diligence and KYP:
• How did you learn of the product?
• What do you know about the issuer?
• What do you know about the product?
How did you learn of the product is a simple high level filter.
If the information source is not credible or has a poor reputation,
you probably shouldn’t waste resources and simply refuse the
product. The same is true of investment products that sound too
good to be true or pay an excessive commission.
Due diligence on the issuer and its principals and key officers
is an important component of meeting the product due diligence.
There have been scores of investments in both the public capital
markets and the private capital markets that had poor outcomes
due to fraud and misrepresentations of one or more key individuals
associated with issuer. Obviously the issuer’s past track record,
financial statements and other documents would be included the
review. Again, if you are not satisfied with the results of the due
diligence of the issuer; you should refuse the product.
Finally, you examine the investment product itself. This has
traditionally been viewed as the true KYP. This review would include
all the points identified in CSAN 33-315 (listed above) as well as the
product features. The features of the investment product could also
include tax efficiencies and the intended use of funds.
If the EMD firm approves the product, you must ensure that
the firms dealing representatives receive training and understand
the product. While it is the features of the product which will be of
greatest importance in assessing the suitability of the investment for
the client, it is absolutely necessary to include the findings of the due
diligence on the issuer in the training for dealing representatives.
The Notice recommends maintaining documentary
evidence of your due diligence and know your product review.
We recommend a due diligence file for each product you have
considered regardless of whether it was approved or rejected.
Similar to KYC information, it is expected that the KYP will
be updated regularly for products that are in continuous issue
or for issuers that have gone to market multiple times. Dealing
representatives would be trained on any differences in the product
at appropriate times.
Suitability
CSAN 31-336 identifies the elements that should be
considered in assessing suitability and stresses the need for
consistency and documentation. It also makes the point that a
product approved for the dealer’s shelf does not make it a suitable
investment for every client. A suitability assessment is required for
each client. This is the area where professional judgement of the
dealing representative comes into play.
There is not a lot of guidance provided in CSAN 31-336 on
determining the suitability of investments but there is a lot of discussion
on practices uncovered by the CSA. Suitability is the cornerstone of
investor protection and dealers should be able to clearly identify why
the investment is suitable or unsuitable. Many of the practices raised
concerns with the regulators are discussed below.
At the PCMA CCO workshops, we recommended EMDs start
using written suitability assessments. In our experience this is not
a widespread practice in the securities industry. Written suitability
assessments provide evidence that it was done, and secondly, it
prevents regulators from inserting their own suitability assessment
judgement when a written one does not exist. Regulators have often
cited unsuitable investments in compliance reviews based on the lack
of a written suitability assessment in the client file and the regulator
made the determination based on other information in the client file.
The Notice discusses some of additional issues relating to
suitability. The first issue is related to affordability. The CSA makes
the comment that dealers should “consider a client’s willingness
to accept risk and ability to accept risk when assessing a client’s
risk tolerance”. Information is collected by the dealer related to the
client’s assets, investments, liabilities, and whether the client is
borrowing money to purchase securities. Dealing representatives
are professionals and they must exercise their judgement in
determining whether the size of the investment is suitable based
on the client’s overall financial wherewithal.
The CSA notes that extra care should be taken when dealing
with seniors or clients living on a fixed income – but this does
not mean these clients would always be unsuitable for exempt
securities. Dealing representatives must exercise their judgement
in determining whether the size of the investment is suitable based
on the client’s financial wherewithal and their liquidity needs. A
client whose living costs are covered through RIFs, annuities,
pensions or other income sources but has additional savings may
be interested in an investment in an exempt security particularly
if the assets are intended for a legacy purpose. It is important
that the personal circumstances of the client are understood and
recorded in the KYC information.
Client directed trades are also featured in CSAN 31-336. The
section of NI 31-103 permitting client directed trades allows for
the possibility that clients will not always listen to the suitability
advice provided by a dealing representative. The same policy
rationale is behind discount brokers and allowing individuals
to invest in whatever security they wish without receiving any
advice on the suitability of the investment. A client directed trade
is appropriate where a proper suitability has been done by the
dealing representative and the investment has been found to be
unsuitable but the client still wishes to make the investment.
The Notice reports there has been some misuse of this client
directed trade provision and it reiterates the guidance in NI 31-103
that dealing representatives must do a suitability assessment for
all clients. The client directed trade is not a waiver of suitability and
should not be used in that manner.
The particular example used by the CSA in the Notice mixes
a number of issues and not just client directed trades. The
minimum amount investment exemption in NI 45-106 that allows
any person to invest $150,000 in an exempt security has been the
subject of much discussion and concern. The minimum amount
exemption is often used in Ontario because there is not an Offering
