- Establish policies and procedures for collection of KYC information, meaningful KYP and suitability assessment – provide adequate training to ensure understanding by representatives.
- Take proactive steps to maintain current KYC information – beyond "tick the box".
- Have an in-depth understanding of structure, risks, costs and parties involved with product.
- Adequately document and periodically review KYC, KYP and suitability processes.
- Adequately understand and appropriately use client-directed trade instructions.
- Review "best practices" for self-assessment of compliance with regulatory obligations.
On January 9, 2014, the Canadian Securities Administrators ("CSA") issued CSA Staff Notice 31-336 Guidance for Portfolio Managers, Exempt Market Dealers and Other Registrants on the Know-Your-Client, Know-Your-Product and Suitability Obligations (the "2014 Notice"). CSA issued the 2014 Notice to assist portfolio managers ("PMs"), exempt market dealers ("EMDs") and other registrants in understanding and complying with their regulatory requirements regarding the know-your-client ("KYC"), know-your-product ("KYP") and suitability obligations1. The 2014 Notice is also intended to provide PMs, EMDs and other registrants with CSA staff's views on what it considers "best practices" and "unacceptable practices" and accordingly, CSA recommends registrants use it as a self-assessment tool to monitor and ensure compliance with securities laws.
While certain KYC and suitability obligations under NI 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations ("NI 31-103") do not apply to registered members of self-regulatory organizations ("SROs") if such registrants comply with the corresponding obligations imposed by the SRO, a breach of those corresponding obligations may also be a breach of securities laws. Additionally, certain rules and policies of the SROs supplement the obligations under NI 31-103 that do apply. See for example, IIROC Rule 1300 Supervision of Accounts, IIROC Rule 2500 Minimum Standards for Retail Account Supervision, IIROC Rules Notice Guidance Note 12-0109 Know your client and suitability – Guidance, MFDA Policy No. 2 Minimum Standards for Account Supervision, MFDA Rule 2.2.4 Updating Client Information and MFDA Notice 0069 – Suitability.
Background to the Current Guidance
The guidance issued under the 2014 Notice is as a result of recent compliance "sweeps" by securities regulators2 in addition to recent court decisions and regulatory proceedings described in the 2014 Notice. Among the findings from the OSC's 2012 compliance sweep, OSC staff found: (a) 75% of EMDs and 70% of PMs reviewed had inadequate processes for the collection, documentation and maintenance of KYC information; (b) 22% of EMDs and 5% of PMs had inadequate suitability assessments due to inadequate documentation; (c) 45% of EMDs had either no or inadequate policies and procedures and 35% of PMs had inadequate policies and procedures; and (d) 18% of the EMDs appeared to sell securities to investors who did not qualify as accredited investors (and without another prospectus exemption being available).
CSA staff view the KYC, KYP and suitability obligations as cornerstones of the investor protection regime, being among the most fundamental obligations owed by registrants to their clients, and complementary to the duty to "deal fairly, honestly and in good faith" with clients. In the 2014 Notice, CSA staff reiterates its view that a failure to comply with these obligations is an "extremely serious matter" and will take appropriate regulatory action, including enforcement action to ensure compliance. The 2014 Notice also supplements previous reminders and guidance regarding KYP and suitability obligations that the CSA issued in September 2009 under CSA Staff Notice 33-315 Suitability Obligations and Know Your Product.
The 2014 Notice reminds registrants that current KYC information is required whenever a suitability determination is required. To properly meet its suitability obligation, a registrant must take reasonable steps to ensure it has sufficient information, to the extent necessary for a particular trade, regarding the client's investment needs and objectives, including the client's time horizon, financial circumstances and risk tolerance for different securities, while taking into account the client's level of investment knowledge (collectively, the "Investment Needs and Objectives"). EMDs, are further reminded that they would be acting outside of their registration category contrary to securities law if a client purchasing securities does not qualify under the prospectus exemption. While an issuer may rely on representations in a subscription agreement, provided the issuer has no reasonable grounds to believe they are false, the obligation to take further reasonable steps to determine whether a client satisfies a particular prospectus exemption will generally be higher on registrants than an issuer.
Registrants must be proactive in ensuring that KYC information is kept up-to-date. Without adequate and timely KYC information, registrants cannot meet their suitability obligation to clients. Registrants should make all necessary enquiries to obtain a solid understanding of a client's Investment Needs and Objectives and communicate with clients to ensure they understand why the KYC information is required.
The 2014 Notice sets out, among others, the following "best practices" and cautions for registrants to meet, and demonstrate compliance with, their KYC obligations:
Establish policies and procedures for collecting, documenting
and reviewing KYC information and provide adequate training to
staff to ensure understanding of the obligations and
Engage in meaningful KYC discussions with clients – use a comprehensive questionnaire to facilitate the collection and documentation of KYC information.
- Develop an "investor-friendly" KYC form – ensure investment objectives and risks are clearly explained in plain language; ensure sufficient information to determine if client meets requirements of prospectus exemption(s).
- Consider both the client's "willingness" and "ability" to accept risk.
- Update KYC information at least annually, or more often if material change in client's circumstances or significant change in market conditions; have KYC changes reviewed and signed.
- PMs should develop a tailored IPS for each managed account – document the client's Investment Needs and Objectives; set out a planned asset allocation.
- Make further inquiries – where reasonable doubt exists about accuracy of information or validity of client's claim to be an accredited or eligible investor; document the inquiries in the client's file.
- DO NOT use a "tick box" approach or rely solely on representations in a certificate.
- DO NOT use disclaimer language which purports to limit liability from breach of registrant's obligations under securities law.
Know-Your-Product and Suitability
CSA staff view the KYP obligation to be a necessary element of the KYC and suitability determination. Registrants are required under NI 31-103 to take reasonable steps to ensure that a proposed trade is suitable for a client before making a recommendation or accepting their instructions. Additionally, the 2014 Notice cautions registrants that they may by expressly or implicitly recommending a product through conduct such as placing a product on their "shelf" and making it available to a client, by advertising or promoting the product, or by distributing marketing material about the product to a client.
The 2014 Notice reminds registrants that they must conduct (and be able to demonstrate) their own due diligence and fully explain the product to clients. This includes a critical review and assessment of the information contained within the offering documents provided by the issuer and any "independent" third party analysis. However, it is for the registrant to determine if further due diligence is required to allow for a meaningful KYP assessment. Further, a product should only be put on an approved product list after the conclusion is made that the product has a reasonable prospect of meeting its investment objectives and has a reasonable prospect of being a suitable investment for some clients. In the absence of a meaningful KYP assessment, the registrant should refrain from dealing with any product. Registrants should conduct and appropriately document a meaningful suitability assessment which involves meaningful dialogue with the client.
The 2014 Notice sets out, among others, the following "best practices" and cautions for registrants to meet, and demonstrate compliance with, their KYP and suitability obligations:
- Establish policies and procedures and provide adequate training for reviewing, approving and recommending new and existing products; maintain records of communication with clients.
- Have an in-depth understanding of features, structure, risks, costs, parties, conflicts and regulatory framework of product before recommending to clients.
- Consider competitive products that may be less risky or less costly to clients.
- Assess suitability in light of client's investment knowledge, risk tolerance and circumstances.
- Develop a system or process to identify and reject trades that are inconsistent with a client's Investment Needs and
- Objectives; monitor trends or patterns to identify areas for added training.
- Establish a process to periodically review a sample of client files to ensure suitability process is consistently applied; review should be documented and reviewed by senior official (like the CCO).
- Establish policies and procedures and provide adequate training for ensuring client-directed trade instructions are appropriately used and proper explanation to the client on its use.
- Maintain adequate documentation of suitability analysis and client's written instructions to proceed after "not suitable" assessment is communicated to client.
- Establish written procedures to monitor, manage and explain concentration risks in a client's portfolio; consider and document reasonable thresholds.
- DO NOT rely on out-of-date KYC or KYP information to determine suitability.
- DO NOT rely solely on product being on firm's "approved product list" rather than conducting own analysis and suitability assessment or recommend based on similarities with other products.
- DO NOT promote a security actively and then rely on boiler plate language to claim that the trade was a client-directed trade and was not recommended by the registrant.
- DO NOT "hide" or "bury" the client-directed trade instruction in the KYC form or other client documentation; DO develop a separate disclosure document to explain the instruction to the client.
While the 2014 Notice suggests best practices that registrants can employ to meet their KYC, KYP and suitability obligations, CSA staff also point out that they are not the only acceptable practices so long as any alternative practices to those set out in the 2014 Notice adequately demonstrate that the registrants have met such obligations. Registrants should undertake a review and assessment of their current policies and procedures relating to their KYC, KYP and suitability obligations under securities laws.
1 While certain KYC and suitability obligations under NI 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations ("NI 31-103") do not apply to registered members of self-regulatory organizations ("SROs") if such registrants comply with the corresponding obligations imposed by the SRO, a breach of those corresponding obligations may also be a breach of securities laws. Additionally, certain rules and policies of the SROs supplement the obligations under NI 31-103 that do apply. See for example, IIROC Rule 1300 Supervision of Accounts, IIROC Rule 2500 Minimum Standards for Retail Account Supervision, IIROC Rules Notice Guidance Note 12-0109 Know your client and suitability – Guidance, MFDA Policy No. 2 Minimum Standards for Account Supervision, MFDA Rule 2.2.4 Updating Client Information and MFDA Notice 0069 – Suitability.
2 For example, in June 2012, the Ontario Securities Commission ("OSC") commenced a targeted compliance review of certain PMs and EMDs with respect to compliance with their KYC, KYP and suitability obligations. In May 2013, a summary of the review and findings was published in OSC Staff Notice 33-740.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.