The Canadian Securities Administrators (the "CSA") recently 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 "CSA Notice"). The CSA Notice provides guidance on the know-your-client ("KYC"), know-your-product ("KYP") and suitability rules set out in National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations ("NI 31-103") and for determining whether an investor qualifies for an exemption under National Instrument 45-106 Prospectus and Registration Exemptions ("NI 45-106").
In 2012 and 2013 the Ontario Securities Commission ("OSC") conducted a 'sweep' of Exempt Market Dealers ("EMDs") and Portfolio Managers ("PMs") to determine their compliance with the KYC, KYP and suitability requirements set out in NI 31-103. The sweep concluded that the majority of dealers were not in compliance with these obligations. Although the sweep was directed at PMs and EMDs, the advice in the CSA Notice is applicable to all securities registrants.
The CSA Notice recommends the following "best practices" for registrants distributing securities in reliance on a prospectus exemption under NI 45-106:
- Collect and document sufficient minimum KYC information such as name, age, investment objectives, annual income, net assets, net financial assets, liquidity needs, time horizon, risk tolerance and portfolio composition;
- Obtain a breakdown of financial and net assets of the client and make further inquiries about the client's financial circumstances;
- Engage in meaningful KYC discussions with clients and consider a client's willingness and ability to accept risk;
- Develop a KYC form with terms and information in plain language, ensuring that has sufficient information about the client to allow the registrant to determine if the client meets the requirement of the prospectus exemptions;
- Review the completed KYC form with the client for accuracy;
- Develop a separate KYC form for clients that are corporations, partnerships, trusts or other entities (not individuals), to support reliance on the exemption;
- Update the KYC information annually and more frequently if there is a material change in a client's circumstances or investment needs;
- Understand the different categories of investors that make up the definition of 'accredited investors' ("AI") or 'eligible investor' and the conditions contained in these categories; and
- Provide training to staff and dealing and advising representatives to ensure their full understanding of the prospectus exemptions and establish policies and procedures for collecting, documenting and reviewing sufficient KYC information for each client.
The CSA Notice also outlines "unacceptable practices" for determining whether a client qualifies for an exemption under NI 45-106 and for collecting KYC information generally:
- Relying solely on the investor's representation in an AI Certificate, Resident Exemption Form or Eligible Investor Questionnaire without obtaining KYC information from the client to independently assess reliance on the exemption;
- Using a 'tick box' approach to describe an investor's risk tolerance and investment objectives;
- Assuming that another person has complied with the KYC obligation or the obligation to determine that the client qualifies for an exemption or delegating KYC obligations to an unregistered individual;
- Processing prospectus-exempt trades without adequate KYC information to support reliance on the exemption;
- Using outdated KYC information; and
- Using a KYC form that contains disclaimer language purporting to limit liability for all losses, including losses resulting from a breach of the registrant's obligations under securities laws.
A recent decision by the British Columbia Securities Commission ("BCSC") reflects a trend amongst Canadian securities regulators to clarify the scope and strengthen the enforcement of KYC rules.
The BCSC made orders against Frederick Lawrence Marlatt (known as Frederick Lawrence Mitschele) ("Mitschele") and Michael Wallace Minor ("Minor") on the basis that the pair sold securities in contravention of the British Columbia Securities Act (the "BC Act"). The BCSC decided that Mitschele and Minor contravened the BC Act by trading and distributing securities in a corporation without being registered and without filing a prospectus.
Mitschele and Minor relied on the AI and the family, friends and business associate exemptions in NI 45-106. The BCSC held that only a small minority of the investors qualified as family, friends or business associates of Mitschele and Minor and that no investors were qualified AIs within the meaning of NI 45-106.
Notably, the BCSC found that Mitschele and Minor did not take appropriate steps to identify the eligibility of subscribers for either exemption. The only evidence Mitschele and Minor provided to support their position that the investors were AIs were copies of subscription forms in which the investors 'ticked boxes' indicating that they were AIs which, according to the BCSC, is inadequate for identifying an AI under NI 45-106. Furthermore, Mitschele and Minor improperly failed to define AI or provide appropriate information about the AI exemption on the subscription form.
On February 13, 2014, the OSC ordered a written hearing to consider whether it was in the public interest to issue an order against Mitschele and Minor pursuant to paragraph 4 of subsection 127(10) of the Securities Act, Ontario based on allegations by the OSC Staff and the BCSC decision.
The KYC CSA Notice explicitly confirms the guidance with respect to responsibility for compliance found in section 1.9 of the NI 45-106 Companion Policy ("CP 45-106"). CP 45-106 stipulates that a person distributing or trading securities may rely on factual representations by purchasers to determine their eligibility for an exemption. However, it should be noted that the CSA Notice suggests more stringent requirements for securities registrants in determining whether an exemption is available. In this respect, the CSA Notice and the BCSC's decision provide helpful guidance on how to avoid running afoul of compliance requirements and determining whether sufficient information has been obtained to properly determine a purchaser's eligibility for an exemption.
A copy of the CSA Notice is available at: http://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20140109_31-336_kyc-kyp-suitability-obligations.htm
The OSC proceedings against Mitschele and Minor are available (alphabetically under "Marlatt") at: http://www.osc.gov.on.ca/en/5329_5188.htm
A copy of the BCSC decision is available at: http://www.bcsc.bc.ca/comdoc.nsf/0/054a1c30733d66f888257a3f0059d7d2/$FILE/2012%
A copy of NI 45-106 and the NI 45-106 Companion Policy is available at: https://www.osc.gov.on.ca/documents/en/Securities-Category4/rule_20120413_45-106_unofficial-consolidated.pdf
With special thanks to Michael Bowmile (Student-at-law).
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