Canadian Securities Regulators publish their concerns in relation to the distribution, sale and regulation of Principal Protected Notes
On July 7, 2006 the Canadian Securities Regulators (CSA) released CSA Notice 46-303 – Principal Protected Notes (the Notice), detailing their concerns about the distribution and sale of this type of investment, and mapping out the CSA’s proposed approach. This is not a new topic for the securities regulators in Canada, and something like this Notice has been anticipated for a year or more.
Why are PPNs being targeted for review?
PPNs are investment products that consist of two parts: a guaranteed return of principal and a non-guaranteed potential to earn returns based on the performance of an underlying investment.
The Notice points out that not only has there been an explosion in the number and availability of these types of products on offer to retail investors in recent years, but that they are also becoming increasingly sophisticated and complex in their structure. Because many PPN products are marketed without a prospectus (either under a prospectus exemption for guaranteed debt or because they are structured to fall outside the scope of provincial securities legislation), the CSA is concerned that retail investors are not being adequately informed about the nature of and risk in investing in this type of product, and the associated fees. There is also great sensitivity to the fact that the underlying investment of a PPN might be an alternative asset class such as a hedge fund, fund of funds or managed futures which would otherwise not be available to retail investors without a prospectus.
Key areas of concern
The Notice appears to have been triggered by the CSA’s concern that increasingly complex and sophisticated PPN structures are being used as a means of distributing and exposing investors to, alternative investment products, and which, in the CSA’s view, are ripe for closer regulation as a result.
In particular, the CSA has identified the following key areas for attention:
there is a concern that retail investors are not getting all of the information they need to make an informed investment decision. The CSA believes that as a general rule there is inadequate disclosure about how PPNs are structured and how they work. Disclosure documents often lack sufficient detail about the underlying investment, the participants, and applicable fees. Poor or overly-promotional presentation of performance returns have in many cases failed to adequately profile the risks associated with these types of investments, and there is concern that investors are sometimes not alerted to the fact that the terms of a PPN frequently preclude them from selling before maturity; and
Know your client (KYC) and suitability obligations:
In the Notice, the CSA expresses concerns about the "retailization" of alternative investment products through the PPN market, as well as the lack of "know-your-client" and "suitability" obligations in many cases. Referral arrangements are also targeted as being deficient in some cases (presumably as a result of the Portus problems).
What is the CSA proposing to do?
The CSA proposes to monitor the structuring and marketing of PPNs generally, and to consult with industry and stakeholders about how the existing prospectus and registration exemptions are being interpreted in the PPN investment context. Whether new regulatory requirements and guidance is necessary will depend on the outcome of this consultation process.
In the interim, the CSA recommends that issuers intending to distribute and sell PPNs take steps to ensure that disclosure documentation is sufficiently clear, comprehensive, and balanced to enable potential investors and their advisors to make an informed decision or recommendation. They also suggest that investors should be alerted to the applicable fees and risks associated with investing in PPNs, and to the fact that exiting the PPN early could result in a penalty. Further, the CSA is of the view that sellers of PPNs should ensure that, if required, they are properly registered to do so, are appropriately qualified and trained to sell the product, and have a sound understanding of the PPN. In light of this Notice, it would certainly make sense for registered dealers to review their internal policies to ensure that the PPNs they recommend to clients are suitable.
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