Investment Suitability and Strategies

Suitability of Investments and Investment Strategies

• Registered Representatives (RRs) have general and specific regulatory requirements related to the purchase and sale of securities

• The requirements are beyond the Know Your Client (KYC) requirements

• RRs must understand the products they recommend or sell

• They must evaluate the products themselves and their related investment strategies to make sure they are suitable for the client

• Know Your Product (KYP) has emerged along with KYC as a critical concept in the daily lives of RRs

• This obligation applies to sales initiatives, training, and supervision of dealer members

• Areas for RRs to understand to properly discuss investments with clients include

• Issuance of securities via prospectus (e.g., new issue)

• Prospectus exemptions that may be available to certain types of investors

• Rules and processes that apply when issuers purchase the securities of another issuer or buy back their own shares

• An RR must match a clients needs to the risk-return attributes of investment options

• Variables to consider include

• Is the prospective security a new issue

• How long has the product, company, or fund been in existence

• What are the normal price fluctuations of the security or fund unit

• What is the research department's evaluation of the security, both technical and fundamental, and how positive do you feel about it

• Has the firm approved the product for purchase

• Are there any additional training requirements in place regarding how the product is to be sold

• What is the company's track record regarding factors such as previous earnings and dividend payments

• How current, available, and reliable is corporate or market information

• Is the product a structured or synthetic product

• Is the purchase speculative

• Structured and synthetic products are complex and need a greater understanding of how they operate and provide an investment return

• Speculative investments have little or no history of earnings and are entirely dependent on unpredictable future events

Transaction Considerations

• Suitability standards require matching a security’s attributes and the client’s needs to variables in the trade

• Canadian Investment Regulatory Organization (CIRO) rules pertain to both accounts and individual orders

• In determining suitability, considerations include:

• Does the proposed transaction involve a stock, bond, option, or futures contract

• Is it a purchase or a sale

• Is the security being purchased with borrowed funds

• What amount of risk is associated with the transaction

• Is it a large order in a thinly traded issue

• Is it a short sale

• Is the issue under investigation or review

• Is it a hedge to protect an existing position, or is it speculative

• RRs must be able to confirm each factor has been analyzed professionally and competently

• RR must be able to defend the analysis as meeting an acceptable professional standard

• Dealer member's suitability obligations extend beyond assessing suitability at the time a trade recommendation is made

• The intent is to provide added protection in situations where the risk profile of the client and the account portfolio diverge over time

• When an advisor receives an unsolicited order that is unsuitable, they must take steps to deal with it

• Including, advising against the order and recommending suitable alternatives

• Advisors must document their action and not simply re-document or update the client's account to fit the unsuitable trade

• For clients intending to day trade, you should establish whether a day trading account is appropriate

• Warn them of the risks and implement strict leverage limits

• RRs in the retail sector must:

• Provide each client with a copy of their KYC information at the time of the account opening

• Consider time horizon, current investment portfolio composition, and risk profile to assess suitability

• Reassess suitability at the time of prescribed triggering events

• Update the client's KYC profile whenever there are significant changes to the account

Case Study: Ben

• Ben accepted an order without questioning that violated risk requirements

• Duty to ascertain that Sam is aware of the risks associated with speculative stocks

• The risk is high given the significant departure from this client’s strategy

• If objectives have changed, the account application must be updated

• If the objectives have not changed but Sam insists, Ben must recommend suitable alternatives or refuse the order

• Must make sure that every transaction is suitable for that particular client

• Policies may require refusing unsuitable orders or dealing with them case-by-case

• Advise clients against unsuitable transactions based on their account application

• If the client insists, determine whether their investment objectives have changed, and record the change if so

• The order should be marked "unsolicited" and the circumstances documented in the client's file.

• There is a responsibility to ensure that the recommendations are made competently

• Recommendations may be generated by the research department or otherwise based on relevant information that can be substantiated

• Before executing a trade, give a balanced presentation, make yourself aware of new developments

• In making a recommendation, you guarantee nothing about

• The future market price of a security

• Future payments of dividends or interest

• The client's ability to sell a security at a stated price

• The listing of a security on an exchange at a future date

Example Situations

• Examples of what constitutes a recommendation:
• Providing information that is individually tailored to a specific customer or class of customers
• Using client habits, preferences, and past decisions to target them with investment-related information
• Promoting a specific security or trading strategy
• Considering a client's objectives and financial situation with respect to any transaction
• A client placing an order online after an RR's telephone recommendation
• Factors that have no bearing on determining whether a recommendation has been made:
• Supplying a waiver or disclaimer
• Charging a lower commission
• Classifying a transaction as a buy or sell
• The lack of a previous relationship between the dealer member and the client
• A dealer member identifying as a discount broker may still fall under recommendations

Suitability Considerations for Institutional Accounts

• CIRO's IDPC rules set out minimum standards for institutional account opening, operation, and supervision
• The approach is flexible and depends on the dealer member, its procedures, and its customers
• Business activities review determine how standards are applied

Information for Institutional Clients

• An institutional client is defined as:

• An acceptable counterparty or institution

• Regulated entities

• Registrants, excluding individual registrants, under securities law

• Non-individuals managing over $10 million in securities

• On the CIRO platform, all individuals are retail clients, regardless of net worth and sophistication

• Sophistication determines the level of suitability assessment owed to them

• In cases of reasonable grounds an institutional client can make an independent investment, and independent evaluations of the investment risk

• Dealer members do not have a suitability obligation to institutional clients that are also permitted clients, as defined in National Instrument (NI) 31-103

• Clients must be categorized correctly as a crucial part of a compliance program and suitability obligations

Product Due Diligence

• RRs must know their clients and products they introduce
• Regulators mandate a process for firms to evaluate which products are permitted for sale by the firm and its RRs, and on what basis
• Complex products get a more thorough evaluation for placement on the product shelf
• Once the evaluation is done, the firm can impose other obligations that include
• Training requirements
• Documentation
• Supervision

Know Your Product

• Understand how investment products are constructed and likely to perform in market conditions
• Referred to as the Know Your Product (KYP) obligation
• Explain new, non-traditional, complex, or structured products
• This will help assess suitability, explain the product's features and risk

New Product Due Diligence

• Under NI 31-103, firms must take reasonable steps to assess and approve securities before making them available to clients

• They must monitor the securities for any significant changes

• Firms must maintain policies, procedures, and controls conforming to

• The firm's model

• The types of securities offered

• Proficiency of the registered individuals

• Nature of relationships that the firm and its registered individuals have with clients

• Policies, procedures, and controls should include processes for assessing and approving securities as well as monitoring any significant changes

• Guidance Note 3300-21-001 offers guidance to investment dealer members on the due diligence for all securities they make available to clients

• CIRO considers the components of an effective product due diligence process

• A documented approval process, standardized for all securities, or for defined categories of securities

• A preliminary assessment by qualified staff to determine whether the proposed security is new or it’s an existing security. The appropriate level of internal review and approval is crucial

• For complex or novel securities, a detailed and documented review by a qualified and experienced committee or working group is necessary

• A formal security decision comes from a new product committee, etc

• Monitoring client complaints

• Reassessment of training

• Compliance monitoring with any restrictions

• Periodic reassessment of the appropriateness of the security

• Dealer members must ensure that the committee conducts due diligence sufficiently and documents their process and decision

• Members must have the skills and experience for a proper product review, however they are entitled to rely on some facts and disclosure documents

• Exchange-traded funds (ETFs) illustrate the importance of dealer members and RRs

• Some ETFs are complex structured products that use leverage and sophisticated investment strategies

• RRs must be keenly aware of a new ETF's features before advising on them

• RR was fined $40,000 and suspended from registration for purchasing numerous high-risk securities

Leveraged and Inverse Exchange-Traded Funds

• Guidance Note 20-0086 reminds investment dealer members of their sales practice obligations for these funds
• Leveraged and inverse ETFs are highly complex financial instruments built to achieve their stated objectives on a daily basis
• Their performance over longer periods can differ significantly from their stated daily objectives
• These ETFs are generally unsuitable for retail investors who desire to hold them longer than one trading section
• Dealer members sales practices for these ETFs should have policies and procedures pertaining to suitability of recommendations, communications and supervisory procedures

Assessing Suitability

• Suitability must be determined before recommending or accepting client orders for leveraged and inverse ETFs
• RRs must use diligence to ensure that accounts are reviewed for suitability
• RRs need to understand the impacts of market volatility on an ETFs performance when leverage is used

Communication with the Public

• Sales materials and oral presentations for leveraged and inverse ETFs should paint a fair and balanced picture of the risks and benefits
• Communications cannot omit material facts or qualifications

Supervision

• Dealer members must have a supervisory system in place with written supervisory procedures that have
• Product suitability analysis
• Client-specific suitability analysis
• Accurate and balanced sales materials
• Adherence to CIRO rules and securities laws
• Principal-protected notes (PPNs) still have to be sold by registered dealers despite the fact that applicable regulators permit certain PPNs to be sold with no KYC

Distribution of Non-Arm’s Length Investment Products

• Regulatory concerns include conduct-related matters, issuer scrutiny and product review, conflicts of interest, suitability, disclosure, and protection cover
• CIROs expectations of dealer members and sales representatives:
• Perform due diligence
• Identify conflicts and assess ways to address
• Assess the suitability of clients
• If the trade is deemed appropriate, the trade should be completed

Information on Products

• There should be a clear definition of “new product” and an appropriate level of internal review
• Consider proficiency, training, and marketing issues, and have a formal process to monitor and review customer complaints

Case Study: Stanley

• Registered Representatives must apply due diligence in investigating the circumstances of products
• Understanding any new products is essential to providing customers with the right advice
• Review your internal research department and available training

New Issues and Prospectus Exemptions

• An RR must know the client and explain the products sold, know how transactions work under different conditions
• Explain, provide examples and the details of new issues of securities via prospectus and the various prospectus exemptions

New Issues

• When a company raises equity capital, it issues securities from its own treasury

• Proceeds are received by company via public offerings

• Initial public offering (IPO) must file a prospectus with the regulators

• The prospectus is essentially the investment contract between the purchaser and the company

• Details facts upon which potential purchases base their decision to buy

• Company issuing additional securities is called a reporting issuer

• Prospectus is normally required unless an exception is available

• The prospectus of a reporting issuer my be less detailed with already information public

Different Ways Dealers Can Be Involved

• Underwriting, where the dealer may purchase blocks of new securities
• Bought deal, where the issuer acts as agent sell securities with no guarantee of sales of price
• Best efforts deal, where the issuer acts as the agent to sell securities

Information on Deals

• Bought deal, where an underwriter buys all of an issuance for resale
• Best if the dealer sells all, but is not liable to fulfill all

Preliminary Prospectus

• The preliminary prospectus (aka red herring prospectus) include a prominent warning that the securities cannot be sold until a receipt for the final prospectus has been obtained
• Used to determine the extent of public interest when its priced and distributed
• Harmonized with legislation but the preliminary prospectus excludes certain information like price
• Underwriter must keep records of all the people and companies to which it was sent
• Revise if found to be defective

Permitted Activities During the Waiting Period

• Waiting period, where underwriters solicit interest in security (with prospectus)

Regulations

• A dealer cannot not enter into an agreements for the purchase and sale of the security
• Advertising of security and price of security is allowed

Final Prospectus

• Contains details of securities offered with the requirement of true disclosure of all material facts relating to the securities
• Has expert consent
• Copies must be sent to purchasers be the set business day

Prospectus Exemptions

• Also known as exempt market, and participation is limited
• Not required to adhere to public market rules

Not Required To

• Prepare a prospectus and filing it with securities regulators
• Underwriter obliged to undertake a due diligence review
• Filing financial and other reports with securities regulators
• Regulators expect requisite qualification or status

Exemptions

• National Insturment 45-106 includes circumstances
• Purchases are subject to the to resale restrictions and hold periods
• Dealer members selling securities must verify that their clients purchase securities in question
• Take steps to verify purchases as the seller

Exemptions Related to Raising Capital

• Relate to nature of the securities, subject to restricted of resale

Investors or Issues

• Accredited, an individual w wealth owning assets
• Individual accredited investors must sign a risk acknowledgement form, firm must document facts supporting claim for the exemption
• Private issuer, 50 Shareholders, not including employees or former employees + restrictions on transfer
• Securities of a private issuer can be purchased by eligible investors without a prospectus
• Family / friends / business, distribute securities to issuers for all the parties mentioned
• Offering memorandum, which is a memorandum for rescission
• Purchasers must sign a risk acknowledgement form or a right of action
• Minimum amount > $150,00 purchase, restricted to non-individual investors,

Exemptions Related To Crowdfunding

• Regulators have introduced securities crowdfunding, through raising start-ups.
• This makes it easier to raise funds online from the public
• Limits of investments.
• A retail investor cannot invest more than $2,500 (or $10,000) with advice from a registered dealer
• $1,500,000 million on aggregate

Investors

• Must acknowledgement risk
• Provide document

Resale

• Unless securities are exempted, wait for seasoning period
• NI 45-102 relates to securities

Hot Issues &

Placements

• Ensure that the dealer offer all participation to public investors, and that requirements by the province are carried out Client priority in this respect is particularly relevant when dealing with "hot issues"
• Public: Not employees of the dealer or institution
• Dealer must communicate general availability of all clients
• Steps to ensure pre release with all, clients must come first

Erica Case Study

• Dealings in securities outside of normal business activities expose risks
• Private transactions require a lot supervisions
• Member must have all approval from everyone

Take-Over and Issuer Bids

• Understand take-over bids along with issuer bids
• In order to provide all proper advice

Take-Over Bids

• Acquire 20% Outstanding equity securities
• Safeguard with all shareholders

Early Warning Rules

• 10% Disclosure
• 2 % Further acquisition or disposition

Early Warning

• Found in Acts and Supplement

Bids Rules

• Must be offered with at least 105 day bid
• All the terms and conditions complied/waived
• Security class subject is bid
• Can wait 35/ take securities

Withdrawal Rights

• Can withdraw with days
• Before or after
• Holder 10 days from date of notice

Issuer Bids

• Acquire securities
• Rules similar to those applicable circular must receive bid
• Benefits and dividends to all
• Must provide all valuation Exemptions, conditions listed/waived
• Issuer Bids also can be exempt with a recognized exchange