Investment Suitability & Due Diligence

Chapter Overview

• Exploring product due diligence and suitability assessment is covered
• Outlining regulatory requirements for various transactions, recommendations, and product types

Suitability of Investments and Investment Strategies

• Know Your Product (KYP) and Know Your Client (KYC) are critical when recommending products
• Crucial to understand product construction and performance in different conditions

Client Discovery

• Must match needs with risk-return attributes of products
• Need to consider if it's a new issue, how long it has been around, and price fluctuations
• Research department evaluation, firm approval, and training requirements matter
• Company track record, current information, structured/synthetic nature, and speculative aspects need consideration

Transaction Considerations

• Suitability standards match security attributes with client needs based on CIRO rules
• Important questions when looking at transaction suitability:
• Stock, bond, option, or futures contract involved?
• Purchase or a sale?
• Being purchased with borrowed funds?
• Amount of risk?
• Large order with little liquidity?
• Short sale?
• Issue under investigation?
• Hedge against existing position?
• Speculative?
• RRs should analyze each factor professionally and competently, and defend analysis

Unsolicited Orders

• Advisors receiving unsuitable unsolicited orders must advise against proceeding and recommend suitable alternatives
• Advisors must document any actions taken

Day Trading

• Determine if a day trading account is appropriate
• Warn clients of risks and implement strict leverage limits to protect from financial loss

Retail Sector Responsibilities

• Provide KYC information at account opening
• Consider time horizon, portfolio composition, and risk profile for suitability
• Reassess suitability at triggering events and update KYC profile with changes

Case Study - RR Ben

• Ben violated requirements for due care by accepting Sam's order w/o questioning
• He didn't verify Sam's awareness of risks with speculative stocks
• Ben should tell Sam the trade doesn't conform to investment objectives
• Sam should update account application if objectives changed
• Ben should recommend alternatives or refuse order if objectives remain unchanged

Rules for Recommendations

• RRs must make recommendations competently
• Recommendations can come via the research department or other proven information

Balanced Presentation

• Must give a client a balanced presentation
• Includes positive and negative information about discussed securities
• Research and awareness is required of new developments affecting an investment

Guarantees Prohibited

• Cannot guarantee future market price, dividend payments, or security listing unless dealing with a retractable or callable security

Recommendation Analysis

• Analysis is based on whether a reasonable person would believe it was a recommendation
• Examples include tailored information, investment preferences, and promoting specific securities
• Discount brokers or order execution can still be considered as providing recommendations, depending on circumstances

Institutional Accounts

• CIRO's IDPC rules set minimum standards for institutional account process
• Determined by nature of the dealer member, procedures, and customers

Institutional Clients

• It's important to know that on the CIRO platform, all individuals are retail clients
• Institutional clients make own investment decisions, firms must establish their level of sophistication to determine suitability assessment

Product Due Diligence

• Regulators require firms to have a process to evaluate products permitted for sale by the firm and its RRs
• Evaluation determines if products should be placed on the product shelf and requirements for how the product is sold

Know Your Product

• Understand how constructed and performance in various market conditions
• Ability to properly inform new, non-traditional, complex or structured products
• The client expects the RR to know the product and have the right to know what they agree to buy
• Without product knowledge, RRs cannot assess suitability or explain features and risks

New Product Due Diligence

• Firms can't make securities available unless reasonable steps are taken to assess relevant aspects and approve them for use
• Firms monitor securities for changes
• Registered firms must have established policies, procedures, and controls regarding the KYP process in line with firm's model, proficiency when dealing with clients
• These include processes for assessing/approving securities and monitoring their significant changes

Product Due Diligence Components

• Documented standard approval process
• Assessments by qualified staff of proposed/new securities
• Reviews by experienced committees/working groups
• Formal decisions by a new product committee or authorized group that includes senior staff
• Post-approval follow-up processes

Required measures for evaluations

• Evaluation committee must conduct due diligence
• Skills and experience are needed to conduct a product review

Example - ETFs

• Understanding dealer member's and RR's for new products
• Some ETFs use leverage and complex strategies
• RRs must be aware of new ETF features before recommending
• Disciplinary cases highlight obligation

Leveraged and Inverse Exchange Traded Funds (ETFs)

• Sales practice obligations are required
• Complex financial instruments designed to achieve stated objectives daily
• Performance can differ significantly over longer periods
• Generally unsuitable for retail investors holding for longer than one trading session, especially volatile ones
• Dealer members should have policies/procedures for sales practices pertaining to recommendations, communications, and supervisory procedures

Suitability Assessment and ETFs

• Determine transaction suitability before recommending (applies to RR too)
• RRs fully understand product features, risks/benefits, and how they are designed
• Must understand the impact that market volatility will have on performance, combined with leverage

Unsuitable Investment

• Use due diligence to ensure that the order is suitable before accepting client order
• Advise client against proceeding with it if not suitable

Communications with the Public and ETFs

• Sales material & presentations must have balanced risk/benefits information
• Communications must not omit material facts or qualifications if used misleadingly

Principal Protected Notes

• Guidance Note expectations for PPN sales
• CIRO acknowledges regulators can permit some PPNs to be sold by banks without KYC or suitability

PPN sales

• Sold through registered dealers w/CIRO members
• RRs are dually employed, sell PPNs through multiple channels
• CIRO requires PPN sales to be done in RR's capacity as employee/agent
• Members needed have policies/procedures for having oversight of PPN activity

Distribution of Non-Arm's Length Investment Products

• Members should be aware of regulatory concerns for such products, including:
• Conduct matters
• Issuer scrutiny and product review
• Conflict of interest
• Suitability
• Disclosure
• Protection fund coverage
• Expectations of firms are summarized in three steps

New Product Due Diligence Deficiencies

• Examinations by IIROC determined practices regarding new product due diligence
• Key deficiencies: lack of a clear definition of "new product"
• Lack of internal review with written new product proposal
• Lack of considering proficiency , training, and marketing issues
• Absense of formal to monitor complaints with new products, allowing firm systemic issues go ignored

Case Study- RR Stanley

• Stanley negligent by not learning essential details of takeover
• Through negligence he failed to act in client's best interest
• Possible for Stanley to be held responsible for losses/missed opportunity
• Registered Reps due diligence around investment
• Obligation in new products
• Contact the firm's team. That team can provide information on firms
• Seek out trainings, read publications. Contact supervisor for advice

New Issues and Prospectus Exemptions

• A good RR should be well knowledgeable about a client's particular situation
• Transactions are unique to the client
• This chapter covers how business is conducted, including new issues of securities via prospectus and various exemptions
• Equity capital is raised via securities
• Proceeds are collected by the issue company
• If it is the initial, this is called IPO
• A prospectus must first be filed with the regulators
• Prospectus: "Investment contract" between company and purchaser that outlines certain facts

Reporting Issuer

• A company issuing more securities into the marketplace
• Still needed w/ prospectus unless exemption is granted this may be less detailed vs. an IPO since information is available
• Dealers can participate in the offering in assisting the company issue, pricing and sale
• This is called underwriting and distribution w/ whole or partial distribution to investors

Bought, Best efforts Deals

• Bought deal: dealer buys shares and acts as principal
• Best efforts: dealer acts as agent

Preliminary Prospectus

• This is also called Red Herring prospectus
• Must have a statement and subject to change
• Cannot be sold no offers be accepted until later
• This prospectus' purpose is to determine interest levels from distributor, administrator and before product pricing

Form and Content of Prospectus

• Form complies with securities law
• Contents may exclude underwriter pricing
• Exclusion of auditor reports
• Issuer must maintain a record of all those that prospectus information has been sent if one is defective, information changes, the revised prospectus information is sent

Waiting Period

• Time after an issuer receives receipts prospectus to be processed
• During the waiting Period, underwriters may receive interest
• A copy of the preliminary prospectus must be provided to anyone who expressed interest

Other actions during the Waiting Period

• Distribution of materials is not permitted
• A dealer member may not enter into any kind of agreement with a client for the purchase and sale of new securities
• However, alerting the public to a preliminary prospectus is an exception

What is the Final Prospectus

• All details must be included
• Full, true, and plain disclosure is necessary
• Material fact should be noted i.e., anything that affects market price and value of a security
• Offering price, the proceeds to the issuer the underwriting discount, and any information from the preliminary prospectus must be on the document

Disclosure

• There must be written consent of experts such as appraisers, auditors, and lawyers because signatures prove of compliance regulations
• Purchased securities is copy mailed no later than midnight of the second business day

What are Prospectus Exemptions

• Restricted portions of the capital markets where participation is strict or certain entities
• Otherwise they may refer to securities that are generally considered to be low in terms of loss of principal
• Issuers are in the exempt market & they do not need to comply with certain requirements applicable to the market

Exempt Requirements

• Not needed to prepare a prospectus
• Do not involve underwriting due diligence or filing financials
• NI 45-106 provides exemptions for requirement, where purchases are subject to certain resale restrictions
• The majors are described and for seller they must verify their clients qualify and funds are reasonable
• There is an accompanying policy

Exemptions Related to Raising Capital

• Specific exemption rules apply for:
• Accredited investors (financial institutions, individuals w/worth over $1M)
• Require a signed risk acknowledgement form and documentation
• Private issuers
• Company of no more than 50 share holders
• No transfer of securities
• Family, friends, business associates allows issuer distribution securities
• Offering memorandum a document given to purchaser & provide right to rescission
• Minimum Amount requirement

Crowdfunding

• Crowdfunding helps start ups with capital
• The Exemption of securities and prospectus from requirements are for a distribution
• Online Company funding starts w/ regulatory guidelines
• The maximum allowed can have limits
• Must have a signed risk form from each of distribution
• In addition investor has similar right of withdrawal can be exercised w/ 48hrs from Purchase

Resale/Trade & Placements

• Securities can be sold after a certain amount of time and unless otherwise granted exemption
• There is a Bona fide
• Investor can be made of their Total if they participate
• Public investors do not have the ability to jump in with the client
• Employees are excluded
• Clients must also communicate private placements if a problem arises the priority be observed first

Case Study: RR Erica

• Private transactions are riskier and require additional levels of oversignt for which dealer members have specialized departments, such as an investing banking department
• All such transactions must be on the dealer member's books and records so as to be properly supervised
• The dealer member hired Erica to act in retail capacity only. Here, she is also acting in the capacity of money for an issuer
• And has potentially engaged personal financial dealings with a client and has potentially encouraged other clients as well, this is all a conflict of interest.

Compliance for Erica

• Dealer member needs to give written consent to activity , RR should be taken to official evaluation
• Before putting with clients the distribution need be made and compliance with laws

Take-Over and Issuer Bids

• One must know rules involved when buying/selling securities
• You can provide advice w/ knowlege of the work

What are Takeover Bids

• Its buying 20% of target company where its a purchase accept or both
• Thresholds include current holdings offeror and its joint actors
• Safeguarding positions w/ shareholders
• Designed to safeguard position that each has an equal opportunity to make decision

Early Warning Rules

• Threshold prior to the bid
• Designed to alert if might be leading toward takeover
• 10% shares need to be disclosed in press release, including bonds and notes
• When an amount equals to 2% is reached, requires to issue file a press release

Takeover Bid Rules

• The offeror must allow securities to deposit for 105 days form bid
• Not take unless
• 105 days after
• Compliance
• 50% have agreed
• Must be 35 days minimum if not deposit but also expiration requirements

Takeover Rights

• Security holders that deposit may withdraw their securities when: bid expires; 4 days if haven't been collected after and 3 days haven't been paid for
• If changed, shareholder has 10 days to withdraw that must be sent to depository to return holdings

What are Issuer Bids

• All ACT provisions regulate bids to be done from issurers acquire their own securities
• Follow all securities or they won't work
• Rules happen so you can't take over
• Disclosure comes: Reasons, benefits to insiders, distributions, and valuation reports

Issuer Reporting

• Provide a evaluation of security by value prepared by value which adminis summary in the issuer
• And the acts provide exemptions from if certain conditions are met

Normal Course Issuer Bids

• From ACT is followed and if rules/ policies have been recognized and approved
• Must prepare submit to exchange approval, must be a press release
• And summary must go to shareholders of shares
• On the stock is given for security purchased through purchases to a certain security