Product Due Diligence and Suitability

Overview

• Product due diligence and suitability assessment are related but distinct concepts
• Regulations related to transactions, recommendations and product types explained
• Transaction-related topics relevant to Registered Representatives (RRs) are highlighted

Learning Objectives

• Identify suitability requirements for sales and trading
• Understand Know Your Product (KYP) requirements
• Understand special considerations for exchange-traded funds (ETFs) and principal-protected notes (PPNs)
• Explain public, private capital raising, and prospectus exemptions
• Describe takeover/issuer bid requirements and considerations

Key Terms

• Accredited investors: Individuals or entities meeting specific income or asset thresholds, allowing them to invest in certain securities offerings not available to the general public
• Best efforts deal: The underwriter agrees to use their best efforts to sell as many securities as possible to the public
• Bought deal: An underwriting agreement where the underwriter purchases the entire offering from the issuer at a guaranteed price and then resells the securities to investors
• Crowdfunding: Raising capital from a large number of people, typically through online platforms, in exchange for equity, debt, or rewards
• Early warning: Regulations require investors who accumulate a significant percentage of a company's outstanding shares to disclose their holdings to the public
• Exchange-traded funds (ETFs): Investment funds traded on stock exchanges, holding a diversified portfolio of assets and offering investors exposure to various market sectors or strategies
• Exempt market: A segment of the capital market where securities can be offered and sold without the need for a prospectus, subject to certain exemptions and restrictions
• Final prospectus: A legal document providing detailed information to investors about a securities offering, including financial statements, risk factors, and management's discussion and analysis
• Initial public offering (IPO): When a private company offers shares to the public for the first time
• Institutional client: A financial organization that trades securities in large volumes
• Issuer bid: The company repurchases its own outstanding shares in the open market or through a tender offer
• New issue: A security that is being offered to the public for the first time
• Preliminary prospectus: An initial registration document filed with securities regulators containing preliminary information about a securities offering, subject to changes and amendments before the final prospectus is issued
• Principal-protected notes: A debt instrument that guarantees investors the return of their principal investment, while also offering potential upside exposure to an underlying asset or index
• Private placements: The securities are offered and sold directly to a limited number of accredited investors without being registered with securities regulators
• Prospectus: A legal document that provides detailed information about a securities offering to potential investors, including financial statements, risk factors, and management's discussion and analysis
• Red herring prospectus: A preliminary version of the prospectus that contains a disclaimer stating that it is subject to change and not an offer to sell securities
• Reporting issuer: A company that has issued securities to the public and is required to file regular financial and other reports with securities regulators
• Right of rescission: Grants investors the right to cancel their investment within a specified period of time if they change their minds or discover misrepresentations in the offering documents
• Right of withdrawal: Allows investors to withdraw their offer to purchase securities within a specified period of time after submitting their application
• Short form prospectus: A simplified version of the prospectus used by seasoned issuers who have a track record of compliance with securities regulations
• Take-over bid: An offer made by an acquirer to purchase the outstanding shares of a target company directly from its shareholders
• Underwriting: The underwriter guarantees the issuer a certain price for the securities and then resells them to investors
• Waiting period: The time between when a company files a preliminary prospectus with securities regulators and when the final prospectus is approved

Introduction

• Regulatory requirements related to securities sales go beyond Know Your Client (KYC) rules
• Understanding products and related strategies is vital to ensure their suitability for clients
• Know Your Product (KYP) is as important as KYC
• Product due diligence and suitability assessment are crucial concepts.

Suitability of Investments and Investment Strategies

• Registered Representatives (RRs) must identify suitability requirements for sales and trading
• Match client needs to risk-return attributes of investments after fulfilling KYC obligations
• Consider if the security is a primary distribution, how long it has been around, and its price fluctuations -RRs should know their firm's research evaluation, product approval status, and training requirements
• Registered Representatives (RRs) must also know the company’s track record, corporate and market information reliability, and whether the product is speculative

Transaction Considerations

• Suitability standards mandate matching security attributes with client needs to determine suitability
• Ask questions to determine a security's suitability for a client:
  • Does the proposed transaction involve a stock, bond, option, or futures contract?
  • Is it a purchase or a sale?
  • Is it being purchased with borrowed funds
  • Amount of risk, thinly traded issue, or a short sale?
  • Is the issue under investigation or review?
  • Is it a hedge or speculative?
• Registered Representatives (RRs) must analyze each factor professionally and competently and defend the analysis
• Advisors must advise against and offer alternatives for unsuitable unsolicited orders, and document actions
• Determine the suitability of a day trading account for clients
• Day trading clients should be warned of risks, and strict leverage limits must be implemented

Important Considerations for Retail Sector RRs

• Provide clients with KYC information copies when accounts open
• Gauge suitability through client time horizons, investment portfolio composition, and risk profile
• Reassess suitability during triggering events
• Update the client’s KYC profile with significant changes

Case Study: Ben

• Ben takes an order without questioning the speculation risk, and violates due care
• Ben must tell Sam that this type of trade does not conform to the investment objectives
• Ben must recommend suitable alternatives or refuse the order if the client insists

Recommended Conduct for Compliance

• Ensure every client transaction is suitable
• Refuse unsuitable orders or seek supervisor guidance
• Advise clients against unsuitable transactions
• Advise clients to update account applications if investment objectives change
• If they are unable to dissuade a client from a unsuitable trade, talk to your supervisor or compliance
• Mark accepted orders as "unsolicited" and document trade circumstances

Rules for Recommendations

Registered Representatives (RRs) must make competent recommendations based on substantiated data

Recommendations

• Provide balanced presentations, positive and negative
• You are to be aware of new developments, conduct independent research if necessary, and make no guarantees regarding:
  • Future Security Market Price
  • Future Dividends or Interest
  • Selling securities at a stated price
  • Exchange Listing at a future date

Recommendations by Example

• Providing individually tailored information to a specific customer/class of customers
• Examining client data (habits, investment preferences, past decisions) to target information
• Promoting a specific security/trading strategy to a client
• Taking into account a client's objectives/financial situation when recommending any transaction
• Client placing order after RR's online or telephone recommendation

Not Considered Recommendations

• Supplying waivers/disclaimers stating that information provided is not to be considered recommendation
• Charging lower commissions
• Transactions classified as either buy or sell
• Lack of pre-existing relationship

Institutional Account Suitability

• CIRO standards for opening, operating, and supervising institutional accounts
• Rules are flexible based on dealer member nature, procedures, and customers
• Review business activities to determine standards application

Institutional Clients

• An institutional client is defined in the IDPC rules follows:
• Acceptable counterparties
• Acceptable institutions
• Regulated entities
• Registrants (other than an individual registrant) under securities law
• A non-individual with total securities under administration or management exceeding $10 million
• All clients on the CIRO platform, regardless of sophistication are considered retail
• Institutional clients make their own investment decisions
• Assess sophistication to determine suitability assessment

Product Due Diligence

• Also know the products for recommendations
• Regulators require firms to evaluate which products RRs can sell and on what basis
• Guaranteed investment certificates (GICs) and mutual funds sold via prospectus are straightforward
• Firms conduct evaluations, impose compliance obligations, and consider training, documentation, and supervision

Know Your Product

• Registered Representatives (RRs) must understand product construction and performance likelihood
• Know Your Product (KYP) is a companion obligation to KYC
• Be able to explain new, complex, and structured products
• Clients deserve to know what they agree to purchase
• Assessing suitability and explaining product features/risks requires knowledge

New Due Diligence

• NI 31-103 stipulates registered firms must not offer securities until assessing and approving them
• Securities must be monitored for changes
• Registered firms must maintain Know Your Product (KYP) policies and procedures based on business models
• Appropriate processes are needed for assessing/approving securities available to clients and monitoring for changes
• (Guidance Note 3300-21-001) provides direction to investment dealer members about conducting due diligence
• CIRO considers the following to be components of an effective product due diligence process:
• Documented approval process, standardized for all securities, or alternatively for various defined categories of securities
• Preliminary assessment by qualified staff to determine the security is a new security or a significant change to an existing security, and the appropriate level of internal review and approval
• CIRO recommends for complex or novel securities, a detailed and documented review by an appropriately qualified and experienced committee or working group
• CIRO recommends a formal decision on the security by a new product committee or other authorized group that includes senior staff
• CIRO recommends if the security is approved, a determination and documentation of the appropriate level of post-approval follow-up, including:
  • Monitoring of client complaints and grievances related to the security
  • Reassessment of training needs on a continuing basis
  • Monitoring of compliance with restrictions placed on the sale of the security
  • Periodic reassessment of the appropriateness of the security
• It is important that the dealer member has processes to ensure due diligence in evaluating a product
• Committee members must have skills to conduct reviews, cannot rely on others work, and that they are able to rely on provided facts unless there are clear reason to question the information

Example: Exchange-Traded Funds (ETFs)

• Exchange-Traded Funds (ETFs) illustrate the importance of Registered Representatives (RRs) knowing new products
• Simple Exchange-Traded Funds (ETFs) resemble mutual funds while, some Exchange-Traded Funds (ETFs) use leverage
• Registered Representatives (RRs) must be aware of the features before recommending ETF's
• Disciplinary cases highlight this obligation
• One case example, a RR purchased leveraged ETFs for a client whose prior investment experience was limited to GICs; the RR was suspended

Leveraged, Inverse Exchange-Traded Funds (ETFs)

• (Guidance Note 20-0086) reminds investment dealer members about sales practices regarding leveraged and inverse ETFs
• These funds are complex and designed for daily objectives
• Performance can differ a lot from stated objectives
• Often unsuitable for retail investors holding >1 trading session, particularly in volatile markets
• Dealer members should have policies for ETF sales practices

Assessing Suitability of Funds

• Dealer members must determine the transaction fitness
• Registered Representatives (RRs) should also make sure accounts are reviewed
• Registered Representatives (RRs) must understand product features, risks, benefits, and leverage

Unsuitable Investments

• Use due diligence to ensure leveraged or inverse ETFs are suitable
• Advise against unsuitable orders

Communication with the Public

• Communication materials must accurately portray risks/benefits and must not omit facts

Supervision

• Dealer members require a supervisory system in place for compliance of laws
• Firms must have written procedures to:
• Impose product suitability analysis
• complete client-specific analysis, balance sales materials, and follow CIRO rules

Principal-Protected Notes (PPNs)

• (Guidance Note 2500-21-003) addresses Registered Representatives (RRs) principal-protected notes (PPNs) sales
• All PPNs must be sold through registered dealers; some banks are exempted from KYC/suitability

Dual Employee Considerations

• Given all the risks associated with the categories for PPN's, its requires that all PPN's must be conducted in the RR's capacity as an employee of the dealer member, policies must be put in place to ensure adequate oversight when involving PPN's

Non-Arm Investment Products

• Dealer members will be aware of the regulations dealing with Non-Arm investment products
• Some concerns are conduct, issuer scrutiny, review, conflict interest, suitability, and disclosure etc.
• CIROs expectations summarized in three steps:

1. Perform due diligence by learning about the product
2. Assess any conflicts
3. Evaluate any client or RR recommendations

IIROC Review

• IIROC issued deficiency and recommendation notice
• They included:
• Absence of a clear definition of "new product"
• Absence of an appropriate level of internal review
• Lack of subject information - Absence on the issues

Stanley Case Study

• Stanley gets an order from the client to speculate on a proposed takeover, recommends an excess share and makes a loss on the trade
• Stanley was negligent for bot learning key details and failed to act in the clients best interest; he could be held liable
• RR need to comply with recommendations by enlisting the help of the team and ensure there is up-to-date information; contact your supervisor

New Issues and Prospectus Exemptsions

• (Registered Representative)RR needs to know the client situation and be aware with products
• Details such as new securities are explained
• Issuer issues the documents for the public to know and the prospectus must be filled

New Issues for Public Offerings

• Securities are sold to public and then the proceeds are received
• Issuances will be called (IPO) and a prospectus must be filled with the regulators
• The prospectus is essentially the investment contract between the purchaser and the company

Other Issuances and Underwriting

• Company is going to be called a reporting issuer
• Is less detailed than an IPO

Preliminary Prospectus

• Have to require filings
• Includes Red Herring Prospectus
• Must say that information in the document is not yet final

Why The Preliminary?

• To determine public interest on the issue, even when being reviewed
• Can exclude some price information

Red Herrings, Cont'd

• An agent must maintain a record of all people given the record to
• If it needs to be sent back again, those should be sent also

Permitted Activities

• In between processes is going to called waiting periods
• They require potential investors to express interest, weather solicited or not

Restrictions

• However, it does alert the public but cannot violate any securities, may contain the following information.

Final Prospectus

• Details must be complete
• Means what and when is legislation needed?
• Information included:
• Offering price to the public
• Proceeds to the issuer
• With signature experts

Exemption Market for Prospectus

• Has restricted territory and may also include low risk principals
• Issuer doesnt need to comply with the public issues

Raising Capitals

• Regulations, Trades and resales
• Exemptions are in certain circumstances

The Exemptions

Includes accredited investors

• Trust company/Wealthy Investors
• Private Investors
• Family Friends, close business

Memorandum Issues

• The issuer must prepare and deliver with the rescission if not available, otherwise it may not be granted for eight years

Exemptsions and Crowdfunding

• Canadian Regulation introduces crowdfunding to raise capital for start-ups
• In an effort for early development and have companies raise funds

Investors

• Sign some acknowledgment that they have read the form
• Provided with additional supporting materials

For Additional

• Read more about what the regulations regarding crowdfunding and contact local CSA members for additional questions

Resale and Trade Contraints

• Regulations are found at (NI 45-101)

Hot Issues/Private Placements

CIRO requires that there an offering will be made

Public Investors with Priorities

Excludes the public from the issue

Private Placements

Clients made aware of the offer will be given allocations before it is forwarded to the issuer. They must all still be followed for client priority.

Erica Case Study

• Is involved with Antoinette, who in turn starts running securities to various clients
• She makes about 10,000$ this way, which means she is not advising her supervisor on the transactions.

Security

• Outside activities means is has exposure to risk
• Must have more oversight

All

• This oversight with transactions must have written contracts for appropriate records

Take-Over and Issuer Bids

• Described as a RR with processes and regulations
• Some holdings are impacted so what advice is best?

##Take-Over Bids

• Is 20% or more of the outstanding securities of a target

Legislation is designed to ensure that each shareholder in the target company has an equal opportunity and adequate information to make an informed decision.

• This process is designed to make an informed decision prior to a take-over, known for earlywarning and must issue or file

After the early filings, the target securities is raised for obligation

• Early warning legislation is found in the various Acts and supplemented by NI 62-103, amended by the adoption of NI 62-104

The offer must allow securietes to be be deposited for around 105 days, all terms have to be met, The offerot in these cases have to be made around 35 days

Withdrawals

• Any security holder who is a depositor may withdraw their security is the following:
• Before the bid expires
• After 45 days for the bid
• If the purcahser has not been paid

Withdrawal Exceptions

• the shareholder only has ten days

##Issuer Bids

• The same as take over bids, provincial actiosn
• The circualr sent must disclose reasons

Similar disclosures are required/expected after the buy bid circular.

• Must have been a good valuer

Normal bids in Course

• Prepare their approval and notice
• Mailing to shareholders
• Only 2% in the 30 day period
• Does not exceed either 10% of the total

Summary

RR must know their client when they are making recommendations

• They must be given to the exotic as they are not fit

The Registered Representative are to take on a lot to clients and there situations to ensure compliance with new issues and exemptions and when they occur.

For the next chapter, you learn how to place and order!