Product Due Diligence and Suitability Assessment

Chapter Overview

• Topics include product due diligence and suitability assessment
• Regulatory requirements regarding transactions, recommendations, and different product types are explained
• Additional transaction-related topics that a Registered Representative (RR) may encounter are touched upon

Learning Objectives and Content Areas

• Suitability requirements associated with sales and trading
• Understanding Know Your Product (KYP) requirements
• Special considerations for products such as exchange-traded funds and principal-protected notes
• Public and private capital raising mechanisms
• Available prospectus exemptions
• Take-over bid and issuer bid requirements and considerations

Key Terms

• Accredited Investors
• Best Efforts Deal
• Bought Deal
• Crowdfunding
• Early Warning
• Exchange-Traded Funds
• Exempt Market
• Final Prospectus
• Initial Public Offering
• Institutional Client
• Issuer Bid
• New Issue
• Preliminary Prospectus
• Principal-Protected Notes
• Private Placements
• Prospectus
• Red Herring Prospectus
• Reporting Issuer
• Right of Rescission
• Right of Withdrawal
• Short Form Prospectus
• Take-Over Bid
• Underwriting
• Waiting Period

Introduction to Regulatory Requirements for Securities Sales

• Ethical and compliance standards are essential for securities sales
• General and specific regulatory requirements exist for purchasing and selling securities
• Topics discussed surpass Know Your Client (KYC) requirements for Registered Representatives (RRs)

Importance of Understanding Products

• Knowing recommended products is crucial
• Evaluating products and strategies ensures suitability for clients
• Understanding a product is essential before recommending it
• Know Your Product (KYP) is a critical concept alongside KYC for RRs

Transaction Topics

• Security issuance via prospectus (e.g., new issue)
• Prospectus exemptions available to certain investor types
• Rules/processes that apply to issuer purchase of another issuer's securities (take-over bid) or own shares (issuer bid)

RR Responsibilities

• RRs need to understand key concepts to discuss them properly with clients

Suitability of Investments and Investment Strategies

• Determining the suitability requirements associated with sales and trading is vital
• During client discovery, RRs fulfill KYC obligations by learning and verifying client information
• Match client needs to the risk-return attributes of potential investments
• Factors to consider include whether the security is a new issue, the length of time the product/company/fund has been in existence, normal price fluctuations, and the research department's evaluation
• Additional factors: firm approval, training requirements, company track record, information availability, product structure, and speculative nature

Transaction Considerations for Assessing Suitability

• Canadian Investment Regulatory Organization (CIRO) rules apply to accounts and orders
• Assessing suitability requires matching security attributes to client needs and understanding the security
• Considerations: transaction type, purchase/sale, borrowed funds, risk amount, liquidity, short sale, investigation/review status, and hedge/speculative nature
• RRs must be able to defend their analysis as meeting an acceptable professional standard

Unsolicited Orders

• For unsolicited orders that are unsuitable the advisor must take appropriate measures
• These measures can include advising against the order and recommending alternatives
• Document actions taken and avoid adjusting the account to fit the unsuitable trade

Day Trading Accounts

• Determine if a day trading account is appropriate
• Consider if a client should have an order execution-only account
• Warn clients of the risks of day trading

Leverage Limits

• Strict leverage limits must be implemented to protect clients from financial loss

RR Responsibilities in the Retail Sector

• Provide clients a copy of their KYC information when opening accounts
• Consider factors like time horizon, portfolio composition, and risk profile to assess suitability
• Reassess suitability at prescribed triggering events
• Update client KYC profiles when significant changes occur

Case Study: Ben

• Ben, an RR, accepts an order without question from Sam, a 72-year-old client, to liquidate his T-bills and invest in a penny mining stock based on a tip from his son-in-law
• Sam's account is primarily income-focused, and the move goes against his objectives
• Ben violates requirements for due care and must ascertain that Sam is aware of the risks

Addressing Risk in Ben's Case

• Ben needs to inform Sam that the trade doesn't align with his investment objectives and his account application must be updated if those objectives have changed.
• If Sam continues to insist, Ben needs to take appropriate measures to suggest alternative investments - or refuse the order entirely

Suggested Conduct

• Conduct every client transaction with specific client needs in mind
• Refuse unsuitable orders
• Contact a supervisor for additional discussion with the client
• Document all additional discussions thoroughly

Compliance Measures when Transactions are Unsuitable

• You must advise them against proceeding
• Record changes to client details and objectives, if any
• The transaction must be cleared with compliance and marked as "unsolicited" if the client's wishes are enforced

Rules Regarding Recommendations

• Ensure recommendations are competent and substantiated
• Recommendations may be computer-generated, but you are still responsible

Balanced Presentation

• Disclose both positive and negative information about securities
• Be aware of new developments that could affect investments
• Perform your research if the research department isn't following a security

Assurance

• Do not guarantee future market price, dividends, interest, or listing of a security on an exchange

Recommendation Determination

• Determined through reasonable analysis of all relevant facts and circumstances

What Constitutes a Recommendation

• Information tailored to a specific customer or class of customers
• Analyzing client data, habits, and preferences
• Promoting a specific security or trading strategy
• A dealer member factoring in a client's objective and financial situation
• Placing orders online after an RR recommendation

What Does Not Influence Recommendation?

• Supplying a waiver/disclaimer
• Charging a lower commission
• The fact that the transaction is classified is either buying or selling
• Existing business or relationship

Discount Brokers

• Discount brokers or Order Execution Only are still possible to influence client actions

Suitability - Institutional Accounts

• CIROs IDPC rules have minimum standards for opening institutional accounts
• Flexible standards vary depending on business activities

Institutional Clients per the IDPC Rules

• Acceptable counterparties
• Acceptable institutions
• Regulated entities
• Registrants (other than a registrant) as per securities law
• Non-individual clients with >$10 million in assets

Retail Clients

• It is important to note that, on the CIRO platform, all individuals are considered retail clients, regardless of net worth, securities under management, and sophistication

Institutional Clients

• Sophistication level determines suitability assessment level
• If the client can make independent investment decisions and evaluate investment risks, then the suitability obligation is fulfilled
• Obligations do not apply if they are permitted clients under the NI 31-103

Compliance

• Accurately categorizing clients is crucial for suitability obligations

Product Due Diligence

• Know your products, in addition to your clients
• Regulators require firms to have processes in place to evaluate the products they offer
• Complex products require evaluations before they are available for sale
• This evaluation may impose additional obligations, like training

Know Your Product Continued

• Understand how it is constructed and how it will likely perform in different markets
• KYP is a companion obligation of KYC
• Explain new, non-traditional, complex, and structured products clearly
• Clients expect you to know what you are selling and have a right to.
• If you cannot explain the product, the client cannot properly instruct you

New Product Due Diligence

• Firms must take reasonable steps to assess relevant aspects and approve new products per NI 31-103
• They are responsible to monitor for significant changes
• Firms must have policies, procedures, and controls in accordance with their business model, the types of securities offered, registered individual proficiency, and client relationships

Guidance Note 3300-21-001

• Due diligence must be conducted on all securities available to clients
• An effective product due diligence process components are:
  • Documented approval processes
  • Assessing preliminary security if it is a significant change
  • For complex novel securities, have a detailed review from a qualified committee or working group
  • Formal decision on security by a committee or assigned group that includes senior staff
  • Post-approval follow-up

Measures for Evaluating a Product

• Monitoring grievances and client complaints related to the security
• Reassessment of consistent training needs
• Compliance monitoring with restrictions placed on sale
• Periodic reassessment of appropriateness

Committee and Skills Check

• Have conducted adequate due diligence and documented the process/decision
• Have proper skills and experience to conduct a proper product review
• May rely on the facts and disclosure documents provided unless it is questionable

ETFs Example

• Dealer members and RRs need to know new products
• At basics, they are similar to mutual funds
• Some are complex, using leverage and sophisticated strategies
• All RRs must be aware of leverage features before recommending

Disciplinary Case

• RR purchased multiple high-risk securities, including leveraged ETFs, for a client who only had GICs and money market experience
• Client had losses on accounts worth $124,000
• RR was fined $40,000 and suspended for six months

Leveraged/Inverse ETFs

• Guidance Note 20-0086 reminds investment dealer members of their sales practice obligations relating to leveraged and inverse ETFs.
• These are complex financial products with daily stated goals.
• Performance may vary for the long term
• Unsuitable for retail investors who desire to hold in volatile markets.
• Have procedures and policies for suitability of recommendations and supervisory procedures.

Client Orders

• Assess suitability before accepting or recommending
• RRs use diligence to confirm accounts are reviewed for suitability when triggering events occur
• Understand the product: its performance, risks, and benefits.

Unsuitable Investments Action

• Advise any client against proceeding with these

Communication with Public Action

• Sales materials balance risks/benefits
• Do not omit material facts

Supervision Requirements for Leveraged/Inverse ETFs

• An appropriate product suitability analysis is completed
• A client-specific suitability analysis is carried out
• Sales materials must be accurate and balanced
• CIRO rules and securities laws must be followed

Principal-Protected Notes (PPNs)

• Guidance Note 2500-21-003 has CIROs expectations with regards to PPNs being sold by registered investment dealers
• Regulators allow PPNs to be sold with no KYC/suitability obligations by banks
• All other PPNs must be sold only by registered dealers

Some RRs may be Dually Employed

• Investment dealers and affiliated financial institutions may allow some RR to sell through either channel
• Ciro requires RRs to conduct all sales of PPNS in the RRs capacity as an employee or agent/dealer member

Distribution of Non-Arm's Length Investment Products

• Regulatory concerns of distribution:
  • Conduct-related matters
  • Issuer scrutiny
  • Product review
  • Conflicts of interest
  • Suitability
  • Disclosure
  • Protection fund coverage
• Ciro's Expectations by sales reps: 1). perform product due diligence by learning non-arm's lengths products that they will be distributing 2). Identify any conflicts or assessments that can be addressed 3). assess suitability of RR recommendations and client orders
• The trade could be completed, but must comply with all laws and SRO Rules

Examination Findings

• New product practices were examined at dealer members by the IIROC
• Key deficiencies/recommendations listed in Notice 10-0234 that they found: -No clear definition of "new product" -No appropriate level of internal Review. A written new product proposal with expertise in all relevant areas was not present

Examination Continued

• No consideration given to marketing , proficiency, and training issues
• No process to monitor and review customer complaints involving new products

Stanley Case Study

• Stanley, an RR, gets a call from Felicia. After a discussion, Felicia instructs Stanley to invest her money in shares of an auto parts maker
• Stanley learns through a research source that the takeover was directed at ONLY the company's voting shares, and the client doesn't profit
• Class B Shares: non-voting
  • Class A Shares: 1 vote per share

Stanley's Negligence

• Stanley did not learn the fundamental details of the company and its proposed takeover
• He likely is responsible for the missed opportunity and Felicia's loss

Conducting Compliance for Stanley

• Need a deep understanding of the new product's recommendation
• Registered Reps must apply due diligence investigating the circumstances around the current prospective

Solutions

• Involve the firm's research department, if they have one.
• Inquire about any specialized product or strategy-specific areas for training
• Review financial and news publications to stay current on industry trends

New Issues and Prospectus Exemptions

• RRs must know clients and be able to explain the products being sold(new issues via prospectus)
• Understand any exemptions available given those circumstances in the course of business

New Issues

• When a company wants to acquire equity capital, it offers its own securities in the marketplace
• The business will receive any proceeds gained. For a first time security issuance it is called IPO and a prospectus will be drawn up.
• Prospectus: investment contract between the company and the purchaser

Reporting Issuer and Prospectuses

• When a company has existing shares and issues more in the marketplace, it is called a reporting issuer. A prospectus is still generally required unless there is an exemption.
• As they have publicly available info, the prospectus may be less detailed compared to an IPO.

Dealer Member Involvement

• Provide advice on what type of securities to issue, pricing advice, and helping sell
• This called is called underwriting.
  • Bought Deal: the dealer purchases blocks for distribution and bears risk.
  • Best Efforts Deal: acting as agent that sells in best interest, not being liable to buying/selling

Preliminary Prospectus (Red Herring Prospectus)

• Must state in red ink that it is not under "final form"
• It needs to be a clear statement that the purchase offer be made or accepted, or the securities are sold
• Meant so distributor of the new issue can determine how much public interest they can get.
• Auditor reports do not require inclusion.

Permitted Actions During The Waiting Period

• Can solicit expression of interest, but must deliver that preliminary prospectus.

Prohibited Actions During Waiting Period

• Enter an agreement for the purchase/sale of new security
• Can't create an advertisement or circular for the new offerings

Final P rospectus

• Must have complete details of the securities being offered for sale
• Provides full, true, and plain disclosure of all important facts/figures related to those securities as required by legislation

The Final Prospectus Must Include:

• Offering price to the public
• Proceeds to the issuer The Underwriting Discount Any other required information that was emitted in some preliminary prospectus

Expert Written Consent

• Include appraisers, lawyers, and auditors
• A copy must be mailed/delivered to all purchasers by the 2nd business day after purchase/sale

Exempt Market

• Participation limited to those who fit the standards set in each specific securities legislation
• Also means certain securities with low risk principals.

Issuers in the Exempt Market

• No prospectus
• No underwriter, no due diligence review
• No filing of financials or reports with regulators

Advantage of Exempt Market Issuance

• It is cost-effective

Securities Regulators Require Investment Firms to Verify Investors:

• Qualifications can be acquired from trade
• Investments do not exceed limit

NI 45-106 Exemptions

• Purchases are subject to resale restrictions

Accredited Investors

• Include financial institutions, governments, pension funds, trust companies, and high-net-worth individuals (>$1,000,000)

Accredited Investors: Important Notes

• Must sign a risk acknowledgment form.
• Both the firm and RR must make efforts to thoroughly keep track of facts supporting their claim

Private Securities Issuers

• Max 50 Shareholders
• Securities transferred are restricted
• Those under employment, or former

Friends & Family Issuers

• Officers, directors & their family , can distribute under these exemptions

Offering: Memorandum

• Must be the proper form
• Delivered when purchased, if bought
• Has the rescission/right of action available if regulation does not

Purchaser Details

• Purchasers must sign the form to be retained for 8 years by the issuer

Minimum Amount

The issuer does not require a prospectus if purchases are $150k greater. This is restricted to only non-individual purchasers, because that is not able to be syndicated among purchasers

Crowdfunding and Securities

• A funding portal can allow certain companies to raise funds online
• The company needs to be in the early stages of its development.
• Exemptions exists for how much they will be able to invest

Accredited Investors and Crowdfunding

• No more than $2,500 per distribution (or $10,000, as long they get advice from a registered dealer)
• Issues must have no greater than $1,500,000 on the aggregate

For Crowdfunding Investors have to :

• Sign a risk form, acknowledging they understand the warnings
• Document much be presented with all material
• 48 hours is allocated for withdrawal, if needed

Resale/First Trade Exemptions

• Usually, Securities are sold with an exemption period and may be restricted for sale until it has ended
• First trade exemptions are found in NI 45-102.

Hot Issues/Private Placements

• Per CIRO , members should make a bona fide offering to public members/investors
• Public investor: Those with investment knowledge employed by firms, but acting on their own initiative

Members Selling:

• Communicate general info, through statements
• Has the press release issued? Clients get first priority if they subscribe before allocations sent to issuer

Ericka Case Study

• Accomplished RR , Antoinette, is contacted to invest. Erica is impressed and agreed to invest $10,000 for 10,000 common shares.
• After, Erica mentions the investment to other clients, obtaining checks from them payable to Toyco Inc in exchange for share titles to the client
• Her thought process: That these clients may believe she represents the member trading them on investment to securities

Problem?

• Outside deals like are very very risky
• Dealer member has no knowledge causing supervision to not be in place
• Private placements are very dangerous requiring specialization

Solutions

• Get firm consent to deal with the type of business arrangements to take place
• Have written consent from firm, and be evaluated properly to any official that is appropriate for the business plan
• Record any trades that follow a normal process, and confirm is sent with monthly statements

RR Must Learn and Understand

• RR must understand the existing securities of other issusers (aka takeover bidders) , or when issuers sell their own bids/shares(aka issuer bids).
• RR needs to be able to know how it affects shareholders and how it works

Take-Over Bids

• A takeout bid is an offer to obtain 20% or more of any ongoing votes or equity securities
• The act must safeguard the position of all target company members so adequate and info must flow to all
• Person or company (offeror) and joint actors now own all securities.
• Goal: shareholders get all they an equal shot at that decision

Early Warning

• designed for accumulating leads that might take over bid by helping alert the investing
• Requirements extend to all target securities that are convertible to other securities

Further Action

• Any 2 % more of securities leads to an obligation to disclose a press
• must be done again until threshold reaches 20% total

Offer Required

The offeror must give the securities' details to the customers with approval

Withdrawal Rights

• Deposit shares
• In the following circumstances: During the time period of the bid(usually 35-105 days)
• Can back out if unfulfilled(45 days), or if purchaser never sends a transaction

Issuer Bids

Those acts of the provinces regulate issuer bids Contains provisions specifically for acquiring one's securities other than what may be able to be convertible to non-debt securities.

Additional Notes

• Circular must go to security holders getting the bid, providing reasons , benefits to insiders, and the issuers dividend policy