Product Due Diligence & Suitability Assessment

Chapter Overview

• Product due diligence and suitability assessment are separate but related
• Registered Representatives(RRs) must understand regulatory requirements for transactions and recommendations
• RRs must be aware of different types of products
• It is important to understand transaction-related topics

Key Terms

• Accredited Investors: Investors meeting specific financial requirements, often with higher risk tolerance.
• Best Efforts Deal: Investment dealer sells securities as an agent without guaranteeing sales or price.
• Bought Deal: Underwriter purchases entire security issuance for resale, assuming capital risk.
• Crowdfunding: Raising capital from a large number of people, typically online
• Early Warning: Disclosure requirement when an investor accumulates a significant stake in a company.
• Exchange-Traded Funds(ETFs): Investment funds traded on stock exchanges, similar to mutual funds.
• Exempt Market: Market where securities can be sold without a prospectus, subject to certain restrictions.
• Final Prospectus: Document containing complete details of securities being offered.
• Initial Public Offering(IPO): A company's first sale of stock to the public.
• Institutional Client: Large investor that meets specific criteria
• Issuer Bid: Company's offer to buy back its own shares.
• New Issue: Security that is being sold to the public for the first time
• Preliminary Prospectus: Initial registration document filed with the SEC by an organization planning to offer securities to public
• Principal Protected Notes(PPNs): Debt instruments that guarantee the return of principal at maturity.
• Private Placements: Sale of securities to a select group of investors without a public offering
• Prospectus: Document that describes a security and discloses financial information about the issuer.
• Red Herring Prospectus: Preliminary prospectus that does not include offering price of the investment
• Reporting Issuer: A company that has already issued securities to the public
• Right of Rescission: Investor's right to cancel a contract and receive a refund
• Right of Withdrawal: Investor's right to back out of a contract
• Short Form Prospectus: A type of prospectus used by well-established companies.
• Take-Over Bid: Offer to acquire control of a company by purchasing its shares
• Underwriting: Process by which investment banks raise investment dollars from investors on behalf of corporations and governments
• Waiting Period: The period between the issuance of a receipt for a preliminary prospectus and the receipt for a final prospectus

Introduction

• Besides ethical standards, there are regulatory requirements for security sales
• This chapter's concepts go beyond Know Your Client(KYC) obligations
• Understanding products and evaluating investment strategies are crucial
• It is important to ensure suitability for the client
• Know Your Product(KYP) is critical along with KYC
• RRs must understand these concepts to discuss them with clients

Suitability of Investments and Investment Strategies

• RRs must identify suitability requirements associated with sales and trading
• Match client needs with risk-return of various products
• Variables to consider include whether the security is a new issue, product history, and price fluctuations
• Factors include research evaluations, firm approval, and training requirements
• Consider the company track record, data availability, and whether speculative

Transaction Considerations

• Suitability standards link security attributes to client needs
• The Canadian Investment Regulatory Organization(CIRO) rules apply to accounts and orders
• It is important to understand the security to determine suitability
• Is the security being purchased with borrowed funds?
• What amount of risk is associated with the transaction?
• Is the issue under investigation or review?
• Is it a hedge to protect an existing position, or is it speculative?
• RRs should confirm they have analyzed each factor professionally

Case Study: Ben

• Ben accepted an order without ensuring Sam understood speculative stock risks
• Ben violated due care requirements
• The risk was high because it significantly departed from Sam's strategy
• Ben must advise against the trade and recommend suitable alternatives or refuse the order
• Supervisor should document discussions

Rules Regarding Recommendations

• RRs must ensure recommendations are made competently
• Recommendations can originate from research or substantiated information

Recommendations

• Disclose all relevant information, both positive and negative
• RRs must stay aware of new developments affecting client investments
• Must do own research if firm does not follow the security
• No guarantees can be given regarding future price, dividends, or listing
• Whether a transaction is recommended depends on the facts and if a reasonable person would believe so

Examples of Recommendations

• Providing tailored information to specific customers
• Examining client data and investment preferences
• Promoting specific securities or strategies
• Considering client objectives
• A client entering an order with the same dealer member online following an RR's telephone recommendation

Examples of Factors That Have No Bearing on Whether a Recommendation is Made

• Supplying a waiver or disclaimer
• Charging a lower commission
• Classifying a transaction as a buy or sell
• The lack of a prior relationship

Suitability Considerations for Institutional Accounts

• Clients can be categorized as acceptable counterparties, acceptable institutions, regulated entitites, registrants, or non-individuals with over $10million in total assets

Product Due Diligence

• RRs must understand Know Your Product (KYP) requirements of products like ETFs and PPNs.
• Firms must evaluate which products RRs can sell and how
• Complex products need thorough firm evaluation and may have obligations like training

Know your Product

• RRs must understand product construction and performance in various markets
• KYP is a companion to KYC
• RRs must explain new, complex products
• Clients can rightly expect and understand what they purchase

New Product Due Diligence

• Under NI 31-103, firms must assess and approve securities that are presented to clients
• Firms must monitor securities for changes
• Firms should use appropriate processes for assessing/approving securities

Effective Product Due Diligence

• Includes documented approval, preliminary assessment, detailed review for complex securities, and formal security decision
• If approved, determine post-approval follow-up like complaints monitoring and reassessment

Exchange-Traded Funds(ETFs)

• ETFs provide a good case of knowing your products
• At their simplest, these types of products are similar to mutual funds.
• Some ETFs are complex structured products that use leverage and other sophisticated investment strategies.
• RRs must be aware of the features of a new ETF before recommending it

Leveraged and Inverse Exchange-Traded Funds

• Investment dealer members must understand sales guidelines for leveraged and inverse ETFs
• These types of funds are designed to achieve their objectives on a daily basis.
• Over longer periods of time, instruments can differ from daily objectives
• Typically considered unsuitable for retail investors with long trading sessions primarily in volatile markets

Assessing Suitability

• Dealer members should determine suitability of leveraged and inverse ETFs
• Accounts are reviewed for suitability given triggering changes
• RRs must fully understand ETF features, risks, how designed, and impact of market volatility

Unsuitable Investments

• RRs must advise against proceeding with leveraged or inverse ETFs if unsuitable

Communication With The Public

• Sales materials for leveraged and inverse ETFs must be fair and balanced
• Communications to public must not omit material facts or qualifications that could be construed as incorrect

Supervision

• Dealer members must impose supervisory system in order to ensure compliance with applicable rules, and securities laws when recommending or accepting orders for leveraged and inverse ETFs
• Firm must have written supervisory procedures that impose requirements

Sale of Principal-Protected Notes (PPNs)

• Can only be sold through registered dealers, including CIRO investment dealer members

Distribution Non-Arm's Length Investment Products

• Dealer members must acknowledge regulatory concerns when it comes to products
• RRs must include conduct-related matters, issuer scrutiny, review, conflicts of interest, suitability, disclosure, and protection fund coverage.

Expectations For Sales Reps are Summarized in 3 Steps

• Steps include product due diligence, learning what you are distributing, and identifying conflicts
• It is important to asset the suitability of client orders and RR recommendations.
• If a trade is considered suitable, it has to complete appropriate laws and SRO rules

Case Study: Stanley

• Stanley failed to learn enough about the takeover
• Stanley failed to act in the client’s best interest, and this negligence, could result in liability.

Ensure Compliance

• Registered Representatives must check the situations of investment opportunities
• This means understand any new product being recommended.
• Use the company research office and take advantage of training offered

New Issues and Prospectus Exemptions

• RRs must understand client situations/products and how transactions work
• Details include new issues of securities via prospectus and available exemptions.

New Issues

• First offerings are called initial public offerings (IPOs)
• Prospectus must first be filed with regulators

Reporting Issuer

• Company with additional securities in the marketplace
• Prospectus is normally required unless a prospectus exemption is available.
• Prospectus may be less detailed

Underwriting

• Dealer members may be involved in the offering process in a number of ways, including providing advice, and helping to sell new securities
• Regarding distribution, the dealer may purchase the whole or partial block of new securities and distribute to institutional or individual investors

Preliminary Prospectus

• Both a preliminary prospectus and final prospectus typically must be filed
• Used to determine the extent of interest and requires, on its front cover, a red inked statment

Prohibited Activities During the Waiting Period

• Most other activities considered to be in furtherance of an issuance of securities are prohibited during the waiting period, such as the use of marketing materials

Final Prospectus

• Full, true, and plain disclosure of all material facts relating to the securities that are going to be distributed
• It indicates compliance with law

Prospectus Exemptions

• The purchase costs must be $150,000 or more

Exemptions Related to Crowdfunding

• Regulators introduced securities crowdfunding to raise capital for startups and early stage issuers.
• Designed to facilitate the investment in Canadian companies in earlier stages
• Designed to give funds from the public via a funding portal

Resale or First Trade Exemptions

• Securities acquired are restricted to a certain restricted time

Hot Issues and Private Placements

• Client priority must be addressed in private placements.

Case Study: Erica

• Dealer member must have knowledge, and give written consent to business dealings outside of normal business.RR should take proposals for proper evaluation
• RR needs to make sure compliance with securities legislation, so trade can be recorded in a normal way and a client statement sent out

Take-Over and Issuer Bids

• Must understand rules and processes involved when issuers purchase the securities
• RR may need to inform clients of such bids

Take-Over Bids

• Act to acquire 20% or more of shares of the target

Early Warning Rules

• Designed for any company that accumlates 10% or more of voting shares, to alert investing public

Early Warning Legistlation

• Can be found in the Acts and supplementend through NI 62-103, as amended by NI 62-104

Take-Over Bid Rules

• Offeror must allow securities to deposit for more than 105 days from the bid date. Offeror should not take securities with certain circumstances

Withdrawal Rights

• Any security holder can transfer securities with certain conditions
• Takeover bid changes after the expiration, shareholder has 10 days to transfer securities

Issuer Bids

• Provisions with regulatory provisions
• Circular must be sent to security holders getting the disclosure bid

Issuer Bids

• Subject to similar rules as takeover bids
• Disclose the reasons and benefits for the bit with disclosure similar but more extenisve than disclosure in a Take-over bid

Normal Course Issuer Bids

• Must abide by rules and regulations for an exchange
• An issuer will have to purchase through normal market purchases around up to 2% of its securities in any 30-day. period

Summary

• RRs must know ther clients and the characteristics that they recommend to them
• Understand the rules and their processes