Supervisory and Control Systems PDF

Supervisory and Control Systems 10 CONTENT AREAS Control System to Ensure Registration of Sales Representatives Control System for Disclosure Control System for Leverage Disclosure Con...

Supervisory and Control Systems 10 CONTENT AREAS Control System to Ensure Registration of Sales Representatives Control System for Disclosure Control System for Leverage Disclosure Control System for Ensuring New Client Information is Complete and Accurate Reporting and Compliance with Respect to Client Account Information Control System for Periodically Updating Client Information Standards of Supervision The Internal Branch Sales Checklist Business and Ethical Responsibilities Checklist LEARNING OBJECTIVES 1 | Describe and implement a series of internal control systems and procedures within your branch. 2 | Ensure that you have supervisory systems in place to affirm that all disclosure and compliance issues are properly treated. 3 | Describe the reporting and compliance requirements associated with client account information. © CANADIAN SECURITIES INSTITUTE  CHAPTER 10 SUPERVISORY AND CONTROL SYSTEMS 10 3 INTRODUCTION In this chapter, we provide a summary and review of the internal control systems and supervision procedures to be implemented at the branch level to ensure compliance with a mutual fund dealer’s policies and procedures. The chapter explains how to ensure that established policies and procedures are followed within your branch. Although the financial institution affiliated with a mutual fund dealer will have an overall system of regulatory control, some internal controls should also be implemented at the branch level. Most internal control systems have been discussed throughout this course. This chapter is intended to serve as a useful review and action plan. CONTROL SYSTEM TO ENSURE REGISTRATION OF SALES REPRESENTATIVES A non-registered person, even if qualified, is not allowed to sell or advise on mutual funds. To ensure compliance with this rule, you should schedule regular meetings to discuss and review the functions of non-registered and registered staff. We suggest periodically circulating a memorandum in which you set out allowable and prohibited functions for non-registered employees. A program for the regular monitoring and review of sales orders should be implemented, and orders should be checked at random intervals to reconstruct sales communications within the branch. The purpose is to ensure that non-registered employees were not involved in the mutual fund selling and advisory process. Remember that the account-opening and trading activities of new representatives are subject to special supervision and review under the Mutual Fund Dealers Association (MFDA) Policy No. 1. An employee logbook should be kept at the branch in accordance with the financial institution’s record retention and privacy standards. The logbook can be in electronic or hard copy form and must be kept in a secure location. The qualifications and registration status of each employee must be listed and kept up to date. The logbook will serve as a useful reminder of employee status to ensure that registration requirements are kept current. The branch compliance officer (BCO) often has responsibility for obtaining a signed Agreement of Approved Person (often referred to as a Schedule G) from each sales representative, which is required by the MFDA. A section of the logbook should be dedicated to reviews of your sales representatives’ status so that material changes can be identified promptly. For example, you could maintain a monthly record with a tick box beside the name of each sales representative indicating that you have reviewed their status with them. The internal control system should also include a regular review of correspondence, by both mail and electronic means, to ensure that only qualified and registered sales representatives are conducting registerable activities. Further, a review of sales representatives’ correspondence and other dealings with clients is needed to ensure that no sales representative is acting in a capacity that requires additional registration or proficiency, for example, trading in stocks or derivatives. CONTROL SYSTEM FOR DISCLOSURE Sales representatives must provide the fund facts document at account opening and before accepting a mutual fund purchase. The simplified prospectus, annual information form, semi-annual or annual management report of fund performance, and semi-annual or annual financial statements should be provided to the client upon request when they are purchasing mutual funds. To ensure that appropriate disclosure is carried out, it is advised that you, as BCO, design an internal branch sales checklist that sales representatives can complete to verify that disclosure has been made. The checklist can be in electronic or hard-copy form and may resemble the following table: © CANADIAN SECURITIES INSTITUTE 10 4 BRANCH COMPLIANCE OFFICER’S COURSE Table 10.1 | Branch Sales Checklist 1. Did the client request and receive the current fun facts document, simplified prospectus, annual information form, semi-annual or annual management report of fund performance, or semi- annual or annual financial statements? (Underline the document or documents provided.) 2. Was the client advised to read the documents? 3. Does the client understand that the mutual fund dealer is a separate legal entity from the affiliated financial institution? 4. Does the client understand that there is no Canada Deposit Insurance Corporation (CDIC) or other insurance fund guarantee? 5. Does the client understand that there is no financial institution guarantee? 6. Does the client understand that mutual funds have fluctuating net asset values? 7. Does the client understand that money market funds have fluctuating yields? 8. Does the client understand that past performance is no guarantee of future performance? 9. Was the client provided with the relationship disclosure document? 10. Was the client provided with the leverage disclosure document (if applicable)? The completed document should be placed in the client’s file and updated as required. We recommend that you encourage the client to sign the form as well. CONTROL SYSTEM FOR LEVERAGE DISCLOSURE Disclosing the implications of leverage is an important aspect of client service. The following checklist can serve as a useful reminder of the key points to cover to ensure that the client’s decision to use leverage is an informed one. The client understands and has acknowledged the following facts in writing: A leveraged purchase involves greater risk than a non-leveraged purchase. The full amount of the loan must be repaid regardless of the performance of the investment. The entire amount of the investment is at risk, not just the client’s equity. Interest is paid on the borrowed funds, which reduces the overall return on the investment. The sales representative has verified that the following steps have been taken: The client has received and acknowledged receipt of the leverage disclosure document. The features and risks of leverage have been fully disclosed. The impact of the investment on the client’s overall asset allocation has been examined and deemed appropriate for suitability and reasonability. © CANADIAN SECURITIES INSTITUTE  CHAPTER 10 SUPERVISORY AND CONTROL SYSTEMS 10 5 Clients with any of the following characteristics who wish to use leverage should come under careful BCO review: Low or poor investment knowledge (or similar categories) Risk profile of lower than medium (or similar categories) Age 60 or above Time horizon of fewer than five years Total leverage amount that exceeds 30% of the client’s total net worth Total debt and lease payments1 that exceed 35% of the client’s gross income, not including income generated from leveraged investments If your mutual fund representative recommends that a client use leverage, having the client sign a waiver to exempt the dealer or mutual fund representative is not appropriate. Lending documents and details of lending arrangements should be maintained to facilitate your review and supervision. Where the client arranges their own financing, it may be difficult to obtain details of the lending arrangement. If the client is reluctant to provide that information, the sales representative must advise the client that they cannot assess the suitability of the leverage strategy without it, and they must maintain evidence of that advice. CONTROL SYSTEM FOR ENSURING NEW CLIENT INFORMATION IS COMPLETE AND ACCURATE After the applicant and the sales representative have signed a completed account opening form (electronic or written), you must initial or sign the form as BCO. Your initials or signature indicate that you have reviewed the form for completeness and accuracy and have accepted the investor as a client. It also attests to the fact that the regulatory requirement of the sales representative who completed the form has been satisfied. A system must be implemented to ensure that you review all new account forms. Your initials or signature is required only for the initial account opening form, not for every subsequent order, as described under MFDA Policy No.2. When a new account is opened, your sales representatives should be instructed to bring you the completed file, including all Know Your Client (KYC) information, for your review and signature. All account files should have a check box on the cover, or an electronic equivalent, to record BCO approval of the account. This item could be added to the internal branch sales checklist (Table 10.1), as follows: Table 10.2 | Branch Sales Checklist 11. Is this a new account? 12. Was the account reviewed and approved by the BCO? 13. Is supporting documentation attached, such as a corporate resolution or trust deed? 1 Total debt payments include all loan types, regardless of whether they were obtained for investment purposes. Total lease payments include all significant, ongoing lease and rental payments such as automobile leases and rental payments on residential property. © CANADIAN SECURITIES INSTITUTE 10 6 BRANCH COMPLIANCE OFFICER’S COURSE REPORTING AND COMPLIANCE WITH RESPECT TO CLIENT ACCOUNT INFORMATION After the client and sales representative have signed the completed account opening form, a designated person (typically the BCO) must approve the form. The designated person’s signature indicates that the account information has been reviewed and approved for completeness and accuracy and that the investor has been accepted as a client. It also verifies adherence to the regulatory requirement that a qualified and registered sales representative completed the form. Make sure that all old KYC files are maintained in accordance with the financial institution’s record retention policies and procedures. Hard or electronic copies of evidence may be essential in the case of a dispute or a legal claim. When an account is closed, the retention period for records is seven years (on-site for one year), or longer if required by your financial institution. Note that the record must be a hard copy with the client’s signature, and electronic records may also be required. As BCO, you should be familiar with your dealer’s electronic record retention policy and capability. Instruct all sales representatives that KYC forms cannot be copied for distribution to others. Furthermore, client lists, client portfolio records, new account forms, and other such material is the property of the dealer and not the sales representative, and all applicable privacy laws must be observed. CONTROL SYSTEM FOR PERIODICALLY UPDATING CLIENT INFORMATION After the client’s account is opened, the BCO’s signature is not required on subsequent transactions. However, the information must be kept current, accurate, and complete. Accordingly, on all subsequent transactions, the KYC information in the client’s file should be reviewed by the sales representative to ensure that the investment recommendation remains suitable. An internal control process should also be in place to ensure that the information is kept up to date. If necessary and where appropriate, the account may need to be re-approved by the BCO. A review of the information on subsequent proposed transactions will allow the client and sales representative to examine the impact of the transaction on the client’s overall portfolio. For example, an isolated trade that appears unsuitable (such as a relatively high-risk or particularly volatile mutual fund) might be acceptable within the context of a client’s whole portfolio mix. Be sure to include warning comments in the file if the client has selected funds that appear unsuitable. It is a best practice to have the client sign a statement acknowledging that the order was unsolicited and not recommended by the firm and that they understand that the trade may not be in their best interest. Your sales representatives should be trained to automatically retrieve and review the client file with the client. We also suggest that both the sales representative and the client sign the KYC form when it is updated. The internal branch sales checklist should have a designated section for showing that the KYC information has been reviewed, as shown in Table 10.3. Table 10.3 | Branch Sales Checklist 14. Has all KYC material been reviewed and updated, and has the date been noted on which the last review was completed? 15. Are there sufficient notes on file showing that the sales representative conducted a review of the KYC information on file, and has the client signed the review? 16. Are products held in the client’s account in keeping with his or her investment objectives and risk profile, as outlined in the KYC account documentation? © CANADIAN SECURITIES INSTITUTE  CHAPTER 10 SUPERVISORY AND CONTROL SYSTEMS 10 7 If the client is using leverage, the leverage disclosure should also be recorded, preferably on the internal branch sales checklist, as shown in Table 10.4. Table 10.4 | Branch Sales Checklist 17. Is the client borrowing funds to buy mutual funds? 18. Was evidence of leverage disclosure provided? You should also review client orders periodically to ensure that your sales representatives are complying with the KYC and suitability rules. The KYC information should be readily accessible to you when performing your review of trades for suitability. As evidence of your supervision, initial all trades you have reviewed, and maintain notes in the file regarding any enquiries you made to the sales representative and any resolutions to those enquiries. Ideally, you should review all orders, but if that is not feasible, you should implement a sampling process. For example, you could review at least 10% of the orders, selected randomly, or another sampling process may be prescribed by your dealer. Furthermore, trades meeting certain criteria, such as leveraged purchases, orders for aggressive growth and sector mutual funds, and orders over a threshold amount such as $25,000, should be reviewed more often. All orders processed by new sales representatives must have scheduled BCO reviews for the first six months. As a further check, a sampling process of the client files should be implemented. A standard, organized system should be implemented for files. For example, a file folder should be maintained for every client, and all client files should be in alphabetical order, with the signed branch copy of the KYC information filed inside if it is not already part of the order form. Records of all discussions between sales representatives and clients should be maintained. Encourage your sales representatives to keep a diary of all client discussions in the client files. Each entry should indicate the date of the discussion, the topics covered, and any directions for future action. Evidence of review as the BCO and sales representative may be maintained electronically. Each firm will have requirements regarding how records of supervision should be maintained. A fixed percentage of files should be reviewed periodically on a random basis to ensure that the information they contain is accurate and up to date. In particular, MFDA Policy No.1 requires a mandatory review of new sales representative’s client files and trades. As part of your review, you should examine client discussions and maintenance of files. Client orders should be checked against the internal branch sales checklist to ensure that your sales representatives are adhering to suitability requirements on every trade. You should also use this periodic review as an opportunity to determine whether the sales representatives are making suitable recommendations on third-party mutual funds. The potential conflicts of interest associated with recommending a fund with a high trailer fee over a fund with a lower one is of particular concern to regulators. Be sure to monitor sales representatives who are recommending an above-average number of third-party load funds. The trading record of these sales representatives should be reviewed to ensure that their recommendations are suitable. STANDARDS OF SUPERVISION Failure to supervise is a major concern to the MFDA and other regulatory agencies. MFDA investigations and sales compliance examinations generally include a review of the adequacy of the supervisory procedures of each member firm and branch. Incidents of failure to supervise may result in significant disciplinary action, fines, or suspensions, alone or in combination. © CANADIAN SECURITIES INSTITUTE 10 8 BRANCH COMPLIANCE OFFICER’S COURSE BRANCH OFFICE SUPERVISION The standards of supervision at the branch level can be met as long as the BCO adheres to prudent business practices and sets aside enough time to perform the management functions. As previously noted, the BCO is responsible for the operation of the branch office, including the opening of new accounts, the supervision of account activity, and the advice given to clients. As BCO, you are responsible for ensuring that the handling of client business at the branch is within the bounds of ethical conduct, consistent with just and equitable principles of investment activity, and not detrimental to the interests of the mutual fund industry. Regulations require that members diligently supervise the accounts of their clients and the orders entered by sales representatives. The regulators have established minimum standards of supervision in directives such as MFDA Policy No.2. In addition, the dealer must establish additional or higher standards where necessary. As BCO, you must conduct daily reviews using reports and other tools provided by head office. You can set your own standards based on reasonable risks, but you must use reasonable judgment regarding what you review. The following list provides guidance on what you should review as BCO: Suitability of investments, going beyond the risk factors and investment objectives to review the client’s financials, investment knowledge, age, and experience to get the full picture Trades in employee accounts or accounts of family members of the sales representative that operate under a power of attorney in favour of the sales representative Initial trades Trades in exempt securities, excluding guaranteed investment certificates Leverage Large transactions Redemptions over $10,000 Trades over $2,500 in moderately high or high-risk investments Trades over $5,000 in moderate or medium-risk investments Trades over $10,000 in all other investments Unusual or numerous cancelled and corrected orders for similar reasons, such as a wrong account number Mutual fund switching, short-term trading, or market timing Unusually high activity in any one investment Prohibited mutual fund switches or switches lacking a reasonable basis HEAD OFFICE SUPERVISION Regulations also require that supervision of client accounts be conducted by head office or the regional compliance officer (RCO). A two-tier structure is required to adequately supervise client account activity. The head office or RCO level of supervision cannot be as deep as branch-level supervision, but it should cover the same elements. The focus of those reviews is on those elements that cannot be carried out at the branch level. The BCO should expect to receive trade enquiries from head office or the RCO and should respond to them promptly and completely. BRANCH REVIEW REQUIREMENTS Under MFDA Policy 2, the dealer is required to conduct an ongoing review of sales compliance procedures and practices at both head office and branch offices to confirm that the procedures fulfil the purposes for which they were designed. The requirement to complete regular branch reviews is consistent with these obligations. As such, © CANADIAN SECURITIES INSTITUTE  CHAPTER 10 SUPERVISORY AND CONTROL SYSTEMS 10 9 dealers are expected to have a continuous branch review process to assess compliance. The process may include substantive testing to verify the accuracy of the information and records at the branch location. Substantive testing should include head office interviews with the BCO and salespersons and reviews of client files, trading records, advertising and marketing material, and other relevant records. As BCO, you will most likely be the central point of contact for head office reviews. Any serious issues detected during a branch review will be communicated to you, and you will need to respond and implement any required changes within a reasonable period. MFDA Policy No.5, Branch Review Requirements, articulates the requirements and expectations of a head office branch examination program. THE INTERNAL BRANCH SALES CHECKLIST All suggestions for maintaining a branch sales checklist form are summarized in Table 10.5. Table 10.5 | Branch Sales Checklist 1. Did the client request and receive the current fun facts document, simplified prospectus, annual information form, semi-annual or annual management report of fund performance, or semi- annual or annual financial statements? (Underline the document or documents provided.) 2. Was the client advised to read the documents? 3. Does the client understand that the mutual fund dealer is a separate legal entity from the affiliated financial institution? 4. Does the client understand that there is no CDIC or other insurance fund guarantee? 5. Does the client understand that there is no financial institution guarantee? 6. Does the client understand that mutual funds have fluctuating net asset values? 7. Does the client understand that money market funds have fluctuating yields? 8. Does the client understand that past performance is no guarantee of future performance? 9. Was the client provided with the relationship disclosure document? 10. Was the client provided with the leverage disclosure document (if applicable)? 11. Is this a new account? 12. Was the account reviewed and approved by the BCO? 13. Is supporting documentation attached, such as a corporate resolution or trust deed? 14. Has all KYC material been reviewed and updated, and has the date been noted on which the last review was completed? 15. Are there sufficient notes on file showing that the sales representative conducted a review of the KYC information on file, and has the client signed the review? © CANADIAN SECURITIES INSTITUTE 10 10 BRANCH COMPLIANCE OFFICER’S COURSE Table 10.5 | Branch Sales Checklist 16. Are products held in the client’s account in keeping with his or her investment objectives and risk profile, as outlined in the KYC account documentation? 17. Is the client borrowing funds to buy mutual funds? 18. Was evidence of leverage disclosure provided? BUSINESS AND ETHICAL RESPONSIBILITIES CHECKLIST The following checklist summarizes your compliance business and ethical responsibilities: For mutual fund dealers operating within a branch of a financial institution such as a bank, make sure that the operations of the dealer are such that a reasonable person would not be confused about which entity they are purchasing mutual funds from. Take steps to ensure that the following requirements are met: Sales representatives have visible nameplates so that clients can identify them. Only registered sales representatives are selling and offering advice on mutual funds. All advertising and promotional materials have been cleared by head office. Clients have received all the necessary disclosure documents. Maintain all recordkeeping as required by head office, including: Account opening forms, including the KYC information Order forms Legal documentation for accounts, including guarantees and joint-account guarantees Trust and banking agreements Trade confirmations Complaint records Books, records, journals, and financial data for audit purposes Letters of authorization and powers of attorney Sales representatives’ notes Enforce the rule stating that sales representatives cannot take inter-provincial phone orders unless they are registered in the province from which the call originates. Make sure that all orders are transmitted promptly to the fund manager for acceptance and execution. Report all initial client complaints and complaint resolutions to the RCO. When discussing mutual fund performance, make sure that standard performance data, as described under National Instrument 81-102 - Mutual Funds, is always supplied to clients, that only current data is used, and that appropriate disclaimers on the use of past performance are made. Make sure your sales representatives never recommend unsuitable trades, that they advise their clients if a trade is unsuitable, and that they caution investors who wish to proceed with an unsuitable purchase or decline the order, depending on the mutual fund dealer’s policy. When cautioning a client on an unsuitable trade, make sure that both you and the sales representative are satisfied that the client is capable of understanding the nature and quality of the cautionary advice. © CANADIAN SECURITIES INSTITUTE  CHAPTER 10 SUPERVISORY AND CONTROL SYSTEMS 10 11 For orders that are both unsuitable and unreasonable: Explain that the proposed trade does not match the client’s objectives. Suggest that the client change the order. If the client refuses, ask the client to reconsider his or her stated objectives, and change the objectives if it is warranted (unless the client’s age, financial circumstances, investment time horizon, or other factors prevent such changes). If the client refuses to change either the order or the stated investment objectives, make sure the order is refused. Review all trades in which a client’s request to switch from or to a specific mutual fund has no apparent investment benefit for the client. Make sure your sales representatives understand and comply with the following requirements: They must make sure the client fully understands that a leveraged purchase of mutual funds involves greater risk than a purchase using cash resources. Written evidence must exist showing that the client understands that a loan for leverage purposes must be paid with interest regardless of the performance of the funds. The confidentiality of all information concerning client accounts must be respected, and nothing must be disclosed without the client’s permission. They must repeat orders back to their clients to reduce the possibility of errors. Unauthorized discretionary trading is illegal and will probably lead to dismissal. If a client wishes to exercise the right of withdrawal or rescission, refer the matter to the legal department at head office; do not deal with it yourself. Once a client dispute is resolved, convey the information to the RCO, and indicate that no further action is being contemplated. Make sure that the sales representative carefully explains the forward pricing aspect of mutual funds to clients, meaning that the trade will be executed at the first available opportunity at the closing price for the day. Neither you nor your sales representatives should design your own model portfolios or portfolio mixes; these are prepared at head office. Head office provides processes and procedures for altering the model portfolios to meet the demands or needs of clients, and these should be followed. Review trades for suitability. If it is not feasible to review all orders, implement a sampling process, such as a review of 10% of orders selected on a random basis. Review a higher percentage of trades that meet certain criteria, such as: Leveraged purchases Orders for aggressive growth and sector mutual funds Orders over a threshold amount such as $25,000 Orders placed by sales representatives compensated on a commission basis Review all trades recommended by new sales representatives under a schedule for the first six months. Make sure all KYC information is readily accessible to you when reviewing trades for suitability; reviewing trades without this information is pointless. Initial all trades that are reviewed for suitability. Hold regular sales or information sessions with your staff, and emphasize all key compliance issues. Keep your sales representatives up to date on changes in your mutual fund dealer’s policies and procedures relating to the sale of mutual funds. © CANADIAN SECURITIES INSTITUTE 10 12 BRANCH COMPLIANCE OFFICER’S COURSE SUMMARY Now that you have completed this chapter, you should be able to meet the following objectives: 1. Describe and implement a series of internal control systems and procedures within your branch. Regular meetings should be scheduled with staff to discuss and review the functions of registered and non-registered staff. A program for the regular monitoring and review of sales orders should be implemented. A random check of sales orders should be implemented regularly. The account-opening and trading activities of new representatives are subject to additional supervision and review obligations. An employee logbook should be maintained (physical or electronic) in the branch to keep track of qualification and registration status of each employee. A regular review of correspondence (via mail or electronic means) should be performed to ensure that only qualified and registered sales representatives are conducting registerable activities. 2. Ensure that you have supervisory systems in place to affirm that all disclosure and compliance issues are properly treated. A number of control systems must be in place to ensure compliance with regulations. « The BCO should design an internal branch sales checklist for the sales representative to complete to verify that all disclosure documents have been provided to the client. « The BCO must initial account opening forms to prove that the application has been reviewed for completeness and accuracy and also to indicate acceptance of the investor as a client. « A process should be in place to ensure that KYC information is reviewed and updated regularly. « Client orders should be periodically reviewed by the BCO. « A standard organized system should be implemented for files. « Various practices and procedures can be enforced at the branch level to avoid unacceptable sales practices. « New sales representatives have additional supervision requirements. For the first 90 days, all new accounts must be approved by the BCO before any trading takes place. For the subsequent 90 days, all new accounts must be approved by the BCO within one business day of opening the account. The BCO must review the greater of five trades or 10% of the new sales representative trades each day. « Sales representatives outside business activities should be reviewed and attested to avoid any perceived or actual conflict of interest. 3. Describe the reporting and compliance requirements associated with client account information. BCOs must review the client account form and initial it to confirm that the account information has been reviewed for completeness and accuracy. Initials also indicate acceptance of the investor as a client and attest to the adherence to the regulatory requirement that a qualified and registered sales representative completed the form. The KYC files of closed accounts must be properly maintained in the branch for one year and seven years at head office. © CANADIAN SECURITIES INSTITUTE