Conduct and Practices Handbook Course (CPH) PDF

CONDUCT AND PRACTICES HANDBOOK COURSE Credentials that matter. ® THE CANADIAN SECURITIES INSTITUTE The Canadian Securities Institute (CSI) has been setting the standard for excellence in life-long education for financial professionals for 50 years. CSI is part of Moody’s Analytics Training and Certification Services, which offers education programs and credentials throughout the world. Our experience training over one million global professionals makes us the preferred partner for individuals, financial institutions, and regulators internationally. Our expertise extends across the financial services spectrum to include securities and portfolio management, banking, trust, and insurance, financial planning and high-net-worth wealth management. CSI is a thought leader offering real world training that sets professionals apart in their chosen fields and helps them develop into leaders who excel in their careers. Our focus on exemplary education and high ethical standards ensures that they have met the highest level of proficiency and certification. CSI partners with industry regulators and practitioners to ensure that our programs meet the evolving needs of the marketplace. In Canada, we are the primary provider of regulatory courses and examinations for the Canadian Investment Regulatory Organization (CIRO). Our courses are also accredited by the securities and insurance regulators. CSI grants leading designations and certificates that are a true measure of expertise and professionalism. Our credentials enable financial services professionals to take charge of their careers and expand their skills beyond basic licensing requirements to take on new roles and offer broader services. CSI is valued for its expertise, not only in the development of courses and examinations, but also in their delivery. CSI courses are available on demand in a variety of formats, thus enabling anytime, anywhere learning. We are continually leveraging new technology and pedagogical tools to meet the changing needs of learners and their organizations. TELL US HOW WE’RE DOING At CSI, we make every effort to ensure that what you learn is accurate, practical, and well written, and we update our courses regularly. However, we recognize that there is always room for improvement, so please let us know what you think. Your feedback counts in helping us keep our learning content fresh and accurate. You can submit comments, suggestions, or concerns to [email protected] © CANADIAN SECURITIES INSTITUTE CONDUCT AND PRACTICES HANDBOOK COURSE (CPH)® PREPARED & PUBLISHED BY CSI 200 Wellington Street West, 15th Floor Toronto, Ontario M5V 3C7 625 René-Lévesque Blvd West, 4th Floor Montréal, Québec H3B 1R2 Website www.csi.ca Credentials that matter.® Copies of this publication are for the personal use Notices Regarding This Publication: of properly registered students whose names are This publication is strictly intended for information entered on the course records of the Canadian and educational use. Although this publication is Securities Institute (CSI)®. This publication may not designed to provide accurate and authoritative be lent, borrowed or resold. 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Identifiers: ISBN 978-1-77176-739-2 (print) ISBN 978-1-77176-740-8 (ebook) First printing: 1971 Revised and reprinted: 1993, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018, 2019, 2020, 2021, 2022, 2023, 2024 Copyright © 2024 by Canadian Securities Institute Course Introduction THE CONDUCT AND PRACTICES HANDBOOK COURSE Welcome to the Conduct and Practices Handbook (CPH) course! As a registrant in the investment industry, you must understand and fully comply with the rules laid out by the provincial securities administrators and the Canadian Investment Regulatory Organization (CIRO). This course is designed to demystify this regulatory environment and provide advice for working within its ethical boundaries. While this course is written from the perspective of a Registered Representative (RR) of an investment dealer, the requirement to observe high standards of ethics and conduct also applies to Investment Representatives (IR), Portfolio Managers (PMs), Associate PMs, and supervisors of RRs and IRs. Your role as an RR is to identify and implement suitable financial and investment strategies that will help your clients accomplish their goals. To do so, you must first discover their personal, financial, and risk profiles so that the products and strategies you recommend will be suitable. To succeed in this role, you must be properly qualified, and you must follow the rules and regulations established for the investment industry. Moreover, you are expected to adhere to ethical practices in the transaction of your business. The CPH identifies many of the requirements of provincial securities legislation and of CIRO that are likely to affect you in your business dealings with your clients. It also provides practical examples illustrating the application of rules in a way that aligns with the standards of conduct you must observe as an RR. WHAT WILL YOU LEARN? The structure of the CPH course was designed after careful consideration of the different elements that comprise the environment and daily tasks of an RR in the Canadian securities industry. It is organized into two major sections that reflect these areas: Section I: Standards of Conduct in the Securities Industry Chapter 1: Standards of Conduct and Ethics Chapter 2: Ethical Decision Making Chapter 3: The Canadian Regulatory Framework Section II: Dealing with Clients in the Securities Industry Chapter 4: Working with Clients Chapter 5: Client Discovery and Account Opening Chapter 6: Product Due Diligence, Recommendations, and Advice Chapter 7: Trading, Settlement, and Prohibited Activities Chapter 8: Maintaining Client Accounts and Relationships Chapter 9: Putting It All Together © CANADIAN SECURITIES INSTITUTE ii CONDUCT AND PRACTICES HANDBOOK COURSE COURSE OBJECTIVE The objective of the CPH course is to help you interpret and adhere to the applicable rules and to the accepted standards of conduct in the industry. Lessons provide practical guidance pertaining to business conduct and the handling of client accounts so that you may operate your practice as an RR in a way that reflects high ethical standards. The course explains important industry rules and shows how to apply them in the context of various client-advisor scenarios. Scenarios include analysis and discussion to encourage you to think critically about proper ethical conduct and to prepare you for competency testing. It is important to note that the CPH is not a rule book for the industry and should not be considered as such. Rather, it designed as a guide that provides context to the rules. By providing examples, we show how certain rules are interpreted and applied in a way that demonstrates proper business conduct. KEY CHAPTER FEATURES Each chapter is organized around the following key learning features: Icons Features Description Learning Objectives The learning objectives show what you will be able to accomplish after studying the chapter. Be sure to read the learning objectives before you begin a chapter. Key Terms Understanding the terminology and jargon of the securities industry is an important part of your success in this course. To help in this regard, we provide a list of key terms at the start of each chapter. Each term is boldfaced on first appearance in the chapter and is defined in the glossary at the end of the textbook. Online Learning Each chapter has learning activities accompanying the text that are Activities available online. To access the online components of your course, log in to your Student Profile at www.csi.ca. Did You Know? This feature provides important information, including facts, statistics, clarifications, and insights, that supports the chapter content. Make sure you read the concise material covered in the Did You Know? feature to keep your knowledge up to date and be fully prepared to write your exams. Dive Deeper This feature provides links to external sources of information that can help you expand your knowledge and gain deeper insight into the financial markets and the industry in general. You will not be tested on the knowledge you gain on external websites. However, by making a habit of staying informed, you will find it easier to reach your goal of becoming a competent and trusted participant in the securities industry. Review Questions Each chapter has a series of multiple-choice questions that allow you to test your knowledge of the subject. The review questions for each chapter are available in the online course. © CANADIAN SECURITIES INSTITUTE COURSE INTRODUCTION iii YOUR JOURNEY THROUGH THE COURSE Although each student will develop an individual technique for studying, you may find the suggestions below helpful. You may be more familiar with some areas of knowledge than others, but we advise strongly against skipping those sections. You can read the material in any order you choose, depending on your particular needs and level of familiarity with the content. However, we recommend instead that you avoid shortcuts and read all chapters in the sequence given. Note that, except for material labeled For Information Only, all of the content in the textbook is examinable. DID YOU KNOW? When you practise with our various assessment tools, keep in mind that your journey is NOT about finding the right answers and memorizing them; rather, it is about knowing HOW to arrive at the right answers. Three crucial behaviours will help you succeed: Build good study habits. Turn the page only after you understand the concept. Practise to assess your knowledge. With this method, you should reap the rewards of your hard work and complete the course successfully. Your registration includes access to online course components, which are designed to reinforce the textbook content and help you assess your knowledge. Before you read a chapter, we recommend that you log in to the online course and use the online chapters along with your textbook. We suggest the following approach: Read the overview section and the learning objectives for each chapter. Read the chapter in your textbook or the online PDF or eBook. Use this first reading to familiarize yourself with the material. Take notes where necessary, especially if there is a concept you don’t understand. Complete the online learning activities for each chapter. Read the chapter slowly a second time. Pay particular attention to those areas you found challenging during your first reading. Pay attention to the tables, charts, and figures. These will help you with the practical aspects of the material. Work through all examples and calculations, making sure you understand how we arrived at the correct answers. Complete the review questions for each chapter. Read the chapter summary to reinforce your learning. Don’t forget to review the key term definitions in the glossary at the end of the textbook. Familiarity with the terminology and jargon used in the industry will help you fully understand the learning material. © CANADIAN SECURITIES INSTITUTE iv CONDUCT AND PRACTICES HANDBOOK COURSE TELL US HOW WE’RE DOING At CSI, we make every effort to ensure that what you are learning is accurate, practical, and well written, and we update our courses regularly. However, we recognize that there is always room for improvement, so please let us know what you think. You can submit comments, suggestions, questions, or concerns to [email protected]. This edition of the CPH textbook was prepared in 2024. The textbook is updated and revised regularly to reflect the rapidly changing financial services industry. We thank those students and industry representatives who helped with the revision process, either through their suggestions or by providing or verifying information for the book. © CANADIAN SECURITIES INSTITUTE CONDUCT AND PRACTICES HANDBOOK COURSE Content Overview 1 Standards of Conduct and Ethics 2 Ethical Decision-Making 3 The Canadian Regulatory Framework 4 Working with Clients 5 Client Discovery and Account Opening 6 Product Due Diligence, Recommendations, and Advice 7 Trading, Settlement, and Prohibited Activities 8 Maintaining Client Accounts and Relationships 9 Putting It All Together © CANADIAN SECURITIES INSTITUTE CONDUCT AND PRACTICES HANDBOOK COURSE vii Table of Contents SECTION 1 | STANDARDS OF CONDUCT IN THE SECURITIES INDUSTRY 1 Standards of Conduct and Ethics 1 3 INTRODUCTION 1 3 STANDARDS OF CONDUCT AND ETHICS 1 4 Ethics and Ethical Behaviour 1 5 INTEGRATING ETHICS WITH INDUSTRY RULES 1 5 Know Your Client 1 5 Know Your Product 1 6 Duty of Care 1 7 RULES OF THUMB TO GUIDE THE CONDUCT OF REGISTERED REPRESENTATIVES 1 9 SUMMARY 2 Ethical Decision-Making 2 3 INTRODUCTION 2 3 OVERVIEW OF ETHICS 2 3 Ethics Versus Rules 2 4 THE RELATIONSHIPS BETWEEN VALUES, ETHICS, AND THE LAW 2 5 VALUE AWARENESS 2 5 The Nature of Values 2 6 Values Clarification 2 6 The Importance of Values to an Organization 2 7 Importance of Values to Individuals 2 7 Importance of Values to Society 2 9 Motives and Behaviour © CANADIAN SECURITIES INSTITUTE viii CONDUCT AND PRACTICES HANDBOOK COURSE 2 10 ETHICAL DILEMMAS 2 11 Right-Versus-Wrong Issues 2 12 Right-Versus-Right Dilemmas 2 12 Types of Dilemmas 2 13 AN ETHICAL DECISION-MAKING PROCESS 2 19 SUMMARY 3 The Canadian Regulatory Framework 3 3 INTRODUCTION 3 3 GENERAL PRINCIPLES OF SECURITIES REGULATION 3 4 Disclosure 3 5 Registration 3 5 Investigation and Prosecution 3 6 KEY GOVERNMENT PLAYERS INVOLVED IN SECURITIES REGULATION 3 6 The Federal Government 3 7 The Provinces 3 7 The Canadian Securities Administrators 3 9 International Activities 3 10 SELF-REGULATORY ORGANIZATION 3 11 Canadian Investment Regulatory Organization 3 12 The Exchanges and Marketplaces in Canada 3 14 INVESTOR PROTECTION FUNDS 3 14 Canadian Investor Protection Fund 3 16 Canada Deposit Insurance Corporation 3 16 Provincial Insurance Funds for Depositors 3 17 MONEY LAUNDERING AND TERRORIST FINANCING IN THE SECURITIES INDUSTRY 3 17 Money Laundering 3 19 Terrorism and Terrorist Financing 3 19 Anti-Money Laundering and Anti-Terrorist Financing Regulations 3 21 SUMMARY © CANADIAN SECURITIES INSTITUTE TABLE OF CONTENTS ix SECTION 2 | DEALING WITH CLIENTS IN THE SECURITIES INDUSTRY 4 Working with Clients 4 3 INTRODUCTION 4 3 REGISTRATION REQUIREMENTS OF A REGISTERED REPRESENTATIVE 4 4 Proficiency Requirements and Categories of Registration 4 7 Restrictions on Non-Registered Staff 4 9 CIRO Registration Reviews: The Fit and Proper Test 4 10 Continuing Education 4 10 COMMUNICATION WITH THE PUBLIC 4 11 Rules for Telemarketing and the National Do Not Call List 4 11 Canada’s Anti-Spam Legislation 4 11 Rules for Marketing Materials 4 12 Electronic Advertising and Social Media Use 4 13 GENERAL REGULATIONS AND GUIDELINES FOR SALES LITERATURE 4 14 Mutual Fund Sales Communications 4 15 Use of Performance Data 4 16 DEALING WITH CLIENTS 4 16 Conflicts of Interest 4 18 Personal Financial Dealings and Outside Activities 4 20 PRIVACY AND CYBERSECURITY 4 20 The Personal Information Protection and Electronic Documents Act 4 21 Cybersecurity 4 22 SUMMARY 5 Client Discovery and Account Opening 5 3 INTRODUCTION 5 3 OPENING ACCOUNTS 5 3 The Cardinal Rule: Know Your Client 5 4 Client Identification Requirements: Anti-Money Laundering 5 8 THE ACCOUNT APPLICATION © CANADIAN SECURITIES INSTITUTE x CONDUCT AND PRACTICES HANDBOOK COURSE 5 12 COMPLETING THE ACCOUNT APPLICATION 5 12 Client Information 5 17 Account Information 5 20 Registrant Information 5 21 Regulatory Section 5 23 DISCLOSURES 5 23 Relationship Disclosure 5 23 Disclosing Conflicts of Interest 5 24 Pre-Trade Disclosure of Charges 5 24 Disclosure When Acting as a Principal 5 24 Disclosure Relating to Products 5 25 Leverage Disclosure 5 25 Additional Documentation for Special Circumstances 5 28 Approval 5 28 Separate Account Applications and Supporting Documents 5 30 Electronic Delivery and Signatures 5 30 CLIENT RECORDS 5 31 Removal of Records 5 31 Records of Orders 5 32 SUMMARY 6 Product Due Diligence, Recommendations, and Advice 6 3 INTRODUCTION 6 3 SUITABILITY OF INVESTMENTS AND INVESTMENT STRATEGIES 6 4 Transaction Considerations 6 5 Rules Regarding Recommendations 6 6 Suitability Considerations for Institutional Accounts 6 7 PRODUCT DUE DILIGENCE 6 7 Know Your Product 6 8 New Product Due Diligence 6 9 Leveraged and Inverse Exchange-Traded Funds 6 9 Sale of Principal-Protected Notes by Approved Persons 6 10 Distribution of Non-Arm’s Length investment Products © CANADIAN SECURITIES INSTITUTE TABLE OF CONTENTS xi 6 11 NEW ISSUES AND PROSPECTUS EXEMPTIONS 6 11 New Issues 6 13 Final Prospectus 6 13 Prospectus Exemptions 6 15 Hot Issues and Private Placements 6 17 TAKE-OVER AND ISSUER BIDS 6 17 Take-Over Bids 6 18 Issuer Bids 6 19 SUMMARY 7 Trading, Settlement, and Prohibited Activities 7 3 INTRODUCTION 7 3 HOW SECURITIES ARE TRADED 7 3 Standard Trading Units 7 4 Settlement Period 7 4 Minimum Quotation Spreads 7 5 Placing an Order 7 6 TYPES OF ORDERS 7 7 Orders Categorized by Duration 7 7 Orders Categorized by Price 7 8 Orders Categorized by Special Instructions 7 11 Other Types of Orders 7 12 Fixed Income Trading 7 13 SALES AND TRADING CONDUCT 7 13 Client Priority 7 14 Best Execution 7 14 Gatekeeper Obligations 7 16 Anti-Money Laundering and Suspicious Transaction Reporting 7 17 PROHIBITED ACTIVITIES 7 17 Frontrunning 7 18 Churning 7 19 Sales Made Outside of a Jurisdiction 7 19 Sale of Unqualified Securities © CANADIAN SECURITIES INSTITUTE xii CONDUCT AND PRACTICES HANDBOOK COURSE 7 19 Illegal Representations to Effect a Trade 7 21 Manipulative Trading Practices 7 22 Unauthorized Discretionary Trading 7 22 Illegal Insider Trading and Tipping 7 27 SETTLEMENTS, TRANSFERS, AND CORRECTIONS 7 27 The Clearing System 7 27 Advantage with Securities Sold 7 27 Accrued Interest to Seller 7 27 Trading Ex-Dividends and Ex-Rights 7 28 Transfer of Securities 7 29 Changes in Ownership 7 29 Failure to Deliver Listed Securities 7 30 Deliveries and Payments 7 30 Errors 7 31 SUMMARY 8 Maintaining Client Accounts and Relationships 8 3 INTRODUCTION 8 3 ACCOUNTING FOR CLIENT TRANSACTIONS 8 4 MARGIN ACCOUNTS 8 5 Margin Agreements 8 6 Long Margin Accounts 8 6 Securities Eligible for Reduced Margin 8 7 Operating a Long Margin Account 8 11 Short Margin 8 13 Combination of Short and Long Positions in a Margin Account 8 14 Special Margin Situations 8 14 Free Credit Balances 8 14 CASH ACCOUNTS 8 14 The Cash Account Rule 8 15 Purchase of Securities 8 16 Sale of Securities 8 17 Settlement Rules for Cash Accounts 8 17 Dealing with Overdue Cash Accounts © CANADIAN SECURITIES INSTITUTE TABLE OF CONTENTS xiii 8 21 COMMUNICATING TRADING INFORMATION TO CUSTOMERS 8 21 Confirmation of Trades 8 22 Account Statements 8 27 Enhanced Performance Reporting 8 27 CLIENT COMPLAINTS AND ACCOUNT TRANSFER REQUESTS 8 29 Complaints and Settlement Reporting System 8 29 How Clients Can Seek Compensation 8 31 Account Transfers 8 32 SUMMARY 9 Putting It All Together 9 3 INTRODUCTION 9 3 REVIEW OF GOOD CONDUCT AND PRACTICES 9 4 CASE STUDY: THE CHENGS’ ACCOUNTS 9 4 The People Involved 9 5 The Facts of the Case 9 6 Case Summary 9 6 Discussion 9 7 Suggested Conduct to Ensure Compliance 9 8 SUMMARY G Glossary © CANADIAN SECURITIES INSTITUTE SECTION 1 STANDARDS OF CONDUCT IN THE SECURITIES INDUSTRY 1 Standards of Conduct and Ethics 2 Ethical Decision-Making 3 The Canadian Regulatory Framework © CANADIAN SECURITIES INSTITUTE Standards of Conduct and Ethics 1 CHAPTER OVERVIEW In this chapter, we discuss the standards of conduct and ethics in the securities industry that should guide the behaviour of dealer members’ representatives. LEARNING OBJECTIVES CONTENT AREAS 1 | Describe the standards of conduct and ethics Standards of Conduct and Ethics in the securities industry. 2 | Explain how a code of ethics is integrated with Integrating Ethics with Industry Rules industry rules through such concepts as Know Your Client, Know Your Product, and duty of care. 3 | Apply the standards of conduct and ethics Rules of Thumb to Guide the Conduct of when dealing with clients. Registered Representatives © CANADIAN SECURITIES INSTITUTE 1 2 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text when they first occur in the chapter. Canadian Investment Regulatory Organization Know Your Client duty of care Know Your Product ethics Registered Representative fiduciary duty suitability © CANADIAN SECURITIES INSTITUTE CHAPTER 1 STANDARDS OF CONDUCT AND ETHICS 1 3 INTRODUCTION Though highly regulated, the securities industry is one based on trust and confidence. Even in the current environment, with its many complex rules and regulations, a strong personal code of ethics and high standards of conduct are warranted. The responsibilities of Registered Representatives (RRs) to their clients are comparable to those of specialists in any regulated profession. For example, like doctors and lawyers, RRs are ethically bound to put client interests ahead of their own. Clients expect their RRs to honour this duty and, in some cases, regulations require it. In all circumstances, RRs must also know their role in the securities industry and the liabilities that come with it. As an RR, you should understand the important difference between compliance and ethics, which is essentially the difference between observing the letter of the law and honouring its spirit. To be compliant is to simply follow a set of rules, whether they are legal and regulatory requirements or internal policies. Ethics go beyond prescribed conduct to guide behaviour when rules are unclear or contradictory. In fact, it is possible to act unethically while still strictly complying with the rules. In this chapter, we discuss the standards of conduct and ethics that underpin the rules and regulations of the securities industry. STANDARDS OF CONDUCT AND ETHICS 1 | Describe the standards of conduct and ethics in the securities industry. The Canadian Investment Regulatory Organization (CIRO) is the national self-regulatory organization that oversees all investment dealers, mutual fund dealers and trading activity on Canada’s debt and equity marketplaces. As such, CIRO regulates the actions and behaviour of its RRs. Along with strict compliance with its rules and regulations, CIRO requires that, as “regulated persons”, its RRs observe “high standards of ethics and conduct” when transacting their business. This integration of ethics into CIRO’s rules essentially applies to all your actions and everyday behaviour as an RR at an investment dealer. While this course is written from the RR’s perspective, the requirement to observe high standards of ethics and conduct also applies to Investment Representatives (IRs), Portfolio Managers (PMs), Associate Portfolio Managers (APMs), and Supervisors of RRs and IRs. DID YOU KNOW? CIRO’s Investment Dealer and Partially Consolidated (IDPC) Rule section 1402, Standards of Conduct, summarizes CIRO’s expectations regarding its RRs as follows: 1. A Regulated Person: i. in the transaction of business must observe high standards of ethics and conduct and must act openly and fairly and in accordance with just and equitable principles of trade, and ii. must not engage in any business conduct that is unbecoming or detrimental to the public interest. 2. Without limiting the generality of the foregoing, any business conduct that: i. is negligent, ii. fails to comply with a legal, regulatory, contractual or other obligation, including the rules, requirements, and policies of a Regulated Person, iii. displays an unreasonable departure from standards that are expected to be observed by a Regulated Person, or iv. is likely to diminish investor confidence in the integrity of securities, futures or derivatives markets, may be conduct that contravenes one or more of the standards set forth in subsection 1402(1). © CANADIAN SECURITIES INSTITUTE 1 4 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 All investment dealers have their own standards of conduct that require compliance with section 1402, though they may differ in wording. A typical set of employee standards of conduct is shown in Exhibit 1.1. Exhibit 1.1 | Employee Standards of Conduct In transacting business, a dealer member’s representatives must observe high standards of ethics and must conduct themselves honourably. Employee dealings with clients must be fair, open, and conducted in accordance with just and equitable principles of trade. Employees must not engage in any business conduct that harms the reputation of the firm, is detrimental to the public interest, or diminishes investor confidence in the integrity of the capital markets. Conduct that contravenes expected standards includes, but is not limited to, the following behaviours: Negligence of duty Failure to comply with legal, regulatory, and contractual obligations, including: CIRO’s rules, regulations, and policies Rules and regulations of the applicable securities commissions or administrators Internal rules and policies of the firm Any unreasonable departure from expected standards of ethics and conduct The penalties for engaging in such conduct may include reprimands, fines, suspension or termination of employment, or termination of registration. ETHICS AND ETHICAL BEHAVIOUR Ethics can be defined as a set of values or morals that guide individual behaviour. Morals are the rules and habits of conduct established according to society’s perceived standards of right and wrong. For the purposes of this course, we treat ethics as a continuous process of examining our choices and making decisions within the context of moral principles. A fundamental difference exists between ethical behaviour and compliance with industry regulations. Regulators set out the rules that must be followed, but the rules can sometimes be unclear. And because rules cannot encompass every possible situation that might occur in day-to-day business, another standard based on ethical behaviour is required. Ethical behaviour goes beyond regulatory requirements. It requires internally established moral judgements that can be applied in any situation. An ethical approach involves compliance not only with the letter of the law, but also with the spirit of the law. In other words, ethical behaviour consists of doing the right thing for the right reasons. In the following pages, we discuss the measures with which ethical conduct is integrated with industry rules. © CANADIAN SECURITIES INSTITUTE CHAPTER 1 STANDARDS OF CONDUCT AND ETHICS 1 5 INTEGRATING ETHICS WITH INDUSTRY RULES 2 | Explain how ethics a code of ethics is integrated with industry rules through such concepts as Know Your Client, Know Your Product, and duty of care. Ethical behaviour is integrated into the rules by measures designed to ensure the suitability of investment recommendations, among other things. In particular, these measures address your three obligations as an RR, as follows: Understand your client’s situation before making investment recommendations. Understand the products you recommend. Act honestly, in good faith, and in a professional manner. We discuss these obligations briefly here and in greater detail later in the course. KNOW YOUR CLIENT The ethical requirement to understand each client’s situation is known across the industry as the Know Your Client (KYC) rule. This obligation is a paramount concern and should be the focus of your daily business as an RR. Until you know a client’s particular situation, you cannot make suitable investment recommendations for that client. Suitability is based on factors that include a client’s current financial situation, investment knowledge, investment objectives, time horizon, and risk profile. Suitability must also be considered in light of concentration and liquidity of securities within the account, the potential and actual impact of costs on the retail client’s returns, and a reasonable range of alternative actions available to the advisor at the time the determination is made. Generally speaking, before you take any action on behalf of a retail client, you must determine, on a reasonable basis, that the action is suitable for the client and puts the client’s interest first. The manner in which you gather information, both initially and throughout the client relationship, is often referred to as a discovery process. This fact-gathering exercise is one that never stops; you must remain continually aware of the essential facts about your clients. The dealer member must keep a record of every client’s information. During the discovery process, it is your responsibility to document this information carefully on an account application. The account application must be kept continually up to date to reflect changes in the client’s circumstances. You should also acquire a diligent habit of taking detailed notes. DID YOU KNOW? The suitability requirement relates to more than the specific products you recommend. The account type, order type, trading strategy, and method of financing the trade must also suit the client’s situation. The suitability analysis should therefore begin well before you receive, recommend, or execute an order. In fact, it should begin during the discovery process, when you and your client decide which account type is best suited to the client’s needs. KNOW YOUR PRODUCT As an RR, before recommending the purchase of any investment product to a client, you must first understand how it is constructed and how it is likely to perform in various market conditions. This companion obligation of the KYC rule is often referred to as the Know Your Product (KYP) obligation. The KYP requirements set out the obligations of the firm and the registered individual that support the need to determine suitability. © CANADIAN SECURITIES INSTITUTE 1 6 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 It is especially important that you be able to properly explain new, non-traditional, complex, and structured products. Your clients have both a rightful expectation that you know what you are selling and a right to know what they are agreeing to purchase. Without this knowledge, you can neither assess suitability nor explain the product’s features and risks. And if you are unable to explain the product, the client will likely be unable to properly instruct you to execute the trade in question. DID YOU KNOW? Under IDPC Rule section 3301, Product Due Diligence: A Dealer Member must not make securities available to clients unless the Dealer Member has taken reasonable steps to: (i) assess the relevant aspects of the securities, including the securities’ structure, features, risks, initial and ongoing costs and the impact of those costs, (ii) approve the securities to be made available to clients, and (iii) monitor the securities for significant changes. CIRO also provides guidance to dealer members regarding the due diligence that must be conducted on all securities they make available to clients. This will be discussed in greater detail further on in the course. DUTY OF CARE The requirement to provide advice to clients fully, honestly, in good faith, and with the proper skills and knowledge is referred to as duty of care. The standard of care that the courts apply is not a standard of perfection, and individuals acting on a firm’s behalf are not expected to guarantee an investment. However, they must at least show that they have reasonably applied the appropriate skills and care under the circumstances. A concept related to duty of care is fiduciary duty, which is a higher standard imposed by common law. Fiduciary duty exists in circumstances where one person must place trust in the honest intentions of another person who holds greater authority or expertise. In general, RRs who provide advice are held to a duty of care rather than a fiduciary duty. The same obligation applies to order-execution-only accounts. However, in certain cases, RRs are held to the higher fiduciary standard. For example, RRs with discretionary authority as PMs over managed accounts always owe a fiduciary duty to their clients. But regardless of whether a fiduciary duty is deemed to exist, it is crucial that you understand your duty as an RR to always deal fairly, honestly, and in good faith with your clients. DIVE DEEPER CIRO’s expectations around the standard of care an RR must provide are set out in the IDPC rules regarding client accounts according to the different services provided, as follows: Rule section 3230: Advisory Accounts Rule section 3240: Order Execution – Only Accounts Rule section 3270: Discretionary Accounts and Managed Accounts Disputes in this regard must sometimes be resolved through civil litigation, and, in some cases, the courts may decide that a client was owed a fiduciary duty in the circumstances. The decision often depends on the client’s vulnerability and the degree to which he or she relied on the RR’s investment advice and product recommendations. If, for example, the RR merely executed the client’s orders without providing advice, the RR may be held to a lower standard of care. © CANADIAN SECURITIES INSTITUTE CHAPTER 1 STANDARDS OF CONDUCT AND ETHICS 1 7 RULES OF THUMB TO GUIDE THE CONDUCT OF REGISTERED REPRESENTATIVES 3 | Apply the standards of conduct and ethics when dealing with clients. The securities industry has no formal code of ethics. However, industry rules and regulations (the “letter of the law”) imply a set of ethical standards (the “spirit of the law”). For the purposes of this course, we have distilled these rules and standards into the following set of guidelines, or rules of thumb, that you must observe as an RR: 1. Gather as much information as you can about your clients, so you understand their needs, goals, and risk tolerance. 2. Learn about the products you sell to ensure that your recommendations suit each client’s situation. 3. Act in an honest, fair, and trustworthy manner in all dealings with clients, employers, colleagues, and the public. 4. Avoid entering into situations where your interests conflict with those of your clients. 5. Conduct business in a professional manner that reflects well on yourself, your employer, and your profession, and encourage others to do the same. 6. Strive to maintain and improve your professional knowledge and that of others in the profession. 7. Conduct yourself in accordance with applicable securities legislation and industry rules. 8. Hold client information in the strictest confidence. Case Study | Sally Sally, an RR, works for a mid-sized investment dealer with locations in several provinces. Upon obtaining her registration, one of Sally’s first clients was an elderly man, Abe, who has continued to trade regularly with her. Abe introduced Sally to his son, David, who also opened an account with her. When David opened his account, he told Sally that his father has been forgetting things lately, and he asked if he could go over Abe’s account details with her. Sally replied that it would be against privacy rules. Abe typically follows all of Sally’s recommendations, meaning that all trades in his account are solicited. On occasion, Sally has left recommendations on Abe’s voice mail. Abe had previously told Sally that if he does not call her back within two hours, she can execute the trade as contemplated “to save time”. Sally has done this a few times, including once recently concerning a recommendation of a leveraged exchange-traded fund (LETF). The dealer member’s product team recently introduced LETFs, but Sally was not yet trained to sell them. The father did not return the call within two hours so Sally placed the trade in accordance with their agreement. Prior to the trade, Sally had not spoken with Abe for about two weeks. Shortly after their last conversation, Abe was admitted to the hospital as a result of a stroke, which rendered him incapacitated. David has now left a message on Sally’s voice mail stating that he had recently opened his father’s mail and discovered a confirmation of the LETF trade. He wondered how his father could have approved this trade given that he is incapacitated. Discussion In this scenario, Sally has clearly violated her KYC, KYP, and duty of care responsibilities. She has a duty to ascertain that any products she recommends are suitable and that her clients are aware of the associated risks. Moreover, she is not a licensed PM and has therefore engaged in unauthorized discretionary trading. © CANADIAN SECURITIES INSTITUTE 1 8 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 Case Study | Sally Suggested Conduct to Ensure Compliance In performing your duty of care as an RR, you must make sure that every client transaction is suitable for that particular client. In order to do this, you must know your clients and know the products that you recommend. Furthermore, each dealer member should have policies in place to ensure that all orders are in compliance with the rules and within the bounds of good business practice. In this case, the dealer member failed to properly train and supervise Sally (the RR) and would be liable in the event of a complaint. © CANADIAN SECURITIES INSTITUTE CHAPTER 1 STANDARDS OF CONDUCT AND ETHICS 1 9 SUMMARY In this chapter, you learned that, as an RR, you must observe high standards of ethics and conduct in the transaction of your business. Those standards are integrated into the rules through measures that ensure the suitability of investment recommendations. In particular, the following three obligations are of primary importance: KYC: Understand your client’s situation before making investment recommendations. KYP: Understand the products you recommend. Duty of care: Act honestly, in good faith, and in a professional manner. To guide your behaviour as an RR, CSI proposes that the securities industry’s rules and regulations be distilled into a set of guidelines based on these three primary obligations. Throughout this course, we take a closer look at the concepts discussed in this chapter to help you understand how to apply high standards of conduct and ethics in all of your dealings with clients. We cover the topics of KYC and product due diligence in detail, and we introduce other key concepts and rules in the context of various scenarios. In the next chapter, we discuss ethical dilemmas and decision-making. © CANADIAN SECURITIES INSTITUTE Ethical Decision-Making 2 CHAPTER OVERVIEW In this chapter, we investigate the nature of values, ethics, and the law. We then use case scenarios to illustrate ethical concepts, and we conclude by providing some practical guidance regarding the fundamentals of ethical decision-making. LEARNING OBJECTIVES CONTENT AREAS 1 | Define ethics and explain the difference Overview of Ethics between ethics and rules. 2 | Explain the relationship between values, The Relationships Between Values, Ethics, ethics, and the law. and the Law 3 | Explain what values are and the importance of Value Awareness value awareness. 4 | Explain what happens when values conflict. Ethical Dilemmas 5 | Apply the ethical decision-making process. An Ethical Decision-Making Process © CANADIAN SECURITIES INSTITUTE 2 2 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text when they first occur in the chapter. end values means values ethical dilemma Mom test ethical relativism morals front page test unified value system legal test values © CANADIAN SECURITIES INSTITUTE CHAPTER 2 ETHICAL DECISION-MAKING 2 3 INTRODUCTION The securities industry could not exist without the public’s trust and confidence. In the previous chapter, we discussed how important it is for Registered Representatives (RRs) to generate trust and confidence by adhering to high standards of ethics and conduct in all of their dealings with their clients. Ethics play a critical role in the securities industry by providing a foundation for the industry’s comprehensive set of rules and a structure in which to interpret and evaluate incidents of potential wrongdoing. An effective ethics program is a powerful tool for creating a strong corporate culture, where company values and aspirations play a critical role. In this chapter, we investigate the nature of ethics and provide practical guidance regarding the fundamentals of ethical decision-making. OVERVIEW OF ETHICS 1 | Define ethics and explain the difference between ethics and rules. Ethics are generally defined as a set of values and standards that guide individual behaviour. A person’s values can change over time, but the change is always driven by standards of right and wrong, and not by personal need. Commonly agreed-upon ethical values include accountability, fairness, honesty, loyalty, reliability, and trustworthiness. Ethics as a concept can be defined more specifically in three ways: The rules or standards governing the behaviour of a particular group or profession A set of moral principles or values The study of the general nature of morals and the moral choices made by individuals Morals are the rules and habits of a society’s conduct that are established according to perceived standards of right and wrong. Moral principles are based on reason. They are not established, nor can they be changed, by authoritative bodies. However, they may underpin decisions made by those authorities. Because the objective of this chapter is to provide a theoretical basis for ethical decision-making, we treat ethics as a continuous process of examining behaviour and making decisions within the context of moral principles. ETHICS VERSUS RULES A fundamental difference exists between ethical behaviour and compliance with rules. An industry’s rules and regulations set out standards that participants must follow. People follow rules because they must do so, not necessarily because they believe it is the right or moral thing to do. In fact, it is possible to act unethically even when complying strictly with the rules. Furthermore, rules cannot encompass every possible situation that may occur in day-to-day business. In contrast, ethical behaviour requires internally established moral judgments that can be applied in any situation. It goes beyond prescribed behaviour to address situations where rules are not clear or are contradictory. Ethics involve compliance not only with the letter of the law, but also with the spirit of the law. In the securities industry, the basic concepts that constitute ethical behaviour are founded on ethics theory and ethical principles. The regulatory environment in which the securities industry operates consists of the rules and requirements of the provincial securities regulators, the self-regulatory organization (SRO) to whose rules a dealer © CANADIAN SECURITIES INSTITUTE 2 4 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 member and approved persons are subject, and, in some cases, the federal government. These rules, coupled with accepted industry practices, set a basic standard for ethical behaviour in the industry. DID YOU KNOW? Ethics in the Securities Industry Industry rules and regulations can be distilled into standards of ethical conduct. As an RR, you are expected to conduct yourself accordingly, as follows: You must take proper care and use independent professional judgment. You must conduct yourself with trustworthiness, integrity, honesty, and fairness in all your dealings with the public, clients, employers, and colleagues. You must, and should encourage others to, conduct business in a professional manner that reflects positively on you, your firm, and your profession. You should also strive to maintain and improve your professional knowledge and that of others in the profession. You must act in accordance with the securities act of the province or provinces in which you are registered. You must also observe the requirements of all SROs of which your firm is a member. You must hold client information in the strictest confidence. THE RELATIONSHIPS BETWEEN VALUES, ETHICS, AND THE LAW 2 | Explain the relationship between values, ethics, and the law. To develop a set of professional or corporate policies and standards based in ethics, you must first understand the interrelationship between values, ethics, and laws. Values Values are the individual or cultural measures of the worth we place on certain ideas and behaviour. Our values inform our life goals and influence the decisions we make to achieve those goals. They reflect the importance we attach to other people, money, work, leisure, and family, and the importance we place on others versus ourselves. As we grow older, our core values may shift, but rarely do they change drastically. Ethics Ethics are a set of moral principles that govern our behaviour. Our personal ethical stance is built on our personal values, and the ethics of a society are built on cultural values. Laws Laws are not synonymous with ethics, but they are commonly contained within and grow out of society’s overall ethical sensibility. Like ethics, laws are based on values held by society. Adherence to common values allows people to live together creatively rather than destructively in an environment where the consequences of their actions are predictable. Rules and laws deal with legally sanctioned behaviour. Ethics are concerned with how we relate to other people, how our actions affect others, and how best to encourage actions that allow us to live together as a society. Makers of laws concern themselves with those actions society deems to be so important that violating them will have serious consequences to society as a whole. Ethics also address these issues, but they are more concerned with how we relate to each other on a day-to-day basis, such that society benefits socially. © CANADIAN SECURITIES INSTITUTE CHAPTER 2 ETHICAL DECISION-MAKING 2 5 For various reasons, ethical behaviour is not synonymous with legal compliance. Laws attempt to lay out the parameters of appropriate behaviour and apportion responsibility for risk by setting standards of allowable behaviour. The legal system requires proof and evidence and attempts, as much as possible, to define behaviour in black-and- white and right-or-wrong terms. However, laws may be out of date, deficient, or even absent in certain areas. Without a strong code of ethics, deficiencies in the law allow for behaviour that may be strictly legal and yet highly unethical. EXAMPLE A number of laws have been created around accounting procedures, corporate governance, and accountability. Previous laws were either not adequate to deal with fraud on this scale, or were simply not taken seriously. For example, before Enron’s collapse, many accountants and auditing firms regularly circumnavigated laws and rules pertaining to transparent accounting procedures because they fully believed they would not be caught. In other words, the law held little importance for those professionals who were not inclined to behave within ethical boundaries. An old adage holds that you cannot legislate ethical behaviour. Companies that base standards only on compliance with today’s laws could well have a recipe for lower profits, greater environmental liabilities, and less than ideal decisions. The ethical corporation is one that identifies its core values, creates an ethical atmosphere that is grounded in its core values norms, and then grounds those values and behaviours in the culture of the organization. It does so in a manner that is at a minimum in compliance with applicable laws, but in so doing, may achieve a higher level of compliance and legal conduct than that which is expected. DID YOU KNOW? What is narrowly correct in legal terms may not be ethically acceptable in practice. Minority shareholder rights are a good example of this legal-versus-ethical dilemma. Currently, a company’s preferred shareholders can legally hold as little as 10% of the total share offering in question and yet still have voting control over the company’s actions. Meanwhile, the remaining 90%, who are common shareholders, also have a financial stake in the company but have no say in its activities. Many investors are currently challenging this unequal distribution of voting power as unfair and unethical. The set-up also lends itself to conflicts of interest in that preferred shareholders may be concerned with their own best interests over those of the company. VALUE AWARENESS 3 | Explain what values are and the importance of value awareness. Integrity, trust, honesty, and competency are all values that are prized by professionals in the securities industry. The security industry justifies its right to be self-regulating on the basis of a claim to these core values. The reputation of an RR who lacks any one of these values would be compromised, which would in turn put the reputation of the industry itself at stake. In this section, we explore the concept of values so that we can better understand them in the context of the securities industry. THE NATURE OF VALUES Values enter into practically every decision you and your company make. They may be based on knowledge, education, and life experience. © CANADIAN SECURITIES INSTITUTE 2 6 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 It is not easy to define the meaning of a particular value to everyone’s satisfaction. A term such as trust, for example, can mean different things to different people. However, though it may be difficult to get group consensus on their meaning, values provide important guidelines for both individuals and companies. Despite their ambiguous nature, values do have several common characteristics: They are beliefs, not facts. They are long lasting, not fleeting; however, they are not fixed or unchangeable. They guide your goals and behaviour on both a personal and corporate level. Your personal value system guides your ethical stance and behaviour, helps you form your life goals, and influences the actions you take to achieve those goals. It is therefore critically important that you take the time to truly understand what your personal values are. VALUES CLARIFICATION Situations that challenge your values can leave you with the uncomfortable sense that something is wrong. A keen awareness of your value system can help you navigate such predicaments. When you know what your values are and are consciously guided by them, you are more likely to act in accordance with those values, even in unfamiliar situations. Without that awareness, you are more likely to make wrong decisions that can damage your reputation and that of your firm. The process of becoming aware of the values that drive your day-to-day decisions and behaviour is called values clarification. If you fail to develop a conscious understanding of your value system, many of your decisions will be influenced by what psychologists call unconscious drives. Our values influence what we perceive life to be, what we want out of life for ourselves, and the actions we take to meet our life goals. There are generally two types of values: end values and means values. The values that help define our personal goals, which may be years away, are our end values. The actions we take today to achieve our goals are directly influenced by our means values. End values include a sense of accomplishment, service to people, security, a world at peace, and social recognition, which can be viewed as goals toward which we strive. Means values include ambition, openness, or competence, which can be viewed as actions we take to achieve our goals. A unified value system is one in which end values and means values mutually reinforce and support each other. Both people and corporations get into trouble when their means values do not align with their end values, which is why values clarification is such a critical process. IMPORTANT NOTE Our goals must be guided by our values, and not the other way around. In clarifying and articulating our values, we must not allow personal or corporate objectives to dictate the process. THE IMPORTANCE OF VALUES TO AN ORGANIZATION Every organization should be guided by a set of values that communicates to all its members what the company stands for. Whether the values are explicit or implied, they constitute the essence of the organization’s spirit and leadership philosophy. Many organizations publish a distilled version of those values in a mission statement, both for public consumption and in internal policy manuals for employees. Such statements set the expectation that the company’s employees will live up to an ideal based in the company’s values. In the financial services industry in particular, the ideal most firms strive for is a climate of ethical behaviour where trust can flourish. The term commonly used to describe this ethical climate is tone at the top. To be effective, tone at © CANADIAN SECURITIES INSTITUTE CHAPTER 2 ETHICAL DECISION-MAKING 2 7 the top should filter down through the organization. Every employee must communicate the firm’s guiding beliefs to every other member and to anyone who has dealings with the firm. Then, these values must be put into practice on a daily basis. An explicit statement of organizational values helps to harmonize the firm’s values with its day-to-day activities. Through such a statement, the firm’s leaders can give clear direction regarding the standards employees are expected to adhere to when executing their responsibilities. It also allows them to encourage ethical behaviour among colleagues and employees without being physically present. Additionally, an explicit values statement provides the following benefits: A sense of common direction for all members and guidelines for their daily behaviour The social energy that moves an organization into action A framework for ethical decision-making A sense of stability and continuity in a rapidly changing environment IMPORTANCE OF VALUES TO INDIVIDUALS Everyone should have a well-thought-out philosophy to provide direction and give meaning to life. At the heart of such a philosophy is a set of beliefs that require no justification other than they are right and central to one’s life. Your ethical practice rests your awareness of these core values. Knowing what your core values are allows you to hold them consciously in place as you live your life and make your daily decisions. Thus, the first question to ask in the values clarification process is, “What are my core values?”. Clearly defined core values will influence the following aspects of your life: Your ability to interpret situations, make decisions, and solve problems Your perception of other people and your ability to relate well to them Your perception of success Your perception of ethical behaviour Your value system as a self-aware person will also provide you with the moral courage to resist when you are being pressured to do what you believe to be wrong. IMPORTANCE OF VALUES TO SOCIETY We are all products of our society, which means we have absorbed the values that influence society from the time we were infants. Societal values have therefore influenced how we think and act. For example, the Agrarian and Industrial Revolutions were marked by uncertainty and a breakdown in ethical norms as individuals and societies faced new social problems. The old way of understanding the world no longer applied. Our current age is also marked by uncertainty and a shift of focus to the individual, who is seen as more important than the group – the so-called “me generation” phenomenon. This mentality, which was rampant from the 1960s to the 1990s, was supported by a system ethicists refer to as ethical relativism. We are only now beginning to balance that stance with an increased focus on the wellbeing of society in relation to the individual. Ethical relativism states that there is no such thing as a universal moral principle that governs our behaviour. Everything is relative, situational, negotiable, and personal. Each new situation requires us to redefine our values and actions, with each of us having an equal say on what is right or wrong. © CANADIAN SECURITIES INSTITUTE 2 8 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 The ethical relativist understands the individual as the focus of ethical behaviour. Therefore, ethical relativism leads naturally to the placement of individual needs over the needs of the community. The consequences of this stance can be catastrophic. In the securities industry, ethical relativism has led to many cases where people in a position of power have put their own interests before those of their clients. As a result, society is currently trying to curb the excesses of individualism and ethical relativism. Serious violations in the securities industry are sometimes the result of the violator’s morally relativistic, “me first” stance. At its worst, in the context of the securities industry, ethical relativism can lead to the following thought patterns: Relative I know how the market works. Situational My client is unsophisticated and will follow any advice I give to him. Negotiable Now that I know my client will follow whatever advice I give to him, what am I going to do? Personal I will make this decision based on my personal value of greed. It’s okay if I personally benefit from this transaction as long as I don’t get caught. Ethical relativism is based on a serious flaw in stating that there is no such thing as a universal moral principle. In fact, much research supports the idea that all cultures accept certain universal principles of right and wrong. Hans Küng, a noted Swiss theologian, found that all major world religions teach the same moral principles, as follows: Do not lie, steal, or kill. Do not practice immorality. Respect parents and love children. Likewise, Rushworth Kidder, an American writer, teacher, and ethicist, interviewed world leaders and found that the following principles are commonly held worldwide: Love Truth Fairness Freedom Unity Tolerance Responsibility Respect for life Thus, contrary to ethical relativism’s stance, there do appear to be universal moral principles by which we must all abide. In fact, our legal system, as well as the industry’s standards of conduct, are based on these principles. Unfortunately, in terms of values education, there is much work to be done. The individual’s right to do what he or she wants to do, regardless of the consequences to other people’s wellbeing, must be constantly challenged. In order for moral principles to prevail, it is critical that securities professionals not only understand that clients’ interests are more important than their own, but that every professional must act in such a manner that the clients’ interests come first. One of the securities industry’s answers to ethical relativism is the concept of professional duty of care under which the client’s interests come before those of the RR’s. Fiduciary duty is also applicable in certain situations. © CANADIAN SECURITIES INSTITUTE CHAPTER 2 ETHICAL DECISION-MAKING 2 9 MOTIVES AND BEHAVIOUR Ethical managers stress that their organization’s goal is to create client and firm profit through ethical actions. A firm and its employees must comply with society’s norms when these exceed legal standards. They must also comply with society’s expectations of fair competition; highly qualified staff and service; and respect for life, property, and the environment. In effect, responsible behaviour requires that both compliance- and integrity-based requirements be satisfied. Narrow adherence to only the letter of the law, but not to its spirit, can quickly erode a firm’s reputation on which RRs and the firm heavily depend. Ethically tuned employees may do the right thing for right or wrong reasons. Enlightened managers, in respecting their employees, may pay less attention to the reasons behind actions, and more attention to actual ethical behaviour. Whether the employee’s motive is fear of punishment, respect for authority, or concern with society’s human rights, the result is the same. Likewise, as long as employees provide exemplary service, it may not matter to the client or the regulator what motivates them. A high level of duty of care may be the result of self-gratification, need for approval, or personal commitment to service. Whatever their motivations or reasons, what is important to all parties concerned is that they make the ethical choice. This is not to say that employee motives are unimportant to an organization. Rather, what matters is good behaviour, not the reasons behind the behaviour. As investors become more active in demanding a say in how the companies they invest in are run, new governance models are emerging. At issue are new definitions of shareholder and employee rights, director and executive liability, and corporate governance. The implications here go beyond mere legal compliance to touch on ethical issues. It may be that new sets of ethically tuned standards regarding acceptable business practices must be articulated and made the corporate norm. Existing laws may not yet legally reflect current challenges. However, the gap does not mean that a proactive business can afford to ignore them, whether on business, legal, or ethical grounds. Case Study | Garret Garret is a portfolio manager at York Investments, an advisory firm specializing in managing assets for high-net- worth clients. Garret often directs a large number of his trades to Block Inc., a small securities dealer run by Mark, his old school classmate. Block is not very competitive on order execution pricing compared with other large dealers. However, the company does supply free research as part of its arrangements with its clients. Three of York’s equity analysts have questioned the usefulness of Block’s research, demanding to know why Garret continues to use Block for order execution. The truth is that, in return for Garret’s business, Mark recommends Garret’s advisory services to Block’s wealthiest clients. Garret has not disclosed this arrangement to York or to the clients Mark refers to him. As part of his working relationship with Garret, Mark charges all of his clients a slightly higher fee for access to research. About 80% of Block’s clients make use of this research. The remaining 20% do not use it but still pay the higher fee as part of Block’s overall fee structure to its clients. Garret wonders if it is right to charge the fee to those Block clients who do not use his research. Mark, for his part, sees no problem with the arrangement. Analysis Industry and professional codes of ethics do not permit the withholding of information about personal interests that are materially relevant to client services or recommendations. Garret is also faced with the issue of whether his and Mark’s interests are conflicting with the interests of the clients who are paying a research fee, but who are not using the research. Conflicts of interest will be discussed in greater detail further on in this course. However, it is important to note here that under industry rules, approved persons such as RRs and Investment Representatives are responsible for identifying and addressing conflicts of interest. If they cannot be avoided, material conflicts of interest must be disclosed in all cases where a reasonable client would expect to be informed. © CANADIAN SECURITIES INSTITUTE 2 10 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 ETHICAL DILEMMAS1 4 | Explain what happens when values conflict. An ethical dilemma arises when we are faced with two or more choices and we must make an ethical decision. However, not all ethical decision-making involves an ethical dilemma. Every ethical decision falls into one of two categories: Right-versus-wrong issues Right-versus-right dilemmas When faced with a decision in a right-versus-wrong situation, the ethical choice is obvious because the other choice is clearly wrong. An ethical dilemma occurs when our central beliefs regarding the right way to act are present in two or more of the possible choices—in other words, when our core values are in conflict. In this section, we discuss an ethical decision-making process that will help you make decisions in such situations. Case Study | Murray Murray has been an RR with Catskills Investments for over 25 years, during which time he created a large book of clients. Recently, Catskills was taken over by Wealth Makers Securities Inc. (WMS), a firm that specializes in serving high-net-worth clients. To meet each client’s needs effectively, WMS has implemented a policy that prohibits RRs from servicing more than 100 accounts. As with any securities dealer, WMS has expected productivity levels that must be maintained by all RRs. Any RRs who are unable to meet their targets over a given time will be asked to leave the firm. Murray, who wants to stay with the firm despite the account restriction, finds himself facing a dilemma. A number of his elderly clients have been with him since he started in the business and they rely on him. They are not large revenue producers, but they are loyal clients who would be lost if they were forced to find a new advisor. It is unlikely they could find someone to take care of their accounts the way Murray has. On the other hand, Murray knows that he will have to keep only his top 90 clients if he is to meet WMS’s high productivity requirement. Another concern Murray has is that a few of his major clients have opened up small accounts to allow their teenaged children to dabble in the market. Murray is afraid that if he closes out these accounts, the parents would be offended and would close out their accounts as well. Besides, even though the children’s accounts may be relatively small now, these young people are the future heirs to their parents’ assets. Murray knows that maintaining a relationship with them could be lucrative in the future. Murray also has a handful of accounts that belong to day traders. Their accounts are relatively small, but when the market is active, these clients enter several trades a day, which generates a fair amount of commission. However, when the markets are quiet or down, the accounts are relatively dormant. Ethically, what should Murray do? 1 Much of this discussion is based on Rushworth Kidder’s How Good People Make Tough Choices (New York: Fireside, 1996). © CANADIAN SECURITIES INSTITUTE CHAPTER 2 ETHICAL DECISION-MAKING 2 11 Case Study | Murray Analysis In this situation, Murray is faced with a complex ethical dilemma. His top 90 accounts are necessary to meet his productivity targets, which means he has only 10 account spaces available for other clients. Several questions arise. Does he have an equal obligation to all his of clients? Which clients should he keep? His elderly clients who really need professional advice? The children of his wealthy clients, whose accounts may someday become lucrative and whose parents he does not wish to offend? The day traders, whose accounts could bring in a significant amount of money in an extended bull market? Murray has a number of possible courses of action. Each choice has some right elements, and no choice is thoroughly wrong. How is he to decide on the right course of action? Murray’s first step in resolving the dilemma is to identify which of the following values are in conflict: Professionalism: Is he conducting his clients’ business in a professional manner? What is the best way to let clients go when he can no longer work with them? Financial wellbeing: How can he generate sufficient revenue to meet his firm’s imposed revenue goals from a reduced client base? Fiduciary responsibility: Does he have a fiduciary duty to put all of his clients’ interests in this situation above his own? Integrity: Are his actions in keeping with how he sees himself as a person and as a professional? In the course of Murray’s ethical decision-making, these are just some of the issues that he must consider and act upon. RIGHT-VERSUS-WRONG ISSUES A right-versus-wrong issue will have one of the following characteristics: One choice is clearly illegal. One choice lacks a basis in truth. The negative consequences of one choice will far outweigh any possible positive results. One choice does not conform to society’s shared code of fundamental values that define right and wrong. With right-versus-wrong issues, there is only one right course of action. Codes of conduct, codes of ethics, and compliance policies are mainly concerned with these types of issues. However, as Murray’s case study shows, not all situations are black and white. In fact, most of the ethical decisions we face day to day do not involve clear-cut, right-or-wrong choices. In Murray’s case, several conflicting “right choices” make the decision-making process difficult, as follows: Loyalty and personal responsibility to his elderly clients versus the business interests of his employer Long-term business goals (in the case of his teenaged clients) versus the short-term need to drop unprofitable clients Self-preservation in terms of his financial wellbeing versus the wellbeing of his clients The right course of action in this situation is not obvious. Murray has entered a grey area where each choice contains right elements, and where his core values are present in each possible decision. In other words, he has entered that shaded area where most of our decisions must be made. © CANADIAN SECURITIES INSTITUTE 2 12 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 RIGHT-VERSUS-RIGHT DILEMMAS The first step in resolving a right-versus-right dilemma is recognizing it as a dilemma. Once you are certain that you are not facing a right-versus-wrong issue, the difficulty begins. Indeed, with many of the decisions we must make, each possible choice has an element of “right” in it, and no solution will satisfy all competing demands. This unsettling predicament can leave us confused as to what to do. In this section, we look at a method of breaking down dilemmas into four paradigms. By this means, we can critically evaluate various situations to determine the nature of the dilemma, which thus assists us in our decision- making process. TYPES OF DILEMMAS Most dilemmas can be categorized as one of four types: Truth versus loyalty In a truth-versus-loyalty dilemma, the values of honesty or integrity clash with the values of commitment, personal responsibility, or promise keeping. For example, suppose you recommend an in-house investment product to a client, and the client asks if it is the best of its kind on the market. Strictly based on return on investment, the product is fairly competitive with most similar products. However, some products on the market are currently earning a better return. Truth demands that you tell your client that higher-performing products exist (which does not mean they will continue to perform well over time). However, loyalty to your firm demands you support the in-house product. Individual versus group In an individual-versus-group dilemma, the rights and values of the few clash with the rights and values of the many. This dilemma type can be seen in terms of us versus them, self versus others, or the smaller group versus the larger group. For example, suppose you have been allocated 10,000 shares of a new issue that appears to be an excellent investment. To whom among your clients do you offer these shares? Is it fair to offer them to your best customers only, who represent the smaller group? Or should you select lottery-style from among all your clients, who represent the larger group? Short term versus In a short-term versus long-term dilemma, a conflict arises when immediate needs or long term desires run counter to future goals or prospects. In other words, means values clash with end values. For example, suppose a client wants to invest in a security, but you have doubts about its suitability for that client. However, the client insists that you purchase it for him. Do you go ahead with the transaction, or do you refuse because it does not suit the client’s long-term goals? © CANADIAN SECURITIES INSTITUTE CHAPTER 2 ETHICAL DECISION-MAKING 2 13 Justice versus mercy In a justice-versus-mercy dilemma, the values of fairness, equity, and righteousness conflict with the values of compassion, empathy, and love. For example, suppose you are supervising an employee who has been working overtime during a very busy period. She was supposed to take a seminar that would fulfill her continuing education requirements but did not have time. She decided to take the web- based course instead. To speed things up, she asks a colleague who had previously taken the course to give her the answers to the accompanying quiz. When you find out from another colleague what happened, you have to make a decision. Do you mete out justice by publicly disciplining the employee for cheating? Or do you grant mercy by taking her aside and telling her to take the seminar as soon as she can and to avoid cheating in the future? AN ETHICAL DECISION-MAKING PROCESS 5 | Apply the ethical decision-making process. Ethical decision-making is an eight-step process, as follows: 1. Recognize that there is a moral issue. 2. Determine whose moral issue it is. 3. Gather the facts. 4. Test for right-versus-wrong issues. 5. Test for right-versus-right paradigms. 6. Apply the resolution principles. 7. Make the decision. 8. Reflect on the process. In applying the steps, we refer back to the case study involving Murray, who must cull his client list. 1. RECOGNIZE THERE IS A MORAL ISSUE This step requires that you look at your actions to identify whether a moral issue exists. In Murray’s case, he must first consider whether he is serving all his clients properly and, second, how he can act with integrity in this difficult situation. 2. DETERMINE WHOSE MORAL ISSUE IT IS In this critical step, you must determine who must take responsibility for making a decision and who must be accountable for the consequences. A critical aspect of ethical decision-making is that the one responsible for making the decision accepts accountability for its consequences. In Murray’s case, he must make the decision and answer for the results. He cannot pass off the decision to anyone else. To do so would be to evade both the responsibility to make the decision and the accountability for the consequences. 3. GATHER THE FACTS The third step in the process is to gather the facts. To complete this step, Murray should ask the following questions: To whom do I owe a duty in this situation? Is there any way I could follow the firm’s policy and still make sure my elderly clients are well looked after? © CANADIAN SECURITIES INSTITUTE 2 14 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 Is it possible that an exception may be granted regarding the number of accounts? Overall, how beneficial to me are the day traders’ accounts? How do my future business goals align with the accounts of my wealthy clients’ children? Am I acting in a professional manner? Is the firm acting in a professional manner? Is there a solution that allows me to keep my clients while still accommodating the firm’s wishes? 4. TEST FOR RIGHT-VERSUS-WRONG ISSUES Three tests can be used to determine whether you are dealing with a right-versus-wrong issue: the legal test, the front page test, and the Mom test. Given a set of choices, you should subject each choice to the three tests before you proceed. Legal test In Murray’s case, is it illegal or against industry rules for him to inform certain clients he can no longer service them? Is WMS’ policy of allowing him to handle only 100 accounts illegal? No, neither practice is illegal. In fact, it is standard industry practice for RRs to inform clients with whom they will no longer work that the working relationship is ending. Front page test The front page test deals with reputation. Would Murray’s reputation suffer if his behaviour in this situation became public knowledge? He should imagine how his actions would be perceived if a major newspaper were to publish an article about the situation. Would his reputation be harmed if the general public learned that he let certain clients go to meet his new employer’s investment mandate? Assuming that Murray will inform his clients in a professional and honest manner, it does not seem that his reputation would suffer if his actions became public knowledge. In fact, the publicity could attract wealthy investors to the firm when they learn that WMS requires its RRs to dedicate all of their energy to their type of client. Mom test Murray must consider how comfortable he would feel revealing his decision to the people whose opinions really matter to him. For example, if he chooses to let his elderly clients go and keep only his wealthy clients, what would his mother say? If he would be ashamed to tell her, then it is probably not the right decision. If, on the other hand, he would be comfortable telling her, then it passes the test. In this case, it seems Murray has no choice but to drop some of his clients. Though he may feel badly about it, he has no reason to be ashamed. He can honestly tell anyone who wants to know why it was necessary and why he chose one set of clients over another. If, at this point, you determine that you are facing an ethical dilemma, and not a right-versus-wrong issue, you can move on to the next step. If, however, you have determined that there is only one right choice, you should stop the process here and take the correct action. In Murray’s case, he had identified an ethical dilemma rather that a right-versus-wrong issue. He should now continue the process and decide the best course of action. © CANADIAN SECURITIES INSTITUTE CHAPTER 2 ETHICAL DECISION-MAKING 2 15 5. TEST FOR RIGHT-VERSUS-RIGHT PARADIGMS At this stage, you should ask the following questions to determine which core values are in conflict: Is this a truth-versus- Murray’s dilemma has some elements of this paradigm. loyalty dilemma? For example, should he tell his elderly clients the truth that they do not fit the investment mandate imposed on them? Or should he be loyal to them and keep them on his book? He does not have this issue to the same degree with the day traders because they do not rely as heavily on his help. They usually contact him only when the markets are performing well, so he does not have the type of personal relationship that requires loyalty. Is this an individual- Murray’s dilemma has a significant aspect of this paradigm in the form of a small-group- versus-group dilemma? versus-large-group conflict. Out of the various groups of clients—the elderly, the wealthy, the wealthy clients’ children, and the day traders, he must determine which group should take priority. Does he owe the same rights of duty to his less profitable clients as he does to his wealthy clients? Is this a short-term Murray’s dilemma has strong elements of this paradigm. From a professional and versus long-term personal point of view, the sensible short-term choice is to concentrate on his wealthy dilemma? clients. They are the focus of his firm’s new mandate and the source of his compensation. However, he must also consider whether this choice will have long-term repercussions. Will his wealthy clients leave if he drops their children’s accounts? What about the harm to his long-term relationships with those children, who may well be his future top clients? Is this a justice-versus- This paradigm could come into play with Murray’s vulnerable elderly clients. mercy dilemma? A just choice would be for Murray to tell these clients that his firm has a new investment strategy that is legal and fair. Unfortunately, he must let them go because they do not fit the new criteria. A merciful choice would be to keep these clients because they have been with him for so long and they would be lost without him. Another merciful choice would be to make sure they are well looked after if he does let them go. 6. APPLY THE RESOLUTION PRINCIPLES The resolution principles consist of four modes of problem solving, as follows: End-based ethical Which solution brings the greatest good for the greatest number of people? thinking Rule-based ethical Which solution results in a suitable rule for others to follow in similar situations? thinking © CANADIAN SECURITIES INSTITUTE 2 16 CONDUCT AND PRACTICES HANDBOOK COURSE SECTION 1 Social contract-based Which solution results in the most harmonious relationships among the various groups? ethical thinking Personalistic-based Which solution aligns most closely with my authentic self? ethical thinking END-BASED CRITICAL THINKING This resolution principle demands a cost-benefit analysis to determine who will benefit and who will suffer. It asks that we look at our actions from the point of view of their consequences for the various parties involved. In Murray’s case, he cannot carry more than 100 clients under the WMS mandate. He should therefore consider which choice would bring the greatest good to the greatest number of people. Suppose he lets go of his elderly clients, the day traders, and any other less profitable clients. If so, his wealthy clients and their investing children would benefit, as would the firm. Any spots available after his wealthy clients and their children have been looked after would go to his most active day traders. If Murray follows this principle, he could well decide to

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