CPH Chapter 1 - Standards of Conduct & Ethics PDF

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...

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