BCO Chapter 6 PDF - Suitability Requirements

Suitability Requirements 6 CONTENT AREAS Suitability Suitable Investments Solicited and Unsolicited Orders The Use of Leverage Suitability and Reasonableness LEARNING OBJECTIVES...

Suitability Requirements 6 CONTENT AREAS Suitability Suitable Investments Solicited and Unsolicited Orders The Use of Leverage Suitability and Reasonableness LEARNING OBJECTIVES 1 | Understand and explain the suitability and reasonableness of an investment. 2 | Explain the distinction between unsuitable and unreasonable orders. 3 | Explain the distinction between solicited and unsolicited orders and describe the standard of care required for each type. 4 | Explain the policy on leverage as it applies to suitability. © CANADIAN SECURITIES INSTITUTE 6 2 BRANCH COMPLIANCE OFFICER’S COURSE KEY TERMS Key terms are defined in the Glossary and appear in bold text when they first occur in the chapter. asset allocation solicited order balanced fund standard performance data common shares suitable recommendation diversification treasury bill discount broker unsolicited order Know Your Product volatility measurements © CANADIAN SECURITIES INSTITUTE  CHAPTER 6 SUITABILITY REQUIREMENTS 6 3 INTRODUCTION In this chapter, we examine how the suitability and reasonability requirements of trades are enforced. We also explain how to ensure that sales representatives provide appropriate advice to their clients. SUITABILITY The key stage in the client service process is the provision of advice by the sales representative and the solicitation of orders. As branch compliance officer (BCO), you must make sure your sales representatives use their best judgment when recommending the purchase of a mutual fund. In some cases, they may need your assistance in developing a suitable recommendation. To develop their judgment, sales representatives should receive appropriate training about the mutual funds and the models used by their dealer. They must understand that they can make recommendations and accept trades only on a reasonable basis after reviewing the research, fund facts, prospectus, and other materials produced by the mutual fund dealer. As BCO, you must make sure that the sales representatives only accept a trade or make a recommendation for an investment product when the decision is based on reasonable evidence and in accordance with the asset allocation models used by the dealer. Regular sales meetings and presentations will help keep all sales representatives fully conversant with the nature and use of your dealer’s asset allocation models (which are usually prepared by head office). Your sales representatives should also be able to interpret mutual fund performance data and be able to present it to their clients according to the strict rules and prohibitions that apply in this regard. These rules dictate how they may discuss specific performance measurements such as rates of returns, volatility measurements, and rankings, as well as the general comments they are allowed to make on performance. As described in Section 15 of National Instrument 81-102, standard performance data must always accompany any performance data supplied to clients. Only current data may be used, and appropriate disclosures relating to past performance must be made. Remind your sales representatives that they should not create their own performance data and that all performance data, including the standard performance data, are normally supplied by the head office. Sales representatives should also understand how to present performance comparisons between competing funds and between other investment products. They should also be able to explain the fee structure of the mutual fund, including the difference between load and no-load funds. The fund facts document for the mutual fund will provide this information. To provide suitable recommendations, the sales representative must have a thorough knowledge of mutual funds and the asset allocation services and programs available to properly match them to the client’s investment needs and objectives. As BCO, you are accountable for your sales representatives’ adherence to the suitability obligations. The suitability principle is the bedrock of the investment advisory process. Most securities legislation contains statements similar to the following: “each [Registered Sales Representative] shall make such enquiries as are appropriate in view of the nature of the client’s investment and of the type of transaction being effected for its account, as to the general investment needs and objectives of each client and the suitability of a proposed purchase or sale for that client.” (Regulations to the Securities Act (Ontario) (section 114(4)). Similar language is found in MFDA Rule 2.2.1.) The first step in the investment management process is to identify objectives and goals. Investment objectives are determined in thorough discussions with clients about their needs, preferences, and resources. The objective is to design a portfolio that is consistent with a client’s personal and financial circumstances, time horizon, investment knowledge, objectives, and ability to tolerate risk. © CANADIAN SECURITIES INSTITUTE 6 4 BRANCH COMPLIANCE OFFICER’S COURSE The suitability requirements go beyond the simple discovery and recording of objectives. Sales representatives must attempt to match the securities they recommend to the objectives they have identified for each client. To ensure that sales representatives meet their Know Your Client (KYC) obligation, they must also fully understand the products they are recommending to clients (See MFDA Notice MR-0048 for details regarding the Know Your Product obligation). Sales representatives should refer to a mutual fund’s fund facts and prospectus to determine its risk ranking. Each mutual fund is assigned a risk in these documents that can change over time. The sales representative must compare the client’s risk profile to the risk ranking for each fund to ensure that the allocation to the fund is and continues to be appropriate. Some mutual fund dealers have investor questionnaires to help sales representatives follow the correct KYC process. Attached as Appendix 6.1 is an excerpt from the MDFA sample client questionnaire. As BCO, you should be fully conversant with the tools available to you as well as the client account documentation requirements of your mutual fund dealer. Most mutual fund dealers affiliated with financial institutions are permitted to sell third-party mutual funds as well as their proprietary funds. As BCO, you must make sure your sales representatives fully understand all of the mutual funds the dealer can offer to its clients, both proprietary and third-party. They should also be familiar with other investments they are allowed to sell, such as treasury bills and guaranteed investment certificates. Weekly sales meetings, training sessions, memoranda, and the like can all be used to keep sales representatives informed. Below is a brief outline of the steps involved in the process of determining suitability: 1. Set investment Determine how much money or assets the client has to invest both in the very short objectives and goals term and over time, and identify his or her investment objectives. 2. Measure the client’s Gather information about the client’s capacity to withstand risk, including financial risk capacity information (such as the client’s annual income and the amount of assets and debt they have accumulated) and information regarding the stability of their income. 3. Construct an Identify the funds to invest in and the proportion of investable wealth to invest in appropriate each security (e.g., a specific mutual fund). Most mutual fund dealers have developed portfolio mix model portfolios that sales representatives should use whenever appropriate. 4. R  evise the existing Determine which funds in the current portfolio are to be sold and which funds are to portfolio be purchased to replace them. 5. Evaluate the Compare the actual performance of the portfolio with that of an appropriate performance of the benchmark portfolio. portfolio SUITABILITY AND REDEMPTION ORDERS Suitability principles should be applied to an overall portfolio, not just to the purchase or redemption of individual funds. Accordingly, the sales representative should be instructed to examine the impact of redemption and purchase orders on the overall asset allocation of the portfolio. If a redemption order would result in an unsuitable but acceptable asset allocation remaining in a client’s portfolio, the client should be cautioned before or upon submitting the order. In such a case, the client must sign an undertaking stating that the order was not solicited and not recommended by the dealer and that the client was advised that it may not be in their best interest. If the redemption would result in a remaining asset allocation that is both unsuitable and unacceptable, the order request must be refused. In this situation, the client’s choice would be to change the remaining asset allocation, withdraw the request, or close the account. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6 SUITABILITY REQUIREMENTS 6 5 ACCEPTABILITY OF ORDERS THAT ARE INCONSISTENT WITH RECOMMENDATIONS OR ASSET ALLOCATION MODELS Another dimension of the suitability process is reasonability. An order may place a client’s asset allocation outside your mutual fund dealer’s asset allocation model, yet still be “acceptable”; in other words, it would not be unreasonable for the client to implement it. For example, suppose a client places an unsolicited order to buy a growth fund that would bring the growth portion of his portfolio to 80%. The client may be placing an order that slightly exceeds the equity asset allocation of the mutual fund dealer’s asset allocation model. However, if the client is a relatively sophisticated investor, the order, although considered not consistent with your dealer’s asset allocation model, may nevertheless be acceptable based on its reasonable nature. Whereas suitability has a quantitative aspect (in that it can be tied to asset allocation models), reasonability is more qualitative and subjective. An acceptable trade is one that could reasonably be seen as consistent with an investor’s risk profile, investment knowledge, time horizon, and investment objectives despite being outside your mutual fund dealer’s asset allocation model. Sales representatives should be advised that, if they are unsure whether a trade is reasonable, they should seek your assistance before accepting the purchase order. The terms “unreasonable” and “unacceptable” are not used at all financial institutions. Some may use the term “inappropriate” or “not in the client’s interests.” The key is to recognize the distinction between trades that can be executed with a warning to the client and trades that should not be executed even if the client insists. The former is an acceptable trade; the latter is an unacceptable trade. An important point to remember is that clients cannot waive the dealer’s suitability obligations. The dealers known as discount brokers can accept trades from clients with no concern for their suitability because they are exempted by the securities regulators from the suitability requirement. This type of broker provides order execution only and does not provide advice. Clients who insist on purchasing a fund that is both unsuitable and unreasonable should be referred to a discount broker, either affiliated or unaffiliated. ACCEPTABILITY AND CONSERVATISM There is a strong element of judgment associated with assessing acceptability. Consider, for example, the case of an investor with a high risk profile, long time horizon, good investment knowledge, and a high net worth who insists on allocating his entire investment portfolio to money market funds. The resulting mix may be acceptable given that it is within an appropriate asset allocation model, but it is so conservative that it is likely inappropriate for the client. The sales representative should review the client’s risk profile and investment knowledge and point out to him the ultra-conservative nature of this portfolio’s asset allocation. If the client wants to proceed with the order, you should consult your mutual fund dealer’s policies on ultra-conservative portfolios. There is a risk that the client may complain at some point in the future about the opportunity loss resulting from the conservative portfolio. Even though the order is “acceptable,” the client must be cautioned, and a notation must be added to his file to indicate that the conservative nature of the portfolio was discussed with him. ACCEPTABILITY AND TYPE OF ORDER An order that may be unacceptable as a lump sum purchase may be acceptable within the context of a periodic purchase plan. For example, if a client with a moderate risk profile and a relatively low net worth requested that most of their money be invested in an aggressive growth fund, this would clearly be an unacceptable order. However, in a periodic purchase plan of, say, $25.00 a month, the order may be acceptable given the overall composition of the portfolio and account holdings. If you are in doubt as to how to interpret the acceptability of an order, consult with your regional compliance officer or head office compliance department. © CANADIAN SECURITIES INSTITUTE 6 6 BRANCH COMPLIANCE OFFICER’S COURSE UNACCEPTABLE TRADES Some trades are clearly neither suitable nor acceptable. For example, consider a client who has indicated that she is safety- and income-oriented and has a low risk profile, a relatively short investment horizon, and little investment knowledge. She tells you she wants to invest 100% of her portfolio in an Asian Pacific fund. This order is not suitable according to any appropriate asset allocation model and it is clearly unacceptable because it is entirely inconsistent with her financial objectives, risk profile, time horizon, and investment knowledge. As BCO, you should design and enforce a procedure for dealing with orders that are unsuitable and unacceptable. The following process is a recommended sequence of follow-up: 1. Tell the client that the proposed trade does not match his or her objectives, and explain why. 2. Suggest that the client change the order. 3. If the client refuses, review the KYC questionnaire and discuss the client’s stated objectives. The client may wish to restate the objectives if it is warranted. However, their age, financial circumstances, investment time horizon, and other factors may prevent such changes. The client should not change a stated objective simply to circumvent suitability requirements. 4. If the client refuses to change the order, and the investment objectives or other KYC information should not be altered, the order should be refused. 5. If the client changes the investment objectives or other area of discrepancy, the order may be acceptable even though it remains outside your dealer’s asset allocation models or model portfolios. If it is acceptable, make sure the sales representative indicates in the client’s file that the client was cautioned. Have the client sign the appropriate disclaimer or caution as evidence of the disclosure. The caution in the file might read as follows: “This trade was unsolicited. The client was advised that the order might not match his or her investment needs and objectives and that it is not recommended by ABC Fund Dealer Inc.” Suitability also applies when a client asks to switch from one mutual fund to another, and the switch has no apparent investment benefit for the client. You should review the trade with the client to discover a motive. If a valid motive cannot be found but the switch is acceptable, see that the order is marked unsolicited, and note in the client’s file that the discussion took place. If possible, have the client sign the note. The suitability and acceptability aspects of the client process create rich opportunities to provide valuable training to your sales representatives. Take advantage by stressing the importance of seeking advice. They should clearly understand that if they are not certain how to deal with a situation (such as whether a fund is acceptable or reasonable for a client), they should enlist your help or call head office for assistance. Remember the obligation to review all trades by new representatives, as prescribed in MFDA Policy no. 1. The following matrix should be useful as a guide to supervising and enforcing disclosure and compliance requirements for client orders. Nature of Unsolicited Order Action Acceptable, but outside asset allocation Accept after discussion; note that caution was given in model portfolio the client’s file, and get a disclaimer signed by the client. Unacceptable Refuse the order. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6 SUITABILITY REQUIREMENTS 6 7 SUITABLE INVESTMENTS A trade is suitable when the investment product selected matches the following aspects of the client’s situation: Financial and personal circumstances Investment knowledge Risk profile Investment time horizon Investment objectives Although the assessment of the suitability of a trade or a portfolio is partly subjective, asset allocation strategies and models can be used to provide an objective underpinning based on quantitative elements. Many mutual fund dealers have developed tools and processes to guide sales representatives with regard to the suitability assessment. Asset allocation is the process of allocating portions of a client’s funds to debt and equity security types. The decision regarding asset allocation is widely accepted in the industry as one of the most important an investor has to make. The industry standards on life-cycle asset allocation are based on selecting from capital preservation, income, and growth securities. For example, investors with low risk profile should select securities with relatively low-price volatility from each asset category. If an investor is particularly concerned with capital preservation, the weighting allocated to each of the groups will depend on the relative importance of the investor’s other primary objectives in terms of income and growth. For example, during retirement, investors frequently have fixed incomes from limited sources such as employer pensions, registered retirement income funds, and government sources of income such as Canada Pension and Old Age Security. These investors have little opportunity to generate income from employment or other means. Accordingly, the primary investment objectives of retired investors are typically capital preservation and income, with the relative importance of each being determined by the level of retirement income and budget constraints. Research shows that equity investments have consistently outperformed fixed income securities over the long term by 3.5% to 5.0% per annum. However, the risk (or volatility) of common shares has also been consistently higher than fixed income securities. For that reason, there is an ever-present danger that the investor will need to liquidate equity holdings at a time when their value has declined. The possibility of a significant loss in the equity or fixed income market is especially high for investors with a short investment horizon. As their time horizon shrinks, capital preservation rather than higher returns should therefore be emphasized. Diversification by type of financial asset (debt versus equity) substantially reduces volatility risk. For example, over the period from 1926 to 1988, the returns were studied on Canadian investment portfolios comprised variously of 100% equities, 65%/35% equities to bonds, 50%/50% equities to bonds, 35%/65% equities to bonds, and 100% bonds. Results showed that the 50%/50% mix had only half the volatility of a 100% equity portfolio while retaining 78% of the nominal return. Furthermore, the probability of a negative result in any one-year period was much lower for mixed portfolios, with the lowest probability recorded for the 35%/65% equity-to-debt mix. SOLICITED AND UNSOLICITED ORDERS The same suitability and acceptability standards apply to both solicited and unsolicited orders. Solicited orders are orders initiated by a sales representative. These orders should always be suitable in that they are consistent with the KYC information on file and therefore acceptable. Unsolicited orders are orders initiated by the client. These orders may be unsuitable, but they must still be reasonable; otherwise, they are unacceptable. © CANADIAN SECURITIES INSTITUTE 6 8 BRANCH COMPLIANCE OFFICER’S COURSE Sales representatives should never solicit an unsuitable order and definitely not an unacceptable order. They should never approve an unacceptable order, even if the refusal embarrasses them or inconveniences the client. As for unsolicited orders, they must caution clients who request a trade that is unsuitable and possibly unacceptable in that it is inconsistent with the KYC information on file and the dealer’s asset allocation model. If the client insists on proceeding, the dealer may have policies that allow the client to sign an undertaking stating that the order was not solicited, that the asset allocation was not recommended, and that they were advised by the dealer that it may not be in their best interest. If the client requests an order that is both unsuitable and unacceptable, the BCO must refuse the order and follow the dealer’s procedures under Unacceptable Trades. SOLICITED ORDERS With solicited orders, due care should be exercised to ensure that they are suitable for the client’s financial and personal circumstances, investment knowledge, risk profile, investment time frame, and investment objectives. Two aspects of suitability apply to solicited orders. First, the order should conform to your mutual fund dealer’s asset allocation (or diversification) model. A purchase order that would result in a portfolio with a weighting that differs slightly from the weightings of your mutual fund dealer’s sample portfolio are not necessarily unacceptable. It is generally more acceptable to accept a lower allocation to equities than the allocation in the model asset allocation. A considerably higher equity allocation typically implies a lack of suitability and acceptability. For an order to be suitable, it should normally fit within your dealer’s asset allocation model. For example, an order to buy an aggressive growth fund that would result in a 90% asset allocation to growth funds for a 65-year-old investor of modest annual income would not be suitable or acceptable. The second aspect of suitability is that the order should align with the client’s stated KYC information. A mortgage fund would not be suitable or acceptable for an investor who wants an aggressive growth fund, assuming, of course, that the aggressive growth fund in itself is suitable for the investor. It would also not be acceptable to sell an investor a growth fund when their objectives are safety and income. The asset allocation and KYC information should be consistent. Solicited orders are often obtained as a result of advertising and prospecting. As previously indicated, MFDA Rules require that your head office or other designated supervisor approve all advertising and promotional materials, including but not limited to prospecting letters. UNSOLICITED ORDERS An unsolicited order is one made at the client’s initiative. Such orders are welcome, but their acceptance requires careful consideration in terms of suitability. For example, a client who places an unsolicited order to buy a growth fund that would bring the growth portion of her portfolio to 90% of the portfolio balance may be placing an unacceptable order. However, if she is a relatively sophisticated client, and the order is within her investment knowledge, risk profile, time horizon and stated objectives, while at the same time being close to your dealer’s recommended asset allocation, it may be acceptable. Nevertheless, you or your sales representative must point out that the order would result in a portfolio weighting to growth securities that exceeds your dealer’s asset allocation models. Having pointed this out, you may accept and process the order since you have determined that it is not unacceptable. However, it is imperative that you and the sales representative be satisfied that the client understands the nature and quality of this cautionary advice and the disclaimer they are signing. Ultimately, if you are truly uncomfortable with the client’s order, you should not accept it. Again, a client who insists on placing an unacceptable order should be referred to a discount broker who has no suitability obligations. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6 SUITABILITY REQUIREMENTS 6 9 If you proceed with the order, make sure your sales representative indicates on the KYC form or elsewhere in the client’s file that the client was cautioned about the trade’s unsuitability. The KYC form might state as follows: “This trade was unsolicited. The client was advised that the order might not match the client’s investment needs and objectives and that it is not recommended by ABC Funds Inc.” Similarly, suppose a client with an annual income of $120,000 places an order to buy a money market fund. His KYC form indicates that he has no dependants, his risk profile is high, his time horizon is long, his investment knowledge is excellent, and his objective is aggressive growth. On inquiry, you discover that his resulting portfolio asset allocation will be 80% safety, 20% income, and 0% equities. He tells you that he almost always buys money market funds but will occasionally buy a mortgage fund. This client’s order to buy a money market fund is neither suitable nor acceptable in that it is entirely contrary to what he stated on the KYC form. An appropriate asset allocation program would include some growth and a much lower weighting to safety. You or your sales representative should discuss the asset allocation model with him and explain why it would not be suitable given his KYC information. Ask him to change the asset allocation to a suitable mix, or review the KYC form with him to determine whether there has been a material change since the last time the form was completed. If he changes his risk profile to very low, the order would then be suitable and acceptable because it would be consistent with the requested asset allocation. Again, to meet your obligation to only sell suitable products, you need to establish consistency between the information on the KYC form and the asset allocation. Remember, unacceptable trades cannot be done, even with an undertaking signed by the client. Furthermore, sales representatives should understand that noting a trade as “unsolicited” does not diminish or relinquish their suitability responsibilities. THE USE OF LEVERAGE Transaction suitability also extends to the use of leverage – that is, borrowing money to buy mutual funds. The suitability of borrowing to invest is a matter of judgment and a function of the client’s tastes and circumstances. The disclosure and acknowledgement obligations relative to leverage are discussed in Chapter 5. The client should fully understand that a leveraged purchase of mutual funds involves greater risk than a purchase using cash resources. In contrast to a cash purchase, where the percentage gain or loss on a fund equals the percentage gain or loss in the value of a fund’s units, the purchase of mutual funds with borrowed money magnifies the loss or gain on the amount invested. Furthermore, the client must also understand that the borrowed funds must be repaid, as must the interest on the funds, regardless of the performance of the investment. You must have written evidence of the client’s acknowledgement that they received this warning. For example, suppose a client wishes to buy 2,000 units of the European Aggressive Growth Fund. The most recent net asset value per unit is $14.60. The client has $15,000 in cash and wants to borrow $14,200 to finance the transaction. The client should be informed that the entire $29,200 is at risk, not just the $15,000. For example, if the NAVPU falls below $7.10, the client would have paper losses in excess of the $15,000 equity. The scenarios could be illustrated to the client using the following matrix: © CANADIAN SECURITIES INSTITUTE 6 10 BRANCH COMPLIANCE OFFICER’S COURSE Table 6.1 | Leverage Illustration If the NAVPU is The value of 2,000 units is The profit or (loss) is $0 $0 $(29,200) 5.00 10,000 (19,200) 7.10 14,200 (15,000) 10.00 20,000 (9,200) 12.00 24,000 (5,200) 14.00 28,000 (1,200) 14.60 29,200 0 15.00 30,000 800 16.00 32,000 2,800 $17.00 $34,000 $4,800 Make sure your sales representatives provide a suitable caution about leverage. Often, there is a warning about leverage on the mutual fund account opening or order form in addition to the required leverage disclosure and acknowledgement. Whether to use leverage is ultimately the client’s decision, but it is your responsibility to ensure that the decision is an informed one based on full disclosure of the features and risks of leverage strategies. What constitutes undue or excessive leverage is a matter of judgment. There is no law that specifies when leverage is acceptable or what amount an individual should or could borrow for investment purposes. Make sure that the overall impact of a proposed leveraged transaction on a client’s asset allocation is examined. If a client intends to borrow $100,000 to buy units of the Aggressive Growth Fund, the investment implications of the purchase should be examined independently of the decision to use leverage. If a leveraged transaction is unsuitable, the client should be cautioned, and an undertaking signed by the client should be placed in the client’s file. If a leveraged trade is unreasonable, it should be refused. KNOW YOUR CLIENT AND LEVERAGE Both the sales representative and the BCO should consider the following KYC criteria when assessing leverage suitability for a client: 1. Investment A leveraged strategy is not suitable for clients who have indicated that their investment knowledge knowledge is low or poor. 2. Risk profile A leveraged strategy should only be recommended or accepted where a client has indicated on the KYC documentation a medium or higher risk profile. 3. Age A leveraged strategy is generally used for long-term investment. Advanced age and a goal of capital preservation should prompt the BCO and sales representative to examine the leveraged trade closely. MFDA Policy no.2 requires supervisory review and investigation for anyone over the age of 60. 4. Time horizon A leveraged strategy is typically more appropriate for clients with a long-term investment time horizon. Review and investigation are required for any client with less than a five-year time horizon. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6 SUITABILITY REQUIREMENTS 6 11 5. Net worth A client should have sufficient net worth to sustain a leveraged trade and the associated implications of purchasing investments with borrowed funds. Review and investigation should be conducted for a total leverage amount that exceeds 30% of the client’s total net worth. 6. Income A client’s income must be sufficient to maintain the debt payments of all of their loans. MFDA Policy No.2 specifies that a client’s total debt and lease payments must not exceed 35% of the client’s gross income, excluding income generated from leveraged investments. Total debt includes all loans regardless of whether it is for investment. With respect to a leveraging strategy recommendation, neither sales representatives nor BCOs may obtain a waiver from the client relinquishing their responsibility to ensure suitability of the recommendation. SUITABILITY AND REASONABLENESS Beyond suitability, the other major aspect of providing advice is investment reasonableness. A sales representative must use good judgment to ensure that a client’s mutual fund purchase is both suitable and reasonable in light of that client’s particular needs and objectives. To provide suitable and reasonable recommendations, the sales representative must have a thorough knowledge of mutual fund products and attempt to match them to each client’s investment needs and objectives. A trade that is unsuitable and unreasonable for a client should be refused. To ensure that sales representatives are complying with this legal requirement, you should initiate procedures for performing periodic checks. A dealer may have relationship databases or an electronic system of filing and supervision. As the BCO, you should be aware of the dealer’s requirements in regard to maintaining evidence of supervision. IMPORTANT NOTE Sales representatives cannot avoid the suitability requirement by transferring the responsibility to the client. A client’s acknowledgement that they understand and are willing to accept the risk of a trade does not absolve the sales representative of responsibility for ensuring that it is acceptable. © CANADIAN SECURITIES INSTITUTE 6 12 BRANCH COMPLIANCE OFFICER’S COURSE SUMMARY Now that you have completed this chapter, you should be able to meet the following learning objectives: 1. Understand and explain suitability and reasonableness of an investment. Sales representatives must have a thorough knowledge of mutual funds and asset allocation services and programs to properly match them to the client’s investment needs and objectives. As BCO, you are accountable for your sales representatives’ adherence to their obligation regarding the suitability and reasonableness of investments. 2. Explain the distinction between unsuitable and unreasonable orders. An unsuitable trade is one that could be seen as inconsistent with an investor’s risk profile, investment knowledge, time horizon, and investment objectives. Discount brokers can accept trades from clients with no concern for their suitability because they have no suitability obligation. An unsuitable trade is one that is unacceptable; it should not be executed even if the client insists. 3. Explain the distinction between solicited and unsolicited orders and describe the standard of care required for each of these types of orders. A solicited order is an order initiated by the sales representatives as a recommendation. Solicited orders should always be suitable in that it is consistent with the KYC information. An unsolicited order is one that is made at the client’s initiative. Acceptance of unsolicited orders still requires careful consideration in terms of suitability. 4. Explain the policy on leverage as it applies to suitability. Leverage is the action of borrowing to buy mutual funds. The suitability of borrowing to invest is a matter of judgment and a function of the client’s preferences and circumstances. The client should fully understand that a leveraged purchase of mutual funds involves greater risk than a purchase using cash resources. The use of leverage must be suitable for the client. The sales representative and the BCO should consider a list of criteria when assessing leverage suitability for a client. Additional disclosure documents must be provided to the client prior to the use of leverage, and the client must acknowledge receipt of the leverage disclosure document. © CANADIAN SECURITIES INSTITUTE  CHAPTER 6 SUITABILITY REQUIREMENTS 6 13 APPENDIX 6.1 – SAMPLE INVESTOR QUESTIONNAIRE Investment Time Horizon The length of your investment time horizon impacts the types of investments that may be suitable for you. Investors with a time horizon of greater than three years have a greater degree of flexibility when building a portfolio (although risk profile and investment objectives must also be considered). If you have a very short time horizon, more conservative investments like GICs or money market funds may be the only suitable option for you. 1. When do you expect to need to withdraw a significant portion (one-third or more) of the money in your investment portfolio? i. Less than 1 year. ii. 1 – to – 3 years. iii. 4 – to – 6 years. iv. 7 – to – 9 years. v. 10 years or more. Investment Knowledge If you have a high level of investment knowledge, you have a good understanding of the relative risk of various types of investments and understand how the risk level affects potential returns. If you have very little knowledge of investments and financial markets, speculative and high-risk investments and strategies are likely not suitable options for you. 2. Which statement best describes your knowledge of investments? i. I have very little knowledge of investments and financial markets. ii. I have a moderate level of knowledge of investments and financial markets. iii. I have extensive investment knowledge; I understand different investment products and follow financial markets closely. Investment Objectives Investment objectives are the goals or results you want to achieve from investing. Understanding your investment goals helps determine the types of investments best suited to meet your needs. The investment products used to meet different goals have varying levels of risk and potential returns. 3. What is your primary goal for this portfolio? i. I want to keep the money I have invested safe from short-term losses or readily available for short-term needs. Your primary goal is safety. Investments that will satisfy this objective include GICs and money market funds. ii. I want to generate a steady stream of income from my investments. I am less concerned about growing the value of my investments. Your primary goal is income. Investments that will satisfy this objective include fixed income investments such as funds that invest in bonds. iii. I want to generate some income with some opportunity for the investments to grow in value. Your primary goal is balance. A balanced fund or a portfolio that includes at least 40% in fixed income investments and no more than 60% in equity funds will satisfy this objective. iv. I want to generate long-term growth from my investments. Your primary goal is growth. A portfolio with a relatively high proportion of funds that invest in equities will satisfy this objective as long as you have a long time horizon and are willing and able to accept more risk. © CANADIAN SECURITIES INSTITUTE 6 14 BRANCH COMPLIANCE OFFICER’S COURSE Risk Capacity (Questions 4 – 9) Your financial situation including your assets, debt, and the amount and stability of your income are all important when determining how much risk you can take with your investments. In addition, the larger the portion of your total assets you are investing, the more conservative you might wish to be with this portion of your portfolio. 4. What is your annual income (from all sources)? i. Less than $25,000. (0 points) ii. $25,000 - $49,999. (2 points) iii. $50,000 - $74,999. (4 points) iv. $75,000 - $99,999. (5 points) v. $100,000 - $199,999. (7 points) vi. $200,000 or more. (10 points) 5. How stable are your current and future income sources? i. Stable. (8 points) ii. Somewhat stable. (4 points) iii. Unstable. (1 point) 6. How would you classify your overall financial situation? i. No savings and significant debt. (0 points) ii. Little savings and a fair amount of debt. (2 points) iii. Some savings and some debt. (5 points) iv. Some savings and little or no debt. (7 points) v. Significant savings and little or no debt. (10 points) 7. What is your estimated net worth, including investments, cash, home, and other real estate (less mortgage loans and all other debts)? i. Less than $50,000. (0 points) ii. $50,000 – $99,999. (2 points) iii. $100,000 – $249,999. (4 points) iv. $250,000 – $499,999. (6 points) v. $500,000 – $999,999. (8 points) vi. $1,000,000 or more. (10 points) 8. Approximately what percentage of your total savings and investments does this investment account represent? (Total savings and investments include all the money you have in cash savings, GICs, savings bonds, mutual funds, and stocks and bonds.) i. Less than 25%. (10 points) ii. 25%-50%. (5 points) iii. 51%-75%. (4 points) iv. More than 75%. (2 points) © CANADIAN SECURITIES INSTITUTE  CHAPTER 6 SUITABILITY REQUIREMENTS 6 15 9. What is your age group? (Your age is an important consideration when constructing an investment portfolio. Younger investors may have portfolios that are primarily invested in equities to maximize potential growth if they also have a higher risk profile and a long investment time horizon. Investors who are retired or near retirement are often less able to withstand losses and may have portfolios that are invested to maximize income and capital preservation.) i. Under 35. (20 points) ii. 35-54. (8 points) iii. 55-64. (3 points) iv. 65 or older. (1 point) Your risk capacity score is. Risk Attitude (Questions 10-14) Your comfort level with risk is important in determining how conservatively or aggressively you should invest. As a general rule, you need to accept more risk if you want to pursue higher returns. If you decide to seek potentially higher returns, you face the possibility of greater losses. 10. Which statement describes your attitude toward making financial and investment decisions? i. Very conservative; I try to minimize risk and avoid the possibility of any loss. (0 points) ii. Conservative, but I am willing to accept a small amount of risk. (4 points) iii. I am willing to accept a moderate level of risk and tolerate losses to achieve potentially higher returns. (6 points) iv. Aggressive; I typically take on significant risk and am willing to tolerate large losses for the potential of achieving higher returns. (10 points) 11.  The value of an investment portfolio will generally go up and down over time. Assuming you have invested $10,000, how much of a decline in your investment portfolio could you tolerate in a 12-month period? i. I could not tolerate any loss. (0 points) ii. A loss of $300 (−3%). (3 points) iii. A loss of $1,000 (−10%). (6 points) iv. A loss of $2,000 (−20%). (8 points) v. More than −$2,000 (more than −20%). (10 points) 12. When  you are faced with a major financial decision, are you more concerned about the possible losses or the possible gains? i. Always the possible losses. (0 points) ii. Usually the possible losses. (3 points) iii. Usually the possible gains. (6 points) iv. Always the possible gains. (10 points) 13. T he chart below shows the greatest one-year loss and the highest one-year gain on four different investments of $10,000. Given the potential gain or loss in any one year, which investment would you likely invest your money in? i. Either a loss of $0 or a gain of $200. (0 points) ii. Either a loss of $200 or a gain of $500. (3 points) iii. Either a loss of $800 or a gain of $1,200. (6 points) iv. Either a loss of $2,000 or a gain of $2,500. (10 points) © CANADIAN SECURITIES INSTITUTE 6 16 BRANCH COMPLIANCE OFFICER’S COURSE Table 6A.1 | Range of Possible Outcomes in 1 Year $2,500 $2,500 Best Outcome $2,000 $1,500 $1,200 $1,000 $500 $500 $200 $0 $0 -$500 -$200 -$1,000 -$800 -$1,500 -$2,000 Worst Outcome -$2,000 -$2,500 i. ii. iii. iv. 14. B  etween February 2020 and April 2020, North American stock markets dropped by over 34%. If you owned an investment that lost more than 30% of its value over a period of three months, what would you do? i. Sell all of the remaining investment to avoid further losses. (0 points) ii. Sell a portion of the remaining investment to protect some capital. (3 points) iii. Hold onto the investment in the hope of higher future returns. (5 points) iv. Buy more of the investment now that prices are lower. (10 points) Your risk attitude score is. DIVE DEEPER For the complete MFDA Investor questionnaire, refer to the MFDA Discussion Paper on the use of investor questionnaires (titled, Improving the Know Your Client Process). MFDA Bulletin #0611-C, July 21, 2014. © CANADIAN SECURITIES INSTITUTE