A BEST DEFENCE IS A GOOD OFFENCE:
By: Cora Pettipas
There are several reasons to make sure your suitability process for clients is something you continuously work on as a central hub of your craft. As is said in CSA Staff Notice 31-336, “A meaningful suitability assessment is required. Assessing suitability is more than a mechanical fact-finding ‘tick the box’ exercise.” With suitability, the conversation is more important than the paperwork. That means that the paperwork should support the client discussion, not the other way around. Documentation should be maintained to support how you determined that each trade was suitable. Please note: a client being eligible to invest in Exempt Market products does not mean that the trade is suitable. To be suitable, the subscription needs to be aligned with the investor’s needs, goals, objectives, and risk tolerance. Admittedly, it takes practice to center the discussion on the client without errors in the paperwork but it is worth the effort, as if you are not basing your advice around suitability you are simply an order taker.
Why Focus on Suitability?
First, it is the right thing to do. KYC, KYP and suitability advice is essential for creating a long term relationship with your clients based on professionalism and mutual trust. If suitability is practise, in good times and bad, you can stand by your clients and the decisions you made for them. You can know your clients better and help build their wealth faster with less overall risk.
Second, you are supposed to. Regulators have made it clear that suitability practises are a priority for them – arguably a primary obligation - as stated in CSA staff Notice 33-336, “KYC, KYP and suitability obligations are among the most fundamental obligations owed by registrants to their clients, and the cornerstone of the investor protection regime.” Registrants have to do suitability on every client, regardless of the exemptions used. Section 13.2 of the companion policy to NI 31-103 indicates that registrants are the ‘gatekeepers of the integrity of the capital markets.’This responsibility is huge, it means suitability comes first. Always. Whether the investments are being distributed in person, or through an online EMD portal, the suitability obligations are the same. KYP, KYC, and suitability obligations do not change as a result of the method of distribution of the securities to investors. Meaningful dialogue still needs
to happen with the investor, even if it is with the use of technology like telephone, email, or video link. For more information on this, refer to OSC Staff Notice 33-745. Non-registrants working under a valid registrant exemption like the Northwest Exemption are not allowed to do suitability under any circumstances, because they are prohibited from providing advice. In other words, the prospectus exemptions are secondary to whether and investor is working with a registrant or non registrant (under an authorized registrant exemption).
Third, it is a priority for clients - especially when things turn sideways. According to the OBSI, last year 39% of their complaints from
investors were based on suitability. That is a significant percentage. Suitability of leverage and fee disclosure came in as the second and third major issues at 13% and 10% of the clients respectively. Therefore, if you or your firm attain a client complaint, it is highly probable it will be based on suitability. This is important to note in the exempt market, as we have been under the OBSI since May 1 2014, but the triggering event of a client compliant falling under OBSI is the date of compliant, not of subscription (within reasonable timelines).
There has been industry confusion about which clients require the suitability process and which do not. There is a sentiment that the suitability needs to be done if the registrant is using the OM Exemption, which is considered a retail exemption. The regulators disagree. It turns out this general assumption is incorrect. That suitability obligations have nothing to do with the prospectus exemption used, but instead the registrant exemptions.
Part of the duty of being a registrant requires that a DR demonstrates suitability on very trade
If you are a registrant, you have to do KYC, KYP and suitability on every client when using a prospectus exemption, if you are not a registrant (using a registration exemption), you are not permitted to give suitability advice.
As a registrant, it is important to note that you cannot delegate the suitability responsibility. Meaning you have to know the products well enough to describe clearly a key list of features and risks and answer questions on the product. You are responsible for the discovery/KYC phase with the client and recommending the suitable product solutions.
An accredited investor is often informally referred to as the 1%er. They, alone or with a spouse, have net financial assets of at least one million. Alternatively, they have a $200,000 regular annual income (or $300,000 household), or they have a net assets of at least five million. CSA Staff Notice 31-336 states that you must “collect adequate information” to justify the use of the specific exemption. The notice does not specify what this is, but it does state that, “It is not sufficient to simply rely on the client’s initialling or checking off the box...”
The Suitability process is an ongoing requirement for you and your clients. CSA Staff Notice 31-336 spells out when suitability
(including KYC & KYP) must be practiced:
- When taking a subscription or new trade from a client
- When presenting a product solution to a client
- When a client deposits or transfers in new investments
- When there is a change of account manager/ dealing representative
- When there is a life event or change in goals for the client
There are two potential huge red flags that Dealing Representatives may want to keep in the top of their minds when taking their clients through the suitability process. These are concentration risk and use of leverage.
As Exempt Market registrants, dealing representatives should take away the importance regulators place on diversification with suitability, as it is the surest defense against overzealous investors (or registrants) placing too much of the investors’ money in one place, which called concentration risk. Concentration is a key component of suitability.
The general rule of thumb is no more than ten percent of an investor’s net financial assets in any one product or type. For a client, net financial assets are defined as financial assets minus liabilities linked to those assets. A financial asset is defined as assets that are intended to build a client’s wealth and are not lifestyle assets. Section 3.5 of 45-106CP spells out what the exact definitions of these terms and gives further elaboration.
Some industry objections I have heard against the 10% guideline are when clients have innate preferences for certain products. For example, clients with certain religious affinities do not like leveraged products, for instance as it is against their beliefs. Alternatively, some clients have a great history with a certain product or product issuer and want to keep with what is working. Therefore, it would be a challenge for a registrant to satisfy their client. There are reasonable objections, but you want to make sure you are protecting the client and yourself.
With public or private investing, no one has a crystal ball to forecast which investments will be rock stars and which will go sideways. As CSA Staff Notice 33-336 states “Most CSA staff will consider investments in securities of a single issuer or group of related issuers that represent more than 10% of the investor’s net financial assets as potentially raising suitability concerns due to concentration.” With a 10% concentration limit, if a product does go sideways, the other products in the client’s portfolio need to carry the weight to achieve the client’s investment objectives – much better than the ‘one horse’ strategy.
The other potential Achilles heel for advisors is use of leverage. “As part of the KYP obligation CSA staff expects a registrant to assess the suitability of leveraged trades or leveraging strategies for those clients that borrow funds...” As stated earlier, suitability of leverage is the second biggest complaint the OBSI sees from investors.
EMDs do not sell leverage products or margin accounts like loans and mortgages, clients have to attain them from a different financial institution. In fact, as stated in section 13.12 of NI 31-103, EMDs are prohibited from lending or providing margin to a client. Therefore, advisors in our space will not receive the same pressure from management to advise the client to leverage to invest. However, client leverage can still lead to increase in product sales, so advisors are considered to have a bias.
When addressing client leverage, it is recommended that you fully educate how leverage moves them up in the risk and return continuum. Greater leverage means greater potential risk and great potential returns, increasing the variability in outcomes greatly. Generally, Exempt Market products are already considered higher on the risk and return scale, so clients need to be cautioned in using this strategy. Using leverage calculator work well.
This article is meant to be a brief introduction to the suitability process and its importance with selling private investments. However, best practises in this space are borrowed heavily from the IIROC and MFDA worlds and the Exempt Market needs to build them with regards to private investing, as rules for publicly traded securities do not neatly fit in the exempt space. Currently, information about suitability information is sparse.
The main guidance for suitability in the Exempt Market is in CSA Staff notice 31-336, and is more principles based and less proscriptive as NI 31-103.The CSA staff notice 33-315 is also a good resource, but more weighted to KYC and KYP than overall suitability. There is an online course called Advanced Suitability for IIROC Advisors that is a good place to start. There is also IIROC Notice 12-0109 and MFDA Notice 0069. Other than that, your CCO and EMD would be the best resources.