IIROC requests comments on draft guidelines on KYC and suitability
 
On October 2 IIROC published a draft guidance note on KYC and suitability obligations, seeking comments by December 16, 2009.  Comments can be sent in writing or by e-mail to

Sherry Tabesh-Ndreka, Policy Counsel
Investment Industry Regulatory Organization of Canada
121 King Street West, Suite 1600
Toronto ON M5H 3T9
Fax: 416-943-6760
e-mail: stabesh@iiroc.ca
 
Comments
 
The following items in the proposed guidelines warrant careful consideration and possibly comment by retail advisory dealers.
 
1. The proposed guidelines would drastically restrict the use of a portfolio approach to KYC and suitability.

The proposed guideline includes an IIROC "position" which is couched as an interpretation rather than a guideline.  It would permit the use of a single new account application form only when:

• The client's investment objectives and risk tolerance are identical for all of the accounts covered by the application;
• In the case of individuals, the beneficial owner is identical for all of the accounts or in the case of non-individual accounts, the entity is identical for all of the accounts;
• The client understands that the accounts on the same account application will be assessed for suitability on a multiple account or portfolio basis; and
• The Dealer Member has the ability to conduct supervision, including reviewing orders for suitability and updating KYC information, on a multiple account or client basis.
• The first point contradicts the third and fourth.  There is little point in having multiple new account forms when taking a portfolio approach to suitability across multiple accounts. 

This is a more restrictive approach than was taken in the proposed new account application requirements and guidelines developed in consultation with the IDA Compliance and Legal Section.  Those requirements were passed by the IDA Board in April, 2006 to replace Form 2, but have been withdrawn from the CSA approval processF[1]F. In brief, that proposal required clarity on which clients and/or accounts were covered by the application details and whose investment knowledge was being assessed. It also required that the relevant information be usable in the dealer's supervision systems.

The proposed guidelines are also inconsistent with the following guidance in section 13.1 of the Companion Policy to National Instrument 31-103: Registration Requirements: "If a client is opening more than one account, the registrant should indicate whether the client's investment objectives and risk tolerance apply to a particular account or to the client's whole portfolio of accounts."

This aspect of the notice is also a departure from the principles-based approach, which would permit a dealer to take a portfolio approach across an individual's or household's accounts provided that the objective - suitability of the portfolio - was attained.

So what?

• The requirement for multiple forms when accounts have different investment objectives and risk tolerance will limit flexibility on which accounts to use for particular types of investments within a portfolio, for example changing the asset mix in Canadian and US funds accounts while maintaining suitability across the portfolio.  One or both of the accounts could falsely appear to be unsuitable judged against the separate account applications, even though the portfolio is not.
• The proposed guideline also prohibits the use of a household portfolio approach because each member of the household and any accounts in which they have differential interests have to be considered separately rather than as an integrated group.
• There are legitimate reasons such as tax considerations for concentrating one type of investment in the account of one member of a household and another type in another member's.  When that approach has to be reflected in separate forms, it could result in a false appearance that the objectives for the account of one household member are inappropriate.

2. The proposed guidelines state that a client's investment objectives and risk tolerance must be reasonable.

The following appears on Page 3 of the guidelines:

Know your client information
Registered Representatives are reminded that the client's investment objectives, and risk tolerance must be assessed based on the client's financial and personal circumstances. The stated investment objectives and risk tolerance must be reasonable in light of those circumstances.

It has been recognized in previous disciplinary decisions that appropriateness and consistency with investment objectives are different standards.  A client is entitled to have investment objectives and risk tolerance that someone else would consider inappropriate to their financial and personal circumstances, but that is the client's privilege.

This approach is reiterated in the discussion of suitability analysis on Page 4 of the proposed guideline, where the draft guidance suggests that the suitability of certain types of accounts "(margin, trust, options accounts, etc.)" should be assessed.  This again suggests a standard that may not be reasonable in all circumstances.  As examples:

• Some dealers have all clients open margin accounts as a matter of convenience should the client ever want to use margin, while recognizing that its use is not appropriate to all and should be considered in assessing the suitability of specific recommendations, trades or accounts.
• An RR commenting on the suitability of a trust account risks overstepping the bounds of his or her expertise.

So what?

The proposed guidelines will in effect prevent the dealer or RR from accepting an account if the dealer or RR concludes that the client's investment objectives and risk tolerance are inconsistent with his or her financial position, even after advising the client appropriately and then only accepting unsolicited orders.

This result is also unfair to the client.  While such a client can, of course, use a discount broker, the guideline would prevent him or her from opening an account with an advisory dealer who would give much needed warnings about the risk of particular investments or strategies.

While a dealer or RR may have to consider extra self-protection where the client's self-generated objectives and risk tolerance are inappropriate, and should refrain from making specific recommendations in pursuit of a course of investment that the dealer or RR considers. imprudent, the guideline suggests that it would be improper to open the account at all.

3. The proposed guidelines include as "best practices" recommendations that go beyond the proposed Client Relationship Model rules.

While noting that the suitability obligation in Regulation 1300 relates to recommendations to a client, the proposed guidelines suggested as a "best practice" a periodic enquiry about changes in the client's circumstances and a periodic review of client accounts, both to be done at least annually.

There are certainly many clients whose circumstances can be expected to change little from year to year and whose portfolios may also change little.  A perfectly reasonable practice might take account of different classes of clients or objectives while deviating from the proposed "best practice" guideline.
Similarly, the draft guideline notes that the proposed Client Relationship Model (CRM)F[2]F rules are pending.  Under those rules suitability has to be reviewed after certain triggering events, but there is no requirement for a periodic review.
Section XX05(2)(c)(III) of the proposed CRM rule requires a disclosure of whether or not the dealer will reassess suitability "in the case of other triggering events not described in Rule 1300.1(r) and, in particular, in the event of significant market fluctuations," but does not require disclosure as to whether the dealer will conduct a periodic review.

So what?

"Best practices" are guidelines, but can be perceived to be more like hard standards and therefore have to be crafted carefully.  They can be raised in civil actions or arbitrations where the adjudicator may not be attuned to how far a reasonable practice may deviate from a "best" practice.

The guidance might benefit, therefore, from a broader discussion including not just "best practice" but also acceptable alternatives and factors to be considered in deciding what approach to take.

If these issues are of concern to you, Sutton Boyce Gilkes Regulatory Consulting Group can help you draft a comment letter.