KYC, Suitability, Accredited Investors, Permitted Client:

What is an exempt market dealer required to do?

The implementation of National Instrument 31-103 - Registration Requirements and Exemptions (NI 31-103) introduced the exempt market dealer registration category. Although there are new standards to be met, the requirement to be registered is not a new concept for limited market dealers in the provinces Ontario and Newfoundland and Labrador. The biggest change for former limited market dealers and exempt market participants is in the compliance area and in particular, the treatment of investors as clients. Exempt market dealers (EMDs) should not expect the light-touch regulatory approach previously taken by the securities commissions with respect to limited market dealers and exempt market participants. The fact that the Ontario Securities Commission has created an Exempt Market Dealers division in the Compliance Branch is indicative of a higher-touch regulatory approach.

1.   Know-Your-Client Information

One of the most important requirements is collecting know-your-client (KYC) information. The KYC obligation is an exercise in due diligence that protects the client, the EMD and the integrity of the capital markets. 

All registrants act as gatekeepers of the integrity of the capital markets. They should not, by act or omission, facilitate conduct that brings the market into disrepute. As part of their gatekeeper role, EMDs are required to establish the identity of, and conduct due diligence on, their clients This includes the requirement to make inquiries if a EMD has a cause for concern about a client's reputation. The EMD must make all reasonable inquiries necessary to resolve the concern, for example, determining the nature of the client's business.

KYC information forms the basis for determining whether trades in securities are suitable for investors. The client's investment objectives, and risk tolerance must be assessed based on the client's financial and personal circumstances including time horizon. The stated investment objectives and risk tolerance must be reasonable in light of those circumstances.

EMDs must take reasonable steps to establish whether the client is an insider of a publicly traded company or other entity. This includes domestic, foreign, exchange listed and over-the-counter markets. It does not include issuers whose securities have been distributed through a private placement and are not freely traded.

KYC is also collected for detection of money-laundering or terrorist financing and verification of a client's identity is important in this respect[i]. There are also special requirements regarding politically exposed foreign persons to prevent corruptly derived funds from entering the Canadian market. EMDs are required to implement a risk assessment program to identify businesses or clients that present a high risk of money laundering, a training program for employees and a biennial audit of anti-money laundering policies and procedures.

The regulations regarding identity verification are complex, particularly for non face-to-face clients. Guidance from the Financial Transactions and Reports Analysis Centre of Canada, the Federal agency charged with ensuring compliance with the requirements, can be found at http://www.fintrac-canafe.gc.ca/re-ed/sec-eng.asp. 

So What?

• EMDs must maintain written records of this information, usually in a new client account form.

• Regardless of the size of the firm, it is not appropriate to keep mental records or say "I know Pat" and not have a written record the KYC information.

• EMDs are required to make reasonable efforts to keep their clients' KYC information current. Since many EMDs only occasionally recommend trades to clients, they should ensure that the client's KYC information is up-to-date when a trade is made. FINTRAC has the authority to conduct audits of dealers and assess penalties for non-compliance as high as $500,000 for a very serious violation.

2.   Suitability

EMDs must take reasonable steps to ensure that a proposed trade is suitable for a client before making a recommendation or accepting instructions from the client. A client's investment objectives, risk tolerance, investment knowledge and financial situation must be considered when assessing suitability of trades and recommendations. Even in the institutional setting, a Representative must make an assessment that products falls within the client's expertise.

The suitability assessment obligations include a requirement to know and understand the risks, key features, and initial and ongoing fees associated with any product recommended to clients. To meet this suitability obligation, EMDs should have in-depth knowledge of all products that they buy and sell to their clients. This is often referred to as the "know your product" or KYP obligation. EMDs have the responsibility to assess the risks associated with the products that they sell. In addition, EMDs must have reasonable grounds to believe that all material facts of the investment are adequately disclosed in the offering documents.  The EMD must conduct the necessary due diligence to reasonably satisfy themselves that the disclosure is appropriate.

Individual representatives should understand, and be able to clearly explain to clients, the reasons that a specific security is appropriate and suitable for the client. Suitability obligations cannot be delegated.

There is no requirement to make a suitability determination for a client that is a registered dealer, portfolio manager or investment fund manager, a Canadian financial institution or a Schedule III bank.

There will be occasion when an EMD determines a trade is unsuitable for a client. In those cases the EMD must inform the client that the trade is not suitable in the opinion of the EMD and must not make the trade. However, the client can still instruct the EMD to make the trade after receiving the warning that the trade may not be suitable.

• With the suitability obligation clearly established in NI 31-103, EMDs can be subject to civil actions by disaffected clients claiming that trades were unsuitable.

• It is a prudent business practice for the EMD to have the client provide written instructions that the trade has been determined to be unsuitable but the client is instructing the EMD to make the trade anyway.

3.   Accredited investors and permitted clients

Registrants should also be aware of, and act in compliance with, the terms of any exemption being relied on for the trade or distribution of the product. Under the accredited investor and permitted client exemptions, EMDs must have a reasonable belief that the client understands the various criteria for qualifying as an accredited investor or permitted client and meets the criteria.

In making this determination, EMDs may rely on facts provided by a client, provided it has no reasonable grounds to believe that those representations are false. EMDs should not rely merely on the representation: "I am an accredited investor". The KYC documentation must also show which criteria are being relied upon and contain all necessary information to show that the client meets the criteria.

The financial tests prescribed in the accredited investor and permitted client definitions are to be applied only at the time of the trade in the security. EMDs are not required to monitor the client's continuing qualification as an accredited investor or permitted client after the trade in the security is completed.

If a client of an EMD is an accredited investor, the EMD must make a suitability assessment before recommending or making a trade for the client.

NI 31-103 introduced the concept of "permitted clients," a subset of the accredited investors. For the most part, permitted clients are institutional investors. As with accredited investors, permitted clients are not exempted from the suitability requirement, however, they may waive their right to a suitability determination. A permitted client can only waive the right to a suitability assessment in writing; the waiver can be a blanket waiver covering all trades.

So What?

• Suitability determinations must be done for accredited investors.

• KYC forms must collect all the information necessary to enable the EMD to make a suitability determination before recommending an investment to a client.

• The client information on the KYC form must jibe with the definition of accredited investor or permitted client selected by the client.