This Bulletin highlights the areas of regulatory focus for the Mutual Fund Dealers Association of Canada (“MFDA”). We recommend Members assess their supervisory structure, risk management practices and policies and procedures in these areas to determine if adequate internal controls are in place.
The areas of regulatory focus include:
- Exempt Securities
- Outside Business Activities
- Trade and Supervisory Inquiries
- Branch Review Programs
- Blank-Signed Forms/Altering Documentation
- Complaint Handling
- Seniors’ Issues
1. Exempt Securities
Prior to the distribution of any exempt securities to clients, Members must have adequate internal controls, as well as policies and procedures, related to the sale of such products.
Issues to be considered by Members prior to distributing exempt securities to clients include:
MFDA Rule 1.1.1 (Business Structures – Members) requires all securities related business to be carried on for the account and through the facilities of the Member. Members and Approved Persons are not permitted to trade or advise in exempt securities through any other entity either directly or indirectly through a referral arrangement.
Due Diligence/Product Approval Process
Certain exempt securities, such as hedge funds, limited partnerships or private notes or debentures, may employ riskier strategies than conventional mutual funds and may also be subject to liquidity restrictions. These securities are not distributed under a prospectus and are not regulated to the same extent as mutual funds. Given these risks, it is important that a reasonable level of due diligence is performed prior to their approval for sale. MFDA Staff Notice MSN-0048 Know-Your-Product provides further guidance regarding the obligations of Members and Approved Persons with respect to the due diligence review process.
Compliance with the Conditions of Exemption
Before selling an exempt security, Members must be aware of the specific exemption contained in securities legislation that is being relied on to distribute the securities and have a process to supervise compliance with the exemption conditions. Members are required to ensure the distribution is conducted in compliance with the conditions of the applicable exemption and cannot rely on the issuer to be responsible for compliance with exemption conditions. With respect to the Accredited Investor exemption, most Member Know-Your-Client (“KYC”) forms do not capture “financial assets”. Members and Approved Persons relying on the net financial asset test to meet the exemption must ensure that sufficient information is obtained and recorded to evidence compliance with the exemption criteria.
Suitability and Account Supervision
Members and Approved Persons are required to ensure that exempt securities sold are suitable for the client and consistent with the client’s documented investment objectives and KYC information. Even if a client meets the exemption criteria, Members and Approved Persons must still assess whether the trade is suitable. Members should be particularly aware of potential suitability concerns with recommending certain exempt securities to seniors and other investors who require income from their investments. Members should consider the risk that certain exempt securities, such as limited partnerships, private shares and debentures, will not be able to pay interest, dividends or distributions, and such investments should not be equated with other investments such as guaranteed investment certificates.
2. Outside Business Activities
“Outside business activities” (“OBA”) means any business carried on by an Approved Person other than business done on behalf of the Approved Person’s MFDA Member firm. MFDA Staff Notice MSN-0040 Outside Business Activities provides clarification regarding the obligations of the Member and Approved Persons regarding OBA and issues that should be considered by the Member before approving OBA.
Members should be particularly aware of any OBA that presents a conflict of interest or places an individual in a position of power or influence over clients or potential clients.
Members are also expected to take reasonable measures to detect unauthorized OBA. Detective measures to identify unauthorized OBA can be incorporated into existing supervisory processes of the Member. Examples of detective and preventative measures include:
Advertising and Marketing Approvals
When approving advertising and marketing materials, Members should be aware of references to activities that have not have been approved by the Member.
Website Reviews and Approvals
Websites of Approved Persons may contain information regarding activity that was not previously disclosed or activity that has changed from when it was previously approved. Approved Person websites disclosing Member business require Member approval and should also be reviewed periodically as part of the Member’s branch review process under MFDA Policy No. 5 Branch Review Requirements.
Trade Name Approvals
As part of the approval process, Members should ask Approved Persons to disclose all activity that is conducted under that trade name.
As part of the planning process of a branch examination, branch review staff should be aware of all approved OBA of Approved Persons at the branch or sub-branch location. When performing the branch review procedures, branch review staff should be alert to any undisclosed OBA.
Trade Reviews and Trend Analysis
In conducting trade reviews or performing trend analysis in accordance with Policy No. 2 Minimum Standards for Account Supervision, Members should look for patterns of redemptions or material decreases in commissions or assets under administration, which may suggest activity is being conducted outside the Member.
Due Diligence in Recruitment
Questions regarding OBA should be included in the due diligence process when recruiting new Approved Persons.
Given the risk involved with unauthorized OBA, some Members, as a best practice, send annual questionnaires to their Approved Persons requesting confirmation of all OBA or any position that may result in a conflict of interest with clients or potential clients to be disclosed. The questionnaires also include a request to advise if there have been changes to previously approved OBA in order for the Member to determine if its approval continues to be appropriate.
3. Trade and Supervisory Inquiries
All Members are required to have a supervisory structure in place which adheres to industry standards for account supervision. This structure should include policies and procedures for issuing, following-up and resolving trade and supervisory inquiries.
An effective trade and supervisory inquiry process should include:
- Guidelines for supervisory staff regarding when an inquiry should be made;
- A standardized process to record inquiries in a readily retrievable format;
- Controls and procedures to track and follow-up on outstanding inquiries;
- Guidelines for acceptable timely resolution of trade and supervisory inquiries; and
- Escalation procedures and disciplinary measures for unresolved or recurring issues.
Members should have policies and procedures with respect to their leveraging suitability obligations, including criteria for assessing the suitability of a client’s use of leverage and describing appropriate client circumstances for recommending the use of leverage. The MFDA Leverage Supervision Guide provides guidance and best practices to assist Members in developing a leverage supervision process.
On February 22, 2013, amendments to MFDA Rule 2.2.1 (“Know-Your-Client”) and Policy No. 2 became effective. The amendments to Rule 2.2.1 clarify that the obligation for Members and Approved Persons to ensure that each order accepted, or recommendation made, for any account of a client is suitable includes recommendations to borrow to invest. Rule 2.2.1(f) clarifies that Members and Approved Persons are also required to use due diligence to ensure that the suitability of the use of borrowing to invest is assessed on transfer of assets purchased using borrowed funds into the Member and at the time the Member or Approved Person becomes aware of a material change in client information. Approved Persons are also required to assess suitability when there has been a change in the Approved Person responsible for the account. Amendments to Policy No. 2 reflect the requirements under Rule 2.2.1(f) and also include the following:
- Clarification that the suitability of leverage must be assessed having regard to the client’s investment knowledge, risk tolerance, age, time horizon, net worth, income, and investment objectives;
- Minimum criteria that would require supervisory review and investigation of leverage recommendations;
- The type of documents Members will be required to review and maintain to facilitate proper supervision of a leveraging strategy;
- The respective obligations of the Approved Person and branch and head office supervisory staff in assessing the suitability of investments and leveraging strategies; and
- Clarification that the obligation to review leveraged trades and leverage recommendations at the branch and head office applies to accounts other than registered retirement savings plans and registered education savings plans.
5. Branch Review Programs
Members are responsible for establishing, implementing and maintaining policies and procedures to ensure that business is conducted and managed in accordance with MFDA By-laws, Rules and Policies and with applicable securities legislation. An effective branch review program is a critical component of a compliance system designed to achieve compliance with these regulatory requirements.
MFDA Policy No. 5 contains standards for the development and implementation of branch and sub-branch review procedures. Topics covered include:
- Risk-based scheduling and examination cycles;
- Planning an examination;
- Content of an examination program;
- Reporting results and resolution of findings;
- Documentation standards; and
- Qualification of reviewers.
For further guidance, Members should refer to the Policy No. 5 Branch Review Workshop on the MFDA’s Members’ Only site.
6. Blank-Signed Forms and Altering Documentation
Members and Approved Persons are required to deal fairly, honestly and in good faith with their clients and observe high standards of ethics and conduct in the transaction of business. Obtaining blank-signed forms, altering client signatures or making subsequent changes to a form without client authorization are actions that contravene this obligation. Members are required to implement procedures designed to prevent and detect the use of pre-signed forms and improper alteration of documentation. MFDA Staff Notice MSN-0066 Pre-Signed Forms provides further information regarding blank-signed forms.
Where blank-signed forms or document irregularities are identified, Members are expected to take appropriate action to address the issue. When there is evidence that blank-signed forms were used to complete transactions, or where client signatures were falsified, the review should include contacting clients in writing or by telephone. Additional action taken by the Member will depend on the nature and severity of the circumstances in each case, but may include a review of all client files of an Approved Person to determine if additional blank-signed forms exist, heightened supervision of an Approved Person, a more frequent Policy No. 5 branch review of the relevant location, or disciplinary measures, such as fines or termination.
Members are responsible for maintaining policies and procedures that ensure the fair and prompt handling of written and verbal client complaints. Effective policies and procedures include provisions for:
- Obtaining a statement from the Approved Person;
- Obtaining and reviewing all relevant documents, including Approved Person notes and advertising and sales communications;
- Reviewing all allegations in the complaint and conducting an objective analysis;
- Providing a fair substantive response to the client addressing all allegations, in most cases within three months of receipt of the complaint; and
- Providing information to the client on other options that the client may choose to pursue with regard to the complaint.
8. Seniors’ Issues
Protecting senior investors is an area of focus and a strategic initiative for the MFDA. In the normal course of performing the supervisory activities, Members should consider the following senior-specific issues:
Reviewing and Approving NAAF/KYC Forms
Supervisory staff should assess the reasonability of investment objectives, risk tolerance and time horizon given a client’s age when approving a NAAF/KYC form.
When performing suitability reviews, supervisory staff should not only consider whether the investments in the account are consistent with information on the client KYC form, but also whether KYC information, such as investment objectives, risk tolerance and time horizon, is reasonable given the client’s age.
Marketing, Advertising and Use of Business Titles
When approving marketing and advertising, which would include seminars, Members should consider if there are particular concerns relevant to senior investors. When Members review the content of seminars, they should determine if it includes products or strategies that may not be suitable for all persons in attendance.
With respect to business titles, MFDA Rule 1.2.1(d) prohibits the use of any business name or designation of qualifications or professional experience that deceives or misleads, or could reasonably be expected to deceive or mislead, a client or any other person as to the proficiency or qualifications of the Approved Person under the Rules or any applicable legislation. Members should gain an understanding of all titles and designations used by Approved Persons, particularly those that are specifically directed towards senior investors, and assess whether they may mislead clients as to the Approved Person’s knowledge or qualifications.
Seniors may have physical restrictions that would make it difficult to submit a formal written complaint. Members should be prepared to assist senior clients in documenting their verbal complaints where the client wishes to document the complaint and it is evident that the client requires assistance. The purpose of documenting the complaint is so that the Member is aware of the main issues it needs to respond to. One method of documenting the complaint is to make an audio recording of the conversation with the client, where facilities exist and the client consents.
Specific Supervisory Procedures
Members should also consider developing specific procedures to supervise Member activity with senior investors which may include:
- Considering, during the due diligence process, whether the product is suitable for seniors, given risk tolerance, investment objective, income, net worth, time horizon, and liquidity concerns applicable to senior investors;
- Determining client demographics at branch and sub-branch locations when establishing the Member’s Policy No. 5 branch review cycle, schedule and sample selections;
- Requiring supervisory staff to have direct contact with seniors where serious concerns are identified to ensure effective communication and resolution of issues; and
- Providing additional training and education to Member staff and Approved Persons on senior-specific issues, such as diminished capacity and financial abuse.