OSC finds suitability compliance shortcomings

Overall, it reports that about 62% of the firms reviewed were issued deficiency reports, where more than 30% of the deficiencies it found were characterized as ‘significant’. “We will continue to closely monitor the responses from these registrants and, in appropriate cases, may conduct follow-up reviews,” it notes.

Additionally, one EMD and one PM were found with enough significant deficiencies to raise significant investor protection concerns, leading to enforcement action; and, two EMDs and one PM discontinued their operations after the review, it says.

The review indicates that the regulator discovered some real problems with EMDs meeting their compliance obligations. For example, it found that most firms (75%) had inadequate processes for collecting, documenting, and maintaining know-your-client (KYC) information; almost half (45%) had deficiencies in their relationship disclosure, or inadequate policies and procedures; 18% sold exempt market securities to unqualified investors; 22% made suitability assessments that were inadequate due to a lack of documentation on how suitability determination made, and 15% made improper suitability assessments due to over-concentration; among various other issues.

Perhaps the most significant violation uncovered in the review is the instances of EMDs selling exempt securities to investors that don’t qualify as accredited investors, which it found at eight of 45 EMDs reviewed, affecting 26 investors from a total of 582 client files (4.5%). The report indicates that this represents approximately $1.7 million in improperly sold securities.

In most of these cases, it says, the dealer promised to advise the clients that the relevant trades had been made in breach of securities law requirements, and that they would refund the proceeds to investors. However, in one case, the OSC says that it found significant issues that were pervasive, and it has recommended further regulatory action in that case.

In terms of the inadequate suitability assessments it found, the OSC says that in most cases dealers were subsequently able to provide information that supported the suitability assessment. But that, in 15% of the firms reviewed, it found cases where EMDs appeared to have sold unsuitable investments to clients, primarily involving mortgage investment corporations (MICs) or mortgage investment entities (MIEs).

In these cases, it found that some clients invested over 30% of their financial assets in a single exempt product; that some EMDs appear to be encouraging non-accredited investors to invest a high proportion of their assets in a single product solely to allow the dealer to rely on the $150,000 exemption; and, it found one dealer who distributed products of a related issuer, relying extensively on the use of “client-directed trade instructions” in situations where the trades were considered unsuitable.

“We have identified these concerns as significant deficiencies with the EMDs in question and are considering further regulatory action with respect to these EMDs,” it says. “We are also considering whether concentration ‘limits’ for individual investments in a client account should be imposed, particularly when investments are purchased under the $150,000 minimum amount exemption.”

The review notes that the Canadian Securities Administrators (CSA) are currently considering changes to the exempt market regime, including a possible repeal of the $150,000 exemption. “In the meantime, we will raise comments with EMDs that use the minimum amount exemption in circumstances where the investment made represents more than 10% of the client’s net financial assets to confirm that the EMDs are in compliance with their suitability obligations,” it says.

The OSC says that it’s also concerned about certain EMDs inappropriately relying on client-directed trade instructions to avoid their suitability obligations. And, it reports that it found a number of situations where EMDs purported to limit their liability for breaches of suitability, or other, obligations by including improper disclaimers in their KYC forms, or other client documentation.

The review also involved the OSC contacting clients directly to verify the accuracy of their KYC information. The OSC says that it found that for approximately 7% of the clients it called the information provided by the client was not consistent with the KYC information maintained by the dealer.

The portfolio managers it reviewed come off slightly better than the EMDs. The review indicates that the OSC found that most firms are generally complying with their obligations, but that “additional work is required to increase the adequacy of suitability assessments.”

In particular, most portfolio managers (70%) aren’t doing enough to ensure their KYC information is sufficient; 45% of these firms are also making inadequate relationship disclosure; 35% have inadequate policies and procedures; and, 5% made inadequate suitability assessments.

The review, which began in June 2012, examined a total of 87 firms. The OSC plans to issue guidance over the next several months, which will include best practices and highlight examples of unacceptable practices, it says.

“Know-your-client, know-your-product and suitability determinations are fundamental obligations owed by registrants to their clients,” said Howard Wetston, chair and CEO of the OSC. “Enhancing compliance among portfolio managers and exempt market dealers is critically important and we are taking appropriate regulatory action where we identified significant compliance issues.”