In the aftermath of portus al- ternative Asset Management Inc. and other such scandals, the Mutual Fund Dealers Association of Canada issued a notice in October 2005 — quickly followed by a set of “frequently asked questions” — confirming the obligation of mutual fund dealers and their approved persons to conduct due diligence on the securities they recommend and/or sell to their clients, including prospectus-exempt securities. But, in spite of these initiatives, many dealers still wonder what specific steps to take to meet this obligation — particularly regarding exempt securities.

Selling so-called “exempt securities” can be challenging for smaller mutual fund dealers that often don’t have the financial or human resources to establish, maintain, perform and enforce due diligence-related policies and procedures. The more sophisticated the exempt security, the greater the level of due diligence is required.

Dealer policies should limit approved persons to the sale of securities that are on an “approved list” and require annual written confirmation of compliance. Back-office staff should be trained to process orders only for securities on the approved list and bring to the attention of compliance staff any commissions or other payments received and “tagged” to a specific salesperson from parties not on the approved list.

A dealer’s written policies and proce-dures for selling exempt securities generally should reflect how the dealer will carry out due diligence, including:

> A review of all relevant documentation, with particular consideration given to conflicts of interest, especially cash flows to and from the principals of the issuer and their affiliates (sponsors, general partners, promoters, for example).

> The establishment of approval criteria that considers the reputation, relevant experience and success of the principals offering the securities and that of other key parties.

> A determination of a maximum percentage (or cap) of the offering devoted to paying up-front “soft costs” such as corporate finance fees, commissions and promoters’ fees.

> The dealer’s senior officers’ consideration and approval of a comprehensive written recommendation with backup documentation, prepared by a trained and experienced individual, that describes in detail the due diligence undertaken. This individual should not report to or through a sales or marketing function, and the individual’s compensation should not be tied to the revenue or profit generated by the exempt security. Limited reliance should be placed on due diligence reports directly paid for by the principals of an offering (or affiliated parties).

> The retention of experts, when appropriate, to advise on the reasonableness of forward-looking statements — including projections, estimates and forecasts — or to assess costs, revenue and overall feasibility of development projects.

> The establishment of internal business rules setting out the characteristics of clients who will be permitted to purchase exempt securities, including level of investment knowledge, age, income and net assets recorded on the know-your-client form. Different rules could be developed for different types of securities, depending on their risk level. The rules might require that each investor receive and sign a statement prepared by the dealer that discloses, in plain language, the risks associated with the securities, which may include lack of liquidity, the issuer’s creditworthiness or the obligation to invest more if called upon (“cash calls”).

> A periodic review of a security’s performance, in order to recommend any necessary and permitted adjustments to client holdings.

> Requiring approved persons who sell an exempt security to have both the knowledge and experience to understand the security and explain its features, both positive and negative, to potential investors.

Establishing and following a due diligence program with these characteristics allows a dealer to demonstrate to regulators and to approved persons that a satisfactory program exists and is being applied. This will increase the dealer’s comfort in promoting exempt securities. It will also show a court that reasonable due diligence was performed prior to selling a security in the event of an allegation of breach of contract, breach of fiduciary duty and/or negligence.

A due diligence program is a necessary reputational risk-management tool. Although the benefits of a good program are difficult to quantify, negative media arising from an investigation by a regulator or litigation flowing from an allegation of a failure to undertake an appropriate level of due diligence has the potential to cause substantial harm to a dealer’s business.

There is one final thing to consider: the potential for significant monetary judgments in class actions may lead insurance carriers to review mutual fund dealers’ due diligence policies and procedures as a step in underwriting of errors and omissions policies. If less than satisfied, these carriers may restrict the extent of their coverage, increase premiums and/or increase deductibles. IE

@page_break@

Richard E. Austin is counsel at the Toronto office of Borden Ladner Gervais LLP.