When a complex financial product is unaccountably popular with retail investors, that’s usually a sign it is being bought and sold without much understanding of its true nature. In the case of principal-protected notes, the Investment Dealers Association of Canada has issued due diligence guidelines to bridge the knowledge gap.

PPNs should have had their “accountability moment” in 2005, when Portus Alternative Asset Management Inc. came crashing to the ground. Whatever went wrong with the firm, it raised a big question for the industry: how did so many small investors find themselves owning such complex and opaque products? The answer: the promise of income and principal protection were making PPNs increasingly popular.

The notes started largely as a clever way around RRSP foreign-content restrictions. But PPNs quickly developed into an asset class of their own; all sorts of assets were being packaged up for investors. And lack of regulation in the area meant that issuers had to do little to demystify products that were typically complex and not well understood.

The Portus debacle wasn’t enough to derail the PPN phenomenon, and regulators have been struggling to come to terms with the product. Securities regulators have been hampered in their efforts to deal with concerns about PPNs because they don’t have direct jurisdiction over the area, since the notes technically are banking products, regulated by the federal Office of the Superintendent of Financial Institutions.

Last year, the Canadian Secu-rities Administrators issued a notice spelling out some of its concerns with PPNs, namely the in-ade-quacy of disclosure, the size and lack of transparency of the fees, suitability, the “retailization” of alternative investments and the use of referral arrangements.

Recognizing the problem, the federal government promised an overhaul of its own oversight of PPNs in the last federal budget. The budget promised to introduce new principles-based disclosure requirements for PPNs that are sponsored by federally regulated financial institutions. The requirements are supposed to ensure that clients are informed of the fees, returns and risks associated with the products, and that they understand their cancellation and redemption rights. The regulations have yet to be issued. The Department of Finance hopes to have them ready for public comments this spring.

One area in which securities regulators do have a role in overseeing the growth of the PPN market is on the sales side. Registered reps selling PPNs are obliged to ensure suitability. That task can be difficult, given the complexity of some of the products, the inherent risks they pose and the fees involved.

The point was made in the IDA’s regulatory review of the hedge fund industry in May 2005. The IDA noted that many small retail investors who wouldn’t otherwise have qualified as hedge fund investors found their way into the funds through PPNs. Yet, the report found “the complexities of many hedge fund products make assessment of their suitability difficult.” It stressed that reps and firms can’t ensure suitability “without sufficient knowledge of the product.”

CHECKING SUITABILITY

The IDA now has introduced guidelines that, it hopes, will help reps and their firms determine whether PPN transactions are suitable. The guidelines are a response to the 2005 report, which called on the IDA to remind firms of their suitability obligation, amongst other measures, including issuing guidelines regarding acceptable referral arrangements and reminding firms of the prohibition of “off-book” transactions.

Paul Bourque, senior vice president for member regulation at the IDA, says development of the guidelines means the association now has fulfilled all the recommendations that were made for it in the 2005 report.

The guidelines also represent the first time that the IDA has issued product-specific due diligence guidelines, Bourque notes. They delve deeply into explaining the various points that a rep must consider to ensure suitability when recommending the product. The guidelines were launched along with a two-part educational Webcast.

The list of issues to consider is a long one. The 72-page guide explains how to evaluate a PPN and the numerous risks the products carry, such as inflation risk, credit risk and a lack of transparent pricing.

The IDA recommends that a detailed review of a particular note be carried out by a committee formed from various parts of the firm, and that the final decision on whether to add it to an approved list be made by a committee that includes members of senior management. The guidelines also include a due diligence questionnaire.

@page_break@The guidelines also spell out for reps selling PPNs the due diligence they should be doing for their clients. The guidelines’ existence may now factor into disputes with clients or regulatory proceedings that could arise regarding the sale of PPNs.

“The guidelines provide a standard that a discipline panel would undoubtedly use to assess whether the conduct in the particular circumstances of a case was reasonable,” Bourque says.

Although the guidelines were specifically developed for IDA firms and reps, they may also be informative for fund dealer reps, who are under the oversight of the Mutual Fund Dealers Association of Canada. Karen McGuinness, the MFDA’s vice president of compliance, notes that the IDA guidelines could be used by MFDA firms and reps, too.

“We have not had a chance to discuss internally whether we will issue anything to our members on these guidelines,” McGuinness says. “But my own view is that it would be beneficial for members and reps to consider these guidelines when offering PPNs.”

The regulators’ efforts to tackle PPNs aren’t over. Earlier this year, the CSA published a review of the hedge fund industry in which, among other things, it reiterated its concerns about the use of PPNs to sell hedge funds. The CSA is continuing to study the PPN issue and expects to publish something on them shortly.

In the meantime, the CSA’s proposal to reform registration requirements includes an effort to define acceptable referral arrangements, which was one of the issues raised by the IDA’s 2005 hedge fund report. IE