Investor Alert:
CIRO is issuing a warning to Canadian investors regarding Canada Token Trade.
Effective Date: December 31, 2021
We are publishing guidance on product due diligence and Know-Your-Product (KYP) to outline our expectations regarding Dealer Member (Dealer) compliance with IIROC Rule 33001 , Product Due Diligence and Know-Your-Product.
Section 3301 of the IIROC Rules sets out the requirement for Dealers to conduct due diligence on all securities2 they make available to clients (product due diligence). More specifically, Dealers must:
By conducting product due diligence, Dealers can identify securities that should be made available to only certain classes of clients, or in certain cases, not be made available to any client. For example, where a Dealer determines that a particular security has complex or unique features making it difficult to fully understand, the Dealer may conclude that the security should not be made available to a certain class or subset of retail clients3 . Examples of such securities include, but are not limited to, the following:
Instead, the Dealer may identify less risky, complex, or costly alternatives that offer similar benefits to its retail clients.
A Dealer makes a security available to clients by:
Product due diligence and underwriting due diligence serve different purposes. Underwriting due diligence deals primarily with disclosure. For example, in a public offering of securities, it is the process by which an underwriter:
In contrast, product due diligence is focused on ensuring that the products a Dealer makes available are appropriate, or suitable, for its client base. For more information on underwriting due diligence, please consult Notice 14-0299.
Dealers may tailor their product due diligence process based on:
For example, the factors considered as part of the product due diligence required may differ between order execution only (OEO) accounts and advisory accounts. This is because, unlike an advisory account, clients who have an OEO account do not receive the benefits of a suitability determination, nor do they have a Registered Representative to provide them with advice. At a minimum, the product due diligence obligation for OEO accounts will include a determination regarding whether certain products should be made available for any clients. There are various reasons for excluding certain securities, such as a lack of information available for investors to assess the security, and also significant conflicts of interest associated with the governance of certain products. In extreme cases a product may be suspected to be of a fraudulent nature. These baseline considerations do not entail a suitability obligation for individual clients.
Dealers may use a risk-based approach to assess and approve securities. Dealers’ policies and procedures may set out different levels of assessment, approval and monitoring for different types of securities, as appropriate.
A security-by-security assessment is not expected in all circumstances. Dealers may consider a less extensive product due diligence process for less complex and less risky types of securities, such as publicly traded common shares. Complex and risky securities may warrant a more extensive product due diligence process. Typically, complex and risky securities include those that have one or more of the following characteristics:
Dealers may want to consider a more extensive product due diligence process for securities sold under a prospectus exemption because they are typically less liquid and there is limited disclosure available about them.
However, Dealers should not assume that little or no review is necessary if a security is similar to one already in the marketplace, or on the Dealer’s product shelf.
Generally, Dealers are not required to approve securities that are transferred-in or held as a result of a client-directed trade if they do not otherwise make those securities available to clients. They, however, must take reasonable steps to assess those securities; the depth of such assessment may vary depending on the nature of the securities, the client’s circumstances and investment objectives, and the relationship between the client and the Dealer.
Approved Persons must have an understanding of all securities held in a client’s account, including those that are held as a result of a transfer-in or a client-directed trade, in order to fulfill their suitability determination obligations in Rule 3400, including with regards to a recommendation to continue to hold or reduce the securities. Approved Persons must therefore take reasonable steps to assess and understand those securities transferred into the Dealer from another Dealer or registrant, as well as those that are a result of a client-directed trade, within a reasonable time after the transfer or trade.
If a Dealer’s parent or affiliate4 assesses new securities that the Dealer will put on its shelf, we expect that Dealer to participate in the parent or affiliate’s assessment process or have its own separate assessment process. We also expect that Dealer to decide on matters such as marketing materials and Approved Person training.
When making securities of related and connected issuers available to clients, Dealers must identify, avoid or otherwise address existing, and reasonably foreseeable, material conflicts of interest, as required by our conflict of interest requirements5 .
We recommend Dealers exercise caution when relying on disclosure prepared by an issuer or an “independent” report prepared by a third-party which may have been commissioned by the issuer.
Where a Dealer distributes a security based on a third-party report that includes the following types of claims about the security:
the Dealer should perform its own product assessment to ensure that the report is fair, balanced and not misleading.
Third-party information can be a key component of a Dealer’s product due diligence process, but the Dealer should also conduct its own product analysis. The Dealer should base the extent of that additional analysis on their assessment of the reliability, objectivity and completeness of the third-party information.
We do not expect a duplication of the product due diligence review, approval and monitoring processes where multiple registrants are involved with securities such as:
We expect that Dealers will comply with their product due diligence obligations as they relate to the securities involved at the level they are making them available to clients. For example, Dealers that make funds or model portfolios available to their clients should assess and understand:
We expect a Dealer’s product due diligence procedures to describe all aspects of the process including:
As set out in clause 3301(1)(iii), a Dealer’s product due diligence process must include appropriate monitoring for significant changes to securities that have been approved by the Dealer and continue to be made available to clients. For example, we would consider a modification to a security that may impact the Dealer’s assessment of that security to be a significant change.
While a change in the overall market or economic conditions may affect a Dealer’s or an Approved Person’s assessment of a security, we generally would not consider it a change requiring reassessment of individual securities. However, a change in market conditions that affects only a particular security, or sector, or new information regarding a particular security or sector, may require a reassessment of the affected securities.
A Dealer’s monitoring process may vary depending on the Dealer’s business model and the type or complexity of securities.
We consider the following to be components of an effective product due diligence process:
Dealers should consider these components when assessing their policies and procedures and implement those that work best for them given their size, structure, operations and business model.
In conducting product due diligence, Dealers should ask appropriate questions to be able to determine whether the security should be offered, and identify important features for marketing and training. Dealers should perform due diligence with an open and questioning mind.
Factors that Dealers should consider as part of their product due diligence process include:
If, following a product due diligence review, the Dealer determines that the security would be:
The product due diligence requirement set out in section 3301 does not apply to accounts maintained at a Dealer who is a carrying broker for those accounts or who only provides trade execution, clearing, settlement or custody services to another Dealer, portfolio manager, exempt market dealer or their respective clients. The rationale behind this exemption is that, in each of these cases, the Dealer is providing services to another registrant or their clients and the product due diligence requirement is the obligation of, and is conducted by, the other registrant (i.e., Dealer, portfolio manager or exempt market dealer). For a summary of all exemptions, refer to the chart in Appendix A.
Section 3302 provides that an Approved Person6 of a Dealer may not purchase, sell or recommend securities for a client unless the Approved Person takes steps to understand the securities (KYP). More specifically, Approved Persons must take steps to understand the securities, including their structure, features and risks, initial and ongoing costs and the impact of those costs, sufficient to enable the Approved Persons to meet their suitability determination and other regulatory obligations.
Also, Approved Persons must ensure that any securities that the Approved Person purchases, sells or recommends for a client have been approved by the Dealer to be made available to clients, pursuant to the Dealer’s product due diligence obligation.
We expect Registered Representatives, Portfolio Managers and Associate Portfolio Managers to understand the terms, features, risks and potential returns of the securities, transactions and trading strategies they recommend, including how:
KYP is also an extension of each Approved Person’s general duty to deal fairly, honestly and in good faith with their clients7 . It is one of the most fundamental responsibilities owed by Approved Persons to their clients and, along with the KYC and suitability determination obligations, is a cornerstone of our investor protection regime.
Approved Persons must conduct KYP for all securities they purchase, sell or recommend for clients.
We do not expect all Approved Persons to be fully proficient in all securities made available by their Dealer. However, an Approved Person should have a general understanding of the securities available on their Dealer’s product shelf to meet its suitability obligation.8
Under the product due diligence requirement9 , Approved Persons must not purchase for, or recommend securities to, a client unless the Dealer has approved those securities. The fact that a security has been “approved” by the Dealer in fulfilment of the Dealer’s product due diligence obligation does not discharge the Approved Person from KYP. KYP is a separate and distinct obligation on an Approved Person that is in addition to the product due diligence obligation on Dealers.
Under the KYP requirement, Approved Persons are required to have an understanding of all securities held in a client’s account, including those that are held as a result of a transfer-in or a client-directed trade, in order to make the required suitability determination under Rule 3400.
When making a recommendation or accepting an order from a client, Approved Persons should understand and be able to explain to the client the security’s structure, features, risks, initial and ongoing costs and the impact of those costs. For example, the Approved Person should understand and be able to explain, among other things:
Approved Persons should not recommend a security solely based on:
Dealers are responsible for ensuring that their Approved Persons understand the securities they purchase, sell or recommend10 . Dealers should use, and share, the information obtained through their product due diligence in carrying out this responsibility. The Dealer’s policies and procedures should outline the training requirements of Approved Persons. Dealers should maintain evidence of the successful completion of this training.
Dealers should create an environment that supports their Approved Persons in learning about the securities on their product shelf. This may include education opportunities such as distributing new security information, security-specific training or regular security-related conference calls.
Generally, the KYP obligation applies to Approved Persons. However, subsection 3303(2) sets out exemptions from the KYP obligation for certain account types, client types or service arrangements. More specifically, the KYP obligation does not apply in respect to:
For a summary of all exemptions, refer to the chart in Appendix A.
IIROC Rules this Guidance Note relates to:
This Guidance Note replaces Notice 09-0087- Best practices for product due diligence.
This Guidance Note is related to Notice 21-0148 - Client Focused Reforms – IIROC Rule Amendments
Appendix A - Summary of Exemptions