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Bulletin

Client Focused Reforms - New Obligations for Registrants Arising Out of Proposed Amendments to NI 31-103

Fasken
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Investment Management Bulletin

On June 21, 2018, the Canadian Securities Administrators ("CSA") published the proposed amendments to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations ("NI 31-103") and to Companion Policy 31-103CP Registration Requirements, Exemptions and Ongoing Registrant Obligations (the "Companion Policy"; collectively with NI 31-103, the "Proposed Amendments") which aim to address key investor protection concerns with respect to the relationship between clients and securities advisers, dealers and representatives ("Registrants") with a focus on clients' best interests (the "Client Focused Reforms"). Click here to consult the Proposed Amendments (PDF).

More specifically, the Client Focused Reforms are meant to better align the interests of Registrants with the interests of their clients, to improve outcomes for clients, and to clarify for clients the nature and the terms of their relationship with registrants.

The Proposed Amendments are expected to impose additional compliance obligations on Registrants along the following themes:

  • Suitability, know your client ("KYC") and know your product ("KYP");
  • Conflicts of interest (including referral arrangements); and
  • Disclosure to clients.

Below, we present in a condensed form a summary of the scope of the Proposed Amendments. However, this bulletin is not intended to be a comprehensive summary of the Client Focused Reforms nor a complete analysis of the potential impacts thereof.

The Client Focused Reforms are subject to a 120-day comment period.

In order to go into greater depth in the scope of the Proposed Amendments arising out of the Client Focused Reforms and to discuss potential issues that Registrants may face if they were to come into effect, our Investment Management team will host a conference and discussion period, in Montreal, on September 14, 2018 from 12 to 2 pm.

Summary of the Client Focused Reforms

Suitability Determination

At the core of the Client Focused Reforms lies a new proposed requirement that Registrants put their clients' interests first when making a suitability determination.

In addition to the changes proposed to KYC-related provisions (described below) and the introduction of new KYP-related provisions (described below) which are meant to improve the ability of firms to made suitability determinations, the proposed enhanced suitability obligations also include:

  • the explicit requirement for Registrants to consider certain factors, including the client's situation and understanding of the security, the features and associated costs of the account type made available to the client, the impact on the account and the overall concentration and liquidity across all of the client's accounts at the firm, the potential and actual impact of costs on the client's returns and a consideration of a reasonable range of alternative actions available to the client through the registered firm at the time the determination is made;
  • the shift from trade-based suitability to an overall portfolio-level suitability analysis; and
  • the prescription of triggering events that will require a Registrant to reassess suitability.

Under the Proposed Amendments, the suitability criteria listed have to be met before a Registrant opens an account, takes an investment action on behalf or, or makes a recommendation to a client, and have to be reviewed and updated, promptly after any of the following occurs:

  • a new registered individual is designated as responsible for the client's account;
  • there is a change in a security in the client's account that may result in the security or account not meeting the criteria;
  • there is a change in the KYC   
  • the Registrant has reviewed the KYC;
  • the Registrant becomes aware that a security or the client's account does not meet the criteria
  • Registrants should take appropriate action, as necessary, promptly after any change in the suitability determination.

KYC

The Proposed Amendments relating to KYC requirements include:

  • the clarification of the information the CSA expects should be collected to "know a client" well enough to meet the suitability determination obligation (including gathering the following new information: personal circumstances, investment knowledge and investment time horizon);
  • the requirement that Registrants take reasonable steps to obtain clients' confirmation of the accuracy of their KYC information collected at account opening and when any significant change occurs; and
  • the provision of the circumstances that require the review and update to KYC, including (i) at any time when the Registrant knows or reasonably ought to know of a significant change to KYC, (ii) every 12 months for managed accounts; (iii) within 12 months from executing a trade or making a recommendation to a client; and (iv) 36 months for other accounts.

KYP

Currently there are no explicit provisions relating to KYP in NI 31-103 and the Companion Policy only provides limited principle-based guidance on the CSA's expectations relating to KYP.  The  Proposed Amendments introduce KYP-related obligations expressly in NI 31-103 which would require that Registrants:

  • understand the securities they purchase, sell or recommend, and how they compare to similar securities in the market;
  • approve the securities they make available to clients, or in the case of a registered individual, refrain from purchasing, selling or recommending a security unless his/her sponsoring firm has approved the security;
  • monitor and reassess securities including for significant changes to the security;
  • maintain an offering of securities and services that is consistent with how the firm holds itself out; and
  • in the case of firms, provide registered individuals with the necessary information about each approved security.

Conflicts of Interest

Conflicts of interests have been identified by the CSA as a key area of concern in the client-registrant relationship.  As such, one of the central changes proposed in the Client Focused Reforms is the adoption a statutory best interest standard with regards to conflicts between the interests of the firm and its clients.  Pursuant to the Proposed Amendments, firms would have to address any conflicts of interest in the best interest of the client.  If a conflict is not, or cannot be addressed in the best interest of the client, then firm must avoid that conflict. 

In addition, the Proposed Amendments provide that Registrants, including registered individuals, must:

  • identify and address all conflicts of interest that are reasonably foreseeable instead of material conflicts of interest that the Registrant would expect to arise in its reasonable opinion (the Companion Policy provides additional examples of potential conflicts of interest and sets out some controls that may be put in place to assist Registrants in addressing conflicts of interest);
  • in the case of registered individuals, report identified conflicts of interest to their sponsoring firm;
  • disclose all conflicts of interest that a reasonable client would expect to be informed of (such disclosure must include an overview of the nature and extent of the conflict of interest as well as the potential impact and risk posed to the client and as how it was or will be addressed); and
  • avoid certain specific conflicts of interest including (i) borrowing money, arranging a guarantee in relation to borrowed money, or borrowing securities or any other assets, from a client, (ii) lending money, providing a guarantee in relation to a loan, extending credit, providing margin or lend securities or any other asset to a client, (iii) acting under a power of attorney from a client, acting as a trustee with respect to a trust in which a client is the settlor or beneficiary, or acting as a trustee or executor in respect of the estate of a client, or otherwise having full or partial control or authority over the assets of a client, unless certain criteria are met.

Referral Arrangements

The Proposed Amendments propose significant new restrictions on the use by firms of referral arrangements. Notably, they require that the party referring clients to the Registrant (and thus, receiving a referral fee) be a Registrant.  

Moreover, proposed prohibitions relating to referral arrangements include that a referral fee must not:

  • continue for longer than 36 months;
  • constitute a series of payments exceeding 25 percent of the fees or commissions collected from the client by the party who received the referral; and
  • increase the amount of fees or commission that would otherwise be paid by the client for the same product or service.

Misleading Communications

The Proposed Amendments provide that Registrants must not hold their services out in any manner that could reasonably be expected to deceive or mislead any person as to their proficiency, experience, qualifications, the nature of the person's relationship, or potential relationship, with the Registrant and the products or services provided, or that may be provided.

Similarly, the Proposed Amendments provide that registered individuals must not use a title, designation, award, or recognition that is based partly or entirely on that Registrant's sales activity or revenue generation, or use a corporate officer title unless their sponsoring firm has approved such title and appointed that Registrant to that corporate office pursuant to applicable corporate law.

Disclosure

The Proposed Amendments introduce additional disclosure requirements for Registrants including:

  • disclosure of the information that a reasonable investor would consider important in deciding whether to become a client of the firm. Such information include information relating to products and services offered, charges and other costs to clients, any third party compensation associated with the firm's products, services, accounts, and client restrictions; and
  • additional disclosure to be included in the relationship disclosure information ("RDI") regarding restrictions on the products and services a firm makes available to its clients, such as whether such firm uses "proprietary products", restrictions on the products, an explanation of the impact of costs, management fees and charges on the client's investment returns.

The CSA expects that firms will monitor and approve information made publicly available.

Education and Experience Requirements

The Proposed Amendments require Registrants other than investment fund managers, in respect of its activities as investment fund manager, to provide training to its registered individuals on compliance with securities legislation including conflicts of interest requirements, KYC, KYP obligations and suitability determination. In addition, such Registrants must provide training regarding the structure, features, returns and risk, initial and ongoing costs (and the impact of those costs) of the securities available through the registered firm for the registered individuals to purchase or sell for, or recommend to, clients.

The CSA expects firms to develop, implement and maintain an ongoing compliance training program which should include ongoing communication and training on changes in regulatory requirements or in the firm's policies and procedures. The firm's training program should be in writing, reviewed and kept up to date.  In addition, CSA expects firms to perform evaluations to test the effectiveness of their ongoing training program at regular intervals.

Recordkeeping and Monitoring

Registrants will be imposed to demonstrate compliance with KYP, training, misleading communications, their duty to provide information and will have to demonstrate how they address and plan to address, the conflicts of interest.

The CSA expects that internal controls should also be specifically designed to assist firms in monitoring compliance with the KYC, KYP and suitability determination obligations.

Impact of the Client Focused Reforms

While many of the firms affected by the Client Focused Reforms already have compliance processes in place that are sufficient to address some of the heightened standards imposed by the Proposed Amendments, the Proposed Amendments are likely to cause significant challenges to certain business models.

Many of the changes, especially those which introduce principles-based standards, can be difficult to interpret and create uncertainty.  While guidance was provided in the Companion Policy with respect to concepts such as "putting the client's interests first" in connection with suitability determinations and acting in the "best interest of the client" in connection with conflicts of interest between the firm and the client, it is unclear what consequences the introduction of these standards will have in practice.

We expect that the new restrictions placed on referral arrangements, if adopted, will result in a significant shift to current prevalent market practice concerning referrals and may have a significant impact on the business model of some firms.

Finally, as with any significant increase of the regulatory burden of firms, we expect that compliance costs may increase as a result of some of the Proposed Amendments.  

Implementation

The CSA is considering a phased implementation schedule for the final amendments:

  • Referral arrangements amendments will come into effect immediately upon coming into force, except that Registrants will have 3 years to bring pre-existing arrangements into conformity;
  • Disclosure amendments relating to the provision of publicly available information will come into effect 1 year after the amendments come into force and other RDI amendments will come into force 2 years after the amendments come into force;
  • KYC, KYP, suitability and conflicts of interest amendments will come into effect 2 years after the amendments come into force;

The CSA was silent on the implementation of the other amendments.

Our Investment Management team will be pleased to discuss the Proposed Amendments with you on September 14, 2018 and to answer any questions you may have.

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