Kenmar Associates. Investor Education and Protection

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1 Sherry Tabesh-Ndreka, Policy Counsel October 9, 2009 Investment Industry Regulatory Organization of Canada 121 King Street West, Suite 1600 Toronto, Ontario Canada M5H 3T9 Fax: (416) Kenmar welcomes the opportunity to comment on. Know your client and Suitability Guidelines C&Language=en By way of introduction, Kenmar Associates is an Ontario- based organization focused on investor education and protection via on-line research papers hosted at also publishes the Fund OBSERVER on a bi-monthly basis discussing investor protection issues primarily for retail investors. Kenmar routinely submit comments and ALERTS on proposed regulatory changes that could impact Main Street. We agree that the suitability requirement is complementary to the fundamental obligation under securities legislation for dealers and their representatives to deal fairly, honestly and in good faith with retail investors. Rule also states that the (advisor) registered representative is responsible for the advice given. In providing this advice, the registered representative must meet an appropriate standard of care, provide suitable investment recommendations and provide unbiased investment advice. Despite the obvious contradiction of unbiased investment advice in a marketplace where getting a product sold has as much to do with commission as anything else, the issue of suitability and responsibility for the process (as well as its transparency) that defines suitability is critical to the client relationship and the ability for the client to make an informed decision on an investment. In effect, a broker has a duty to understand the risk/loss tolerance of an investor, the tax considerations for the client, the client's prior experiences and appetite for risk, and the level of portfolio return desired. We note parenthetically that Britain's Financial Services Authority Investment has unveiled draft rules aimed at making the retail investment market fairer to consumers.the FSA says advisers' revenues should come from upfront charges paid by the client rather than from commission fees paid by insurers, brokerages and investment fund managers. This would eliminate a potential conflict- of- interest that can be damaging to investors and lead to unsuitable transactions and investments. The FSA's proposed rules are open for consultation until the end of October. The regulator will publish a final draft of the rules early next year, and they will come into force in 2012.The OSC s Fair Dealing Model attempted to address similar issues but did not gain the momentum necessary to be implemented. Had it prevailed, many of the issues regarding suitability would now be behind us. 1

2 Our daily contact with retail investors provides an exceptional window into the world of client satisfaction and dissatisfaction.how an industry handles portfolio construction is a good measure of the integrity of the industry and its regulation. Investor losses in 2008 were unduly large due to unbalanced asset allocations, unsuitable investments, lack of mitigation and unnecessary borrowings to invest/use of margin. We see attempts to blame the client for not reading prospectuses, transactions slips and client statements. We see out-of-date, incomplete, missing and even blank pre-signed KYC s. We observe KYC forms with investment objectives that are too general to relate to any specific trade or investment but that relate more to the overall objectives of the account (such as retirement savings or education fund ). We hear persistent rumours that inadequate steps are taken to ensure that the KYC information on back office systems correspond to the KYC information in client files. Question: Is the KYC system really working as intended? We can use our database as a diagnostic tool in evaluating current application of IIROC KYC/Suitability Guidelines. The Guidelines will be effective if they can help prevent unbalanced portfolios, unsuitable/risky investments, unduly costly products, excessive taxation and account churning and other issues that impair nest eggs. As we have noted numerous times before, a professional advisor should employ a mutually agreed upon Investment Policy Statement (IPS) based on the NAAF/KYC and financial plan. This will help prevent a lot of problems for clients, dealers and dispute resolvers like OBSI.. A number of independent reports suggest that Unsuitability is the number ONE issue causing complaints. Part of the problem is the use of models or formulas that focus on the assumed ability to withstand losses rather than the lesser of the client s willingness and ability to accept risk - see point 2.below and APPERNDIX I). The need for competent, trusted advice has never been greater given Canada s demographics and the nasty after-effects of the global credit crisis. According to a recently released CSA investor survey CSA 2009 Investor Index N.pdf?n=6519 barely r half of Canadians (56%) express confidence in their ability to make investment decisions, while two-in-five say they are not very (25%) or not at all confident (13%).Only 25% of respondents have a formal written financial plan yet 46 % say they have a financial adviser. These stats point as much to industry shortcomings as investor behaviour. We offer the following comments with regard to the proposed Guidelines: 1 The New Account Application Form should be standardized throughout the industry with a clear, plain language definition of terms and an awareness by the investor that the document will be used to determine the suitability of investment recommendations and in the resolution of 2

3 disputes should they arise. This provides a robust foundation for suitability. The term Loss Tolerance should be introduced in addition to risk tolerance. See APPENDIX I. 2 It is rare for all accounts to have the same objectives, time horizon and risk tolerance. We therefore recommend that long term plans such as RRSP s always have a uniquely identifiable KYC. We do not concur that time horizon is not a separate requirement, in order to properly assess and record a client s investment objectives and risk tolerance, Registered Representatives should always consider the client s time horizon. The myth of time diversification definitively applies to the new account application forms that are required to be completed upon opening a new brokerage account. Brokerage firm new account documents commonly contain the client investment objective entitled Long-Term Growth. While this selection may or may not be reviewed with the client, it can be an inappropriately defined objective and is frequently used against the investor in a dispute/ arbitration. For the typical client, Long-Term Growth means that they plan on being invested for the rest of their lives and they d like their investments to grow. For the typical registered representative, Long-Term Growth means the conventional time diversification model is in force and they can put the client in more aggressive investments because of their long time horizon. New account forms should ask: How much money are you willing to lose in any one year? The question should be answered in nominal terms and it should have a signature line next to it. This would force both client and registered representative to address within-horizon risk before any investments were made and (hopefully) avoid the get me out at any price decision. 3. We concur that Registered Representatives periodically, at a minimum annually, should inquire with each client as to whether there are any material changes in the client s circumstances. This dialogue should be documented and a new dated KYC form sent to the client, either electronically or by snail mail for signature. We do not understand why a new suitability analysis is required when there is a change in the registered representative. Investors have an implied contractual relationship with a firm not its staff. 4. Where an unsuitable investment is identified within an account, the Registered Representative should take appropriate measures to ensure the client receives advice considering the client s objectives, risk tolerance, and other particular circumstances. We would change An appropriate measure or course of action may include contacting the client in a timely manner to recommend changes. We recommend making such contact mandatory. Kenmar define an unsuitable investment as one that does not contribute to the portfolio s goals. These goals could include tax efficiency, an often overlooked aspect but a critical one, especially for seniors, retirees and pensioners. Low cost/fees, while not an explicit portfolio goal, is in our view an integral part of the Registered Reps obligations to clients. Too often we see expensive mutual funds where history shows a low- cost ETF would do a superior job. We regard unduly high fee products as unsuitable investments. A deferred sales charge mutual fund may very well be unsuitable because it adds costs and reduces liquidity. Churning [unsuitable sales] by definition is also an 3

4 unsuitable investment as is undue borrowing to invest. The Guide as written does not adequately deal with these important real-world matters. 5. We agree that when a Registered Representative receives an unsolicited order that is unsuitable in relation to the client s objectives, risk tolerance and other particular circumstances, it is not sufficient to merely mark the order as unsolicited. The Registered Representative needs to take definitive action to deal with the unsuitable order. Such action would be a clear articulation of caution and a request to modify the KYC/ IPS. Clients should be advised that once an unsuitable investment enters a portfolio, the objectives cannot be met. The sentence Registered Representatives should note that it is inappropriate to update or alter the client s KYC information in an effort to justify the suitability of an investment, order or recommendation that is otherwise unsuitable for the client. is itself inappropriate. Such a malicious act is a lot more than inappropriate - it is unethical and unprofessional if not outright illegal. The Guide should treat such an act as fraud not sugar coat it. 5. Registered Reps making recommendations should identify themselves as professionals with appropriate designations allowing them to be advisors (on written communication and business cards) and those with no professional affiliations should be identified as salespersons. Only those individuals capable of constructing a portfolio that meets the objectives of the investor should be permitted to use the word adviser. Titles such as financial planner, mutual fund consultant, retirement expert etc. should not be permitted as they cause confusion and allow individuals to masquerade as something they are not. Any conflict-of interest should be highlighted. 6. Dealers should be held accountable for the supervision of their staff / agents. In a growing number of cases we see dealers claiming that they did not know of certain transactions that Registered Reps were transacting with clients. These off-book relationships can and have been very costly for retail investors. Any fines levied by IIROC should be against the dealer not the individual advisor. This basic change in protocol will, we feel, attract management's attention to the account supervision/suitability issue. We also recommend that wherever practical, commercially available software be utilized to automate tracking of the suitability of trading activity. 7. It seems to us to be so fundamental that it is almost embarrassing to have to mention the necessity for individual account performance reporting. Without knowing personalized rates of return, it is not possible for a client or the adviser to determine whether the recommendations being made are suitable and actually working towards achieving the investors objectives. It is inconsistent to be in the advisory business and not be able to tell investors how their accounts are performing. All performance reporting should be generated by the firm and not by the adviser in order to ensure adequate management controls and consistency. Many firms already have the capability. For those who don t, a short transition time should be permitted. 4

5 8. The approval of new accounts and KYC updates should include the objective review of the KYC information submitted. For example, a 75 year-old widow with a declared long term time horizon and high risk tolerance should be flagged for follow-up to assess whether the KYC information is accurate or whether there are other objectives of the client that have not been identified or recorded on the KYC form. Firms should also have controls in place to prevent or detect inconsistencies in KYC information. e.g. a client with a speculative investment objective should not also have a low risk tolerance. 9. We believe the Guidelines should be clear that it s a Best Practice for clients to sign-off on KYC s and to deliver a KYC upon request/without delay. We believe some of the delivery issues relate to low levels of process automation. It must be quite a challenge for a Registered rep with clients to keep KYC files current. 10. The 27- page MFDA Suitability Guidelines MR should be adopted, modified if necessary, to suit IIROC clients. As much harmonization as possible is desired since IIROC firms also sell and make recommendations on mutual funds. Quite frankly, we found MR-0069 more useful as a Guideline with greater specificity in critical areas. IIROC may find our Checklist for advisors of interest-see Appendix II. 11. Client statements should show clients (1) the deviation of their portfolio performance from agreed upon benchmarks and (2) asset allocation thus prompting a constructive dialogue. These statements should be at a frequency that allows tracking but not less than quarterly. The information on these statements provides a validation of suitability. 12. For greater clarity, we believe IIROC should include some examples as to what constitutes a material change. We suggest a job loss, a death of a family member, a promotion, an inheritance, an psychological or physical illness and the like. Indeed, a general problem with the Guidelines is that they lack the specificity to provide a basis for behaviour. We urge IIROC to press for changes to the current CSA POS mutual fund disclosure proposals that would among other things provide a misleading description of investment risk, mask tax considerations and reduce the rights of withdrawal. We have previously announced a number of other serious deficiencies with the current proposals. Making decisions based on Fund Facts as currently envisaged will lead to problems and complaints. We add that robust regulatory enforcement will be required to translate words and intentions into actual investor protections. Based on the vast number of complaints we have seen in the last six months alone we have to conclude that the enforcement of existing rules and even common sense were less than what is needed for investors, especially seniors and pensioners, to retain trust in the investment industry. 5

6 And finally we note also the fiasco with non-bank ABCP and more recently leveraged ETF s. Part of the problem is that advisers do not comply with KYP because they are not adequately trained or supervised. We note also that there appears to be a significant lack of education among Registered Reps on the risks and opportunities associated with leverage strategies. Many different investment strategies are associated with the use of leverage, including debt swaps, RRSP catch-up loans, Smith Manoeuvres, margin accounts, leveraged ETFs, and others. Many of these strategies are complex and controversial, and involve a variety of different risks. Registered Reps need to thoroughly understand these strategies in order to determine whether they are suitable for their clients. For each client, representatives must consider factors such as their goals, tax bracket and time horizon in order to determine whether leveraging would be beneficial and appropriate.the point: An otherwise suitable investment becomes unsuitable if unnecessary leveraging is employed. We would also like to take this opportunity to request that, given the critical importance of this Guideline and suitability in general to retail investors, that IIROC not depend solely on written submissions from the public. It should be clear to all that retail investors are at a substantial disadvantage to industry participants with dedicated staff to make such submissions assuming they are even aware of the opportunity. Historically, the submissions from industry participants overwhelm the few retail investor inputs, if indeed there actually are any. This unbalanced situation can lead to seriously flawed rule-making. We therefore recommend that IIROC by way of a policy, establish and fund an Investor Advisory Council this would include retail investors, investor advocates, compliance software suppliers, academia, consumer associations and seniors and pension groups to assist IIROC on major rule changes or additions. Such a process would, we believe, give IIROC a powerful tool to make better regulation. Should you require any additional information, do not hesitate to contact us. Ken Kivenko P.Eng. President, Kenmar Associates kenkiv@sympatico.ca (416) APPENDIX I Risk tolerance, risk capacity and loss tolerance New Account Application Forms try to assess your risk tolerance through checking of a few blocks on the form. This is often the primary basis for advisors in deciding on suitable investments. Much more is needed. Though risk and risk tolerance are both complex issues some of the complexity arises from the 6

7 semantic/ conceptual confusion and from erroneous beliefs. Risk tolerance is sometimes confused with loss tolerance. How somebody feels about taking a risk in choosing between alternative courses of action, risk tolerance, is one thing. How somebody feels if a loss actually occurs, loss tolerance is another. Risk tolerance is relevant to how someone makes decisions. Loss tolerance is relevant to how someone reacts to an event. An assessment of risk tolerance is not a prediction of loss tolerance. How a client will react to an unfavourable outcome, loss tolerance, is not predictable with any certainty. A critical factor will be whether or not the outcome was within the client s range of expectations. Did the client actually understand the risk being taken? If not, the client will be much more upset than if they had. Although nobody enjoys an unfavourable outcome, there is a significant difference between being unhappy with the outcome and being unhappy with the decision that led to the outcome. You may choose to have a birthday party outdoors. If the weather is bad you won't be happy, but you won't necessarily regret the decision and you may or may not make the same decision for next year's birthday. Risk tolerance is sometimes confused with risk capacity. Risk capacity is the amount of money a client can afford to lose without putting the achievement of financial goals at risk. Risk capacity, which more accurately should be called loss capacity, is an objective financial calculation. It represents an absolute downside constraint on strategy selection which must be taken into account of, but it s not the same thing as risk tolerance. There is evidence of four different categories of risk tolerance: social, ethical, physical and financial. Individuals behave consistently within category but not across categories. For example, hand gliding will correlate with mountain climbing but not with public speaking. Overall, studies suggest that gender and age, number of dependents, marital status, tertiary education, income and wealth are all related to risk tolerance. While a broker is required to learn the essential facts regarding every customer and investment, the broker must have a reasonable basis for believing that the investment meets the customer's needs and goals, and that the customer has the ability to bear the risk of loss of the investment and understands it. A retiree should manifestly not be told to invest a significant portion of his or her savings in such risky investments as stock options, futures contracts, index options, SPAC s, thinly traded issues, speculative common stocks, limited partnerships, and similar vehicles APPENDIX II-Kenmar Investment Suitability Checklist This checklist should be used as a guide before making a specific investment recommendation or investment strategy recommendation. 1 7

8 Note: This list should not be interpreted as a total list, and should be supplemented with your own specific questions tailored to what you know about your client. This list is only a guideline. X 1. Explain to clients the processes you use in developing portfolios and selecting specific securities. Tailor your explanation to their level of investment experience. 2. Create and maintain a form which has basic information that you will ask of each client, such as: net worth, occupation, liquid capital, risk capital, investment experience, investment knowledge, age, dependents, tax rate, income, investment goal, and investment needs. 3. Conduct a thorough interview of your client to obtain all relevant facts and circumstances, which might affect your recommendations. 4. Make sure that you are aware of all of your client s other investments so that you can properly evaluate whether your recommendation is appropriate in conjunction with his other investments. 5. Make sure you are aware of your client s total financial needs and goals and that your recommendation is matched to these needs and goals. 6. Make sure that you are aware of your client s risk tolerance, investment experience, and investment knowledge so that you can properly evaluate his ability to understand your recommendations. 7. Make sure your recommendations take into consideration the issues of diversification, liquidity, and the risks/reward relationship. 8. Make sure you document any discussions with your client concerning his needs, any risks, and your investment game plan (as documented in the investment policy statement), and keep this information updated. 9. Consider alternative investments or investment strategies and discuss with your client why you are recommending one over the other. Distinguish between facts and opinions when presenting recommendations to the client. 10. Make sure you know the investment or strategy thoroughly so that you can fully understand the risks and potential rewards. 11. Make sure that with each recommendation the client s interest and needs come first and that you are not influenced by a conflict of interest such as commissions or 8

9 fees. 12. Be aware of any income tax ramifications of your recommendations and incorporate them into your decisions. 13. Make sure that you fully disclose all the essential and key facts that relate to your recommendations. 14. Make sure the client is fully aware and understands the risks and downsides of any recommendations that you make. Whenever the client is very naive, you should tend to keep the recommendations more conservative and take extra steps to keep the client informed. 15. Evaluate your recommendations and the client s needs as client circumstances and the nature of the portfolio dictate, but at least annually. Document your conclusions and discussions with the client. 16. Other suitability assessment steps taken: Comments: NOTE: It would be impossible to list all of the possible facts that might be relevant to an investor. For this reason you must conduct a very thorough investigation and dig deeper when possible areas of concern exist. Examples include tax liabilities, inheritance issues, and exposures through company debt obligations. 9