Suitability grabs regulators attention

Date: Thursday, January 22, 2009
Author: James Langton, Investment Executive

Retail investors want greater accountability from both dealers and regulators.

Knowing the clients you serve and the investments you sell should be a no-brainer for any financial advisor. Yet suitability is a perennial source of client complaints and compliance deficiencies. And regulators may need to force closer attention to the issue.

In mid-December, the Joint Standing Committee on Retail Investor Issues — comprising the Ontario Securities Commission, the Investment Industry Regulatory Organization of Canada, the Mutual Fund Dealers Association of Canada and the Ombudsman for Banking Services and Investments — released the results of its public consultations on the issue of product suitability.

Larry Ritchie, vice chairman of the OSC and head of the joint standing committee, reports that in those consultations, regulators heard that investors are looking for greater accountability from both dealers and regulators when it comes to ensuring suitability. “Retail investors want the regulators to ensure that dealers have a more robust due diligence and new product review process,” Ritchie says. “And [for both to ensure] that advisors are properly trained and supervised so that the people recommending products are in a sufficient position to meet their [suitability] obligations.”

Ritchie says the consultations also revealed that retail investors are feeling very vulnerable in the current volatile markets, that they rely on their advisors a great deal and that they need “sufficient and more meaningful information and dialogue with [their advisors].”

This isn’t just a Canadian phenomenon. This past April, the Basel, Switzerland-based Bank for International Settlements published a review of retail suitability requirements and practices across 11 countries. The review concluded that the need for financial advice is likely to grow, and the complexity of financial products is likely to increase. “The coincidence of these trends should not be lost on regulators or firms,” the BIS report says. “Consumers will need to be able to rely on good advice about products that are suitable for them, with conflicts of interest, if not avoided, clearly disclosed.”

For regulators, that means looking at existing rules to determine whether they clearly set out those obligations, or if those rules need to be beefed up.

The OSC is assessing the adequacy of existing rules and, although it hasn’t come to any conclusions, Ritchie believes the suitability requirements are already well enunciated. Still, he says, investor concerns about these issues will be factored into other relevant rule-making initiatives, including the registration reform project, the investment funds point-of-sale regime and initiatives to improve firms’ complaint handling and investor redress mechanisms.

In the meantime, despite the fact that know-your-client and suitability rules are a well-entrenched part of the regulatory system, they seem to be routinely violated.

For example, IIROC’s examination of the failures in the non-bank asset-backed commercial paper market found that many dealers didn’t understand these products, yet sold them to retail clients. The result: about 2,500 clients were left holding $372 million in frozen paper when the $35-billion non-bank ABCP market seized up.

To be fair, most firms didn’t sell or manufacture this paper. But for those that did, it appears there was a complete failure to ensure suitability. The reason, according to the IIROC report, was that most firms didn’t regard ABCP as a new or particularly complex product. Instead, they saw it as just another money-market instrument — and not a particularly lucrative one at that. So, dealers didn’t subject ABCP to their due-diligence processes and manufacturers bypassed their new product review processes. Nor did either group provide any special training or materials to advisors who sold ABCP, their supervisors or compliance staff.

The ABCP debacle is the most recent — and starkest — example of suitability failures, but it is not the only one. According to the OSC’s compliance report for its latest fiscal year, 64% of the limited market dealers it reviewed had “significant deficiencies” in their ability to make suitability assessments. This was, far and away, the most common deficiency; the use of exemptions and disclosure failures came in a distant second, at just 29% of firms.

Among the deficiencies the OSC found were firms that didn’t properly collect the KYC documentation, KYC information that was inadequate or incomplete, and that some firms contracted out their duty to ensure suitability.

These widespread failings represent the flip side to the suitability failings revealed in the ABCP market. To ensure suitability, advisors and firms must know the products they are selling and the clients to whom they are being sold. In the ABCP market, it was the former responsibility that was ignored; OSC compliance examinations have found widespread failure of the latter duty.

So, if the rules already clearly spell out the obligation to ensure suitability, yet suitability is routinely being ignored, then ensuring that firms live up to these obligations seems to be a job for compliance and enforcement.

Ritchie declines to say whether more enforcement action is needed to drive home the message, but he does point to an August 2008 OSC decision that addresses suitability failures. “It is very clear,” he says, “that we, as a commission, take the position that the suitability obligations of a registered representative include the obligation to know the client, to know the product and to explain properly the risks associated with the products they’re recommending.”

In that decision, the OSC found that an advisor had violated the KYC and suitability obligations in making unsuitable recommendations to six investors. As a result, his registration was terminated, he was banned from serving as a director or officer of a registrant and he was reprimanded. No financial sanctions were ordered as the commission panel accepted a joint submission from both sides in the hearing recommending that he merely be banned from the industry. The panel noted that it might have imposed additional penalties had there not been an agreement on proposed sanctions.

Certainly, Ritchie says, it is up to regulators to get the message out to the industry: “Its important that existing regulations are enforced, and the OSC is committed to that. It is also essential that regulators work with market participants to ensure that they understand and are fulfilling their obligations. That’s an important role that our compliance team plays.”

The self-regulatory organizations have also addressed these deficiencies through added guidance. In April 2008, the MFDA published a notice on how its members could establish a framework for complying with the MFDA’s suitability obligations. In addition to its extensive notice, the MFDA has also proposed amendments to two rules to bring them in line with the expanded guidance.

Along with IIROC’s review of the dealers’ involvement with ABCP, the SRO has made several recommendations that deal with product due diligence and has published draft guidance that sets out best practices for product reviews. That guidance goes beyond ABCP issues, noting that concerns about suitability and conflicts of interest have arisen with the emergence of other complex products such as principal-protected notes.

It remains to be seen if firms will finally get the message. Yet, some dealers seem to be less worried about their own failures and more concerned about other parts of the financial services sector that don’t face similar requirements.

Karen McGuinness, vice president of compliance with the MFDA, reports that the SRO is hearing more frequent complaints from mutual fund dealers about competitive investment products (primarily, segregated funds) being sold without the same regulatory requirements, including suitability obligations. “This leads to regulatory arbitrage,” she says, “which may not be in the best interest of the investing public.”

This complaint was echoed in the BIS report, which found that suitability rules are more specific and enforcement more likely to occur in the securities sector.

Yet, that doesn’t diminish the securities industry’s own suitability shortcomings, which must be addressed. So, if rule changes, added guidance and tougher enforcement aren’t enough, perhaps firms should consider paying advisors for compliance.

The BIS report suggests a number of ways that regulators and firms could improve suitability performance: “Firms should consider the implementation of a remuneration system that rewards those who make substantial efforts to comply, and do comply with the highest suitability and disclosure standards.”

By themselves, suitability rules clearly aren’t enough. If pushier compliance and tougher enforcement don’t do the trick, there is always the option of paying for quality due diligence.