MFDA cites failings on suitability, disclosure

The sad part is that the MFDA even had to issue these documents. Knowing your client and recommending only suitable investments is often called the Cardinal Rule. One would think that every officer and director of a mutual-fund dealer or investment-fund dealer would be familiar with it, as well as with the industry standards expected by the regulators and reflected in their disciplinary decisions. The information should be conveyed to salespeople by their employers so they are aware of the circumstances that brought about these decisions.

Furthermore, how is it that dealers tolerate signature falsification? Hardly a week goes by without an MFDA news release pertaining to salespeople disciplined for falsifying signatures on client forms, altering information on signed forms, obtaining and holding pre-signed forms and using these to process transactions.

The need to issue the two documents seems to indicate that a segment of the industry suffers from poor training, poor attitude and lack of supervision.

Perhaps the MFDA, as a condition of obtaining employment with one of its member firms, should require all current and prospective employees -- including branch managers, officers and directors -- to review a document spelling out the stages involved in determining suitability. It could list the sanctions available for failure to meet the obligations and require the individuals to initial each paragraph, with places for the employee's and his or her immediate superior's signature. A similar document could be prepared covering signature falsification or forgery.

Regulators look at suitability as a three-stage process. The first is Know Your Client and Know the Product. An advisor is supposed to look at a bevy of client characteristics. Some of these -- like personal financial situation, income, net worth and liquid assets -- are simple enough provided that the advisor collects accurate numbers. But others such as investment objectives, risk tolerance and investment experience can be very subjective.

As to knowing the product, one would hope that an advisor planning to recommend a specific investment would read the detailed documentation available rather than the summaries prepared by some issuers for the use of advisors. This is especially important when an advisor or dealer is considering adding speculative exempt issues to its approved list, for which asset values are managements' opinions and may or may not reflect market values.

The second stage is to "apply sound professional judgment to establish suitability of the product or strategy for the client." This, of course, requires the advisor to really understand the client's financial situation, risk tolerance and investment knowledge, as well as the risks of the proposed investment.

The third stage is the requirement to disclose what could go wrong -- the risks -- as well as what could go right -- the potential benefits.

Some advisors believe they protect themselves by getting the client to sign off on something he or she doesn't understand. All this does, in my opinion, is demonstrate a violation of the advisor's obligations and a recommendation of an unsuitable product.

The suitability bulletin includes a section on Know Your Client Forms and procedures. The bulletin notes: "Mischaracterization of a client's information by an Approved Person during the Know Your Client process in a way that is designed to validate an otherwise unsuitable investment recommendation has been described as being a serious breach of an Approved Person's obligations." For instance, it would be in inadvisable for an advisor to check off that a client with few investment assets has a net worth of more than $1 million in order to sell him or her $250,000 of a single issue.

The quality of these forms varies widely. In my opinion the basic forms are problematic. A case in point is the investment-experience section. On some forms the advisor must indicate the client's investment knowledge as one of sophisticated, good, limited or poor/nil. But checking off limited or poor/nil may limit the advisor's range of products to recommend. So it is not unknown for advisors to avoid checking limited or poor/nil. It would be helpful if KYC forms defined the differences between sophisticated and good, and between good and limited. I suspect the Toronto Maple Leafs will win the Stanley Cup before that happens.

An MFDA discussion paper on questionnaires suggests the following, which is much more telling:

Which statement best describes your knowledge of investments?

1. I have very little knowledge of investments and financial markets.
2. I have a moderate level of knowledge of investments and financial markets.
3. I have extensive investment knowledge, understand different investment products and follow financial markets closely.

The validity of the selection would be improved if advisors provided details as to the investments a client held and the circumstances under which they were acquired.