Frequently Asked Questions regarding MFDA Member Regulation Notice MR#-0048 ("Know-Your-Product")
The following is intended to provide Members with guidance in applying the principles outlined in Member Regulation Notice MR-#0048 ("Know Your Product") issued on October 31, 2005. This Notice is intended to clarify the obligations of Members and Approved Persons with respect to the approval and sale of investment products by MFDA Member firms. In order to comply with suitability obligations under MFDA Rule 2.2.1, Members must fully understand the products that are being recommended to clients.
Members are reminded that the level of due diligence performed and the procedures followed will vary depending on the product.
1. What level of due diligence is required with respect to prospectus qualified mutual funds?
Response:
The Notice lists a number of factors that should be considered by Members in a due diligence review. With respect to conventional prospectus qualified mutual funds, MFDA staff would generally not expect Members to perform a due diligence review covering all of the items listed in the Notice. The comprehensive level of review contemplated in the Notice will generally be more applicable for alternative or exempt products, which are more complex and less regulated and transparent than prospectus qualified mutual funds. The expectation is that the Member must understand the products it is offering for sale. With respect to a conventional, prospectus qualified mutual fund, this expectation could largely be satisfied by having a basic familiarity with the portfolio manager and reviewing the prospectus. In special circumstances, where the mutual fund is a new fund or the portfolio manager of the fund does not have a track/performance record, the Member may need to go beyond a review of the prospectus and consider other factors listed in the Notice to gain a sufficient understanding of the product.
2. The Notice states that "In the event that products are being sold that have not been subjected to a reasonable due diligence review, such a review should be performed before continuing to sell the products." Are Members expected to suspend all trading until a due diligence review is performed on every product sold (including prospectus qualified mutual funds)?
Response:
The fundamental consideration is whether the Member has sufficient knowledge of the product to be able to meet its suitability obligations under MFDA Rule 2.2.1. If the Member does not possess sufficient knowledge of the product to meet its suitability obligations, it should not continue to sell the product.
As discussed in the response above, for a conventional, prospectus qualified mutual fund, Members would not likely need to have a due diligence file containing all the items listed in the Notice and accordingly they would not need to discontinue sales due to the fact they had not performed that level of comprehensive review. However, for alternative investments and exempt products, MFDA staff would expect Members to have completed the level of review described in the Notice prior to resuming sales of the product.
3. Member Regulation Notice #0048 outlines some specific steps for Members to consider in performing a due diligence review. What is the expectation of MFDA staff with respect to the following:
a) "A review of any marketing materials related to the product." Are Members responsible for ensuring that the information contained in third-party marketing materials is in compliance with MFDA requirements and securities legislation?
Response:
Members are responsible for reviewing marketing materials that they provide to clients to ensure that they comply with MFDA requirements and applicable securities legislation. In reviewing marketing materials of third-parties as part of the due diligence review, Members should confirm that marketing materials contain sufficient disclosure about the features of the product as well as a consideration of any performance information provided to ensure that it is not misleading.
b) "Consideration of competitive products that may be less costly or risky." Does this require a Member to disclose all potential product alternatives to clients when making a recommendation?
Response:
There is no requirement that Members disclose or present all the potential product alternatives to clients when making a recommendation. However, Members should give consideration to other competitive products that may be less costly or less risky when determining whether to approve a product for sale and making a recommendation to clients. For example, some alternative products may offer benefits that are already available to investors in the form of less risky, less costly and less complex products. This would not require Members that sell only proprietary products to expand their product shelf to non-proprietary products. However, dealers that sell only proprietary products of a related issuer will be held to the same standards with respect to due diligence as non-proprietary dealers. Such dealers must still ensure that they have sufficient knowledge and understanding of the products that they sell.
c) "An assessment of the investment objectives and any projected returns for the product and the likelihood that the investment will meet these objectives and projections." What type of assessment is required?
Response:
Members are expected to assess the reasonability of the information being provided by the issuer. For example, where an issuer provides pro forma returns for a product, the Member should review the returns to ensure that they are not misleading, use unrepresentative statistics to suggest unwarranted or exaggerated conclusions, fail to identify material assumptions or contain an unjustified promise of specific results. Members may also review the performance of other similar products in the marketplace in assessing whether the projected returns are reasonable. Members should consider whether the projected returns are reasonable or justified in light of the risks associated with the product and the fees.
d) "A review of the issuer's financial position and history." Does this refer to the financial position of the mutual fund or the fund management company?
Response:
Members are generally expected to review the financial position and history of the issuer. In the case of a mutual fund, the issuer would be the mutual fund itself and thus Members would be expected to review the financial statements and history of the fund. There may be circumstances however, where the fund manager is not widely recognized or where issues with respect to the fund manager arise which may impact on the operations of the fund which may require the Member to review the financial position and history of the fund management company as well. Members should also make inquiries with respect to the due diligence process of the fund manager and the outsourcing process where certain functions are outsourced.
With respect to exempt securities, the minimum expectation is also that the Member thoroughly review the financial position and history of the issuer. For example, for a limited partnership this would require, at a minimum, a thorough review of the audited financial statements and history of the limited partnership. However, a review of the financial position of service providers or affiliates may be necessary where their operations may impact on the operations of the issuer.
e) "An assessment of management qualifications and track record." What is the expectation of MFDA staff with respect to prospectus qualified mutual funds?
Response:
With respect to prospectus qualified mutual funds, Members would generally not be expected to perform a detailed assessment of an established fund manager with a proven track record. MFDA staff would however expect a more extensive due diligence review of the qualifications and track records of managers of alternative or exempt products.
f) "An assessment of any custodian, investment manager or guarantor associated with the product." What kind of an assessment and what is the criterion for assessing the custodian and guarantor?
Response:
Prospectus qualified mutual funds must have a custodian which meets the requirements of National Instrument 81-102 (Investment Funds). Accordingly, Members would not be expected to perform an assessment of the custodian for a prospectus qualified mutual fund that meets the requirements of NI 81-102.
For other types of products and non-prospectus mutual funds, Members should consider the qualifications of the custodian, whether it is regulated and what regulatory requirements apply. The Member should identify related parties, in particular whether the custodian is related to the issuer. The Member should also consider whether the custodian is a widely known or recognized firm. The Member should also determine where the custodian is incorporated (Canada or off-shore) and the regulatory requirements of that jurisdiction.
The same considerations would also apply to the assessment of the guarantor. Members should carefully review the guarantee to ensure that they are fully aware of and understand any limitations.
4. The Notice states that "Members should not merely rely on the representations of the issuer." Does this mean that the Member cannot believe the information provided by the issuer and is required to verify every representation made with respect to the product?
Response:
This point in the Notice was intended to address situations MFDA staff has identified where a Member's due diligence review simply involves asking general questions of an issuer and attempting to rely on broad warranties regarding the suitability of a product. This does not mean that a Member should not believe the information provided by the issuer, but the Member should view the issuer's responses critically and ensure that the Member's questions are fully answered. Accordingly, simply making inquiries of the issuer is not enough to discharge a Member's due diligence obligation, the Member should follow up on any issues raised until they have a sufficient understanding of the product. Members must make their own objective assessment of the representations of the issuer.
5. Are dealers expected to risk rank products independent of the fund manager's ranking?
Response:
MFDA Members are expected to review the risk ranking that has been assigned to a product by a fund manager and this should carry significant weight in the Members own risk assessment. If the Member disagrees with the risk ranking assigned to the product by the fund manager and assigns a different risk ranking, the Member must be able to justify the different risk ranking and document the analysis performed. This would apply where a Member applies a lower risk ranking to a mutual fund from that found in the prospectus. MFDA staff would not have concerns where the Member's assessment of risk is higher than the risk ranking assigned by the fund manager.
6. The Notice states that where significant changes in market conditions have occurred which would affect the risks associated with certain products, it is appropriate for the Member to revisit the approval/risk ranking. What exactly is expected of the Member with respect to monitoring market conditions on an ongoing basis for all its approved products?
Response:
MFDA staff would expect Members to be aware and informed of significant news items that impact a particular product or sector that may affect the risks associated with the approved products. In such circumstances, Members would be expected to review the approval or risk ranking assigned to the product and the investor profile. General market fluctuations would not require a reassessment of the product approval or the risk ranking.
7. Can Members rely on third-party service providers to perform due diligence reviews of products?
Response:
Members may engage third-party service providers to assist in performing due diligence reviews of products. However, the responsibility to "know-your-product" in order to perform a suitability assessment for clients remains with the Member and cannot be delegated.
Members that engage third-party service providers to assist with due diligence should review the due diligence process of the service provider to ensure that it has taken appropriate steps to properly assess the product. The Member should also carefully review the qualifications of the service provider to ensure that they have the necessary expertise and resources to properly assess the product. In addition, Members should establish procedures for monitoring the performance of third-party service providers on an ongoing basis.
