This article was written by Michael Bookman and Ellen Bessner. Michael Bookman is an associate at Babin Bessner Spry LLP.
Advisors and portfolio managers may be tired of hearing about how they need to improve on their know-your-client (KYC) and suitability obligations, but the Ontario Securities Commission’s (OSC) annual summary report shows a high percentage of reported deficiencies in the compliance systems maintained by dealers. This means advisors and portfolio managers are at risk.
The OSC report states that for 2018-19, 36% of the total deficiencies reported were in relation to compliance systems issues. There is a lot of room for improvement.
The underpinning of getting suitability right is understanding and knowing your client’s risk tolerance. KYC updates ensure that advisors and portfolio managers are reviewing and gathering current information about their clients’ risk tolerance, investment knowledge, and goals.
An area that is ripe for discussion — and a focal point for the OSC in its report — is the over-concentration of risk in client portfolios. Are your clients over-exposed to certain sectors, industries, or asset classes? The OSC says that dealers are not adequately addressing this important suitability risk.
For starters, there is not enough information in KYC intake forms to be able to assess the risk of over-concentration and consider it as part of the overall suitability assessment. For example, is over-concentration a problem when considering a client’s other assets?
It is important for advisors to have meaningful discussions with clients regarding diversification and risk management during the KYC exercise and KYC updates. Clients should be educated about the management of risk through diversification and how to properly appreciate and manage risk.
Another issue is that dealers and advisors too often are not considering concentration risk when assessing suitability for a given transaction. They are instead relying simply on client-directed trade instructions.
In all cases, the OSC recommends that transactions that are deemed suitable despite exposing a client to concentration risk be documented. Indeed, a signed client-directed trade instruction should be completed along with a specific explanation that was given to the client regarding the suitability or unsuitability of the proposed transaction. Without this detailed paper trail, simply relying on the rationale of “that is what the client wanted” will not suffice.
The OSC is encouraging dealers to establish policies and procedures for assessing concentration risk. Dealers and advisors should review the information that they collect from clients that pertains to concentration risk and provide guidance for dealing with the risk of over-concentration.
In the years to come, the OSC is likely to continue to review and audit compliance systems, and look at whether advisors and portfolio managers are reviewing concentration risk and whether failures to do so should attract penalties. Dealers are encouraged to review and revise their compliance systems and advisors and portfolio managers are encouraged to consider these important KYC and suitability issues to protect their licences and reputations.