The Investment Industry Regulatory Organization of Canada has issued the final version of its guidance note regarding best practices for product due diligence, and warns that it will be checking firms’ work in this area later this year.

The guidance arises out of the IIROC’s review of its members’ role in the seizure of the non-bank asset-backed commercial paper market, which found that many dealers didn’t do proper due diligence on ABCP that was sold to unsophisticated retail investors, and that even institutional investors and the dealers themselves often didn’t fully understand the product.

In the notice released Monday, IIROC says the new guidelines are not directed at plain vanilla equities and fixed income products, “but to more complex and non-transparent products having features such as embedded derivatives, variable maturities, complex fee structures or opaque assets.”

The notice points out that increasingly complex products may have unique features that may not be fully understood by the retail customers buying them, or even by the registered representatives who recommend them. “Some appear to offer benefits to investors that are already available in the market in the form of less risky, less complicated, or less costly products, prompting concerns about suitability and potential conflicts of interest,” it adds.

To ensure that dealers develop and implement the necessary procedures for product due diligence and undertake adequate supervision of the due diligence process, the IIROC says that it will undertake a “product due diligence “sweep later in the year. “This sweep will test selected dealer member’s product due diligence processes and will also test whether new products have been subject to a review prior to offering such products to their clients,” it explains.

Along with the final version of the product due diligence notice, the IIROC also published a summary of the comments it received on the draft version of the notice, and its response to each of those comments.

The notice explains that, “The dealer member’s suitability obligation in recommendations to clients requires knowledge of the products sold to those clients. Even in the institutional setting, the dealer member must make a determination that that the assessment of new and different products falls within the client’s expertise.”

It adds that, as gatekeepers to the securities industry, dealers “must take a proactive approach to reviewing and improving their procedures for introducing new products and monitoring those that are not new but that have unique and complex features that may require monitoring.”

“While suitability requirements and other sales practice obligations attach to the recommendation and sale of a product, adequate procedures for reviewing products before they are offered to the public can greatly enhance a firm’s ability to detect and avoid conflicts, unsuitable recommendations, and other problems before violations occur,” it says.

The notice explains that the requirement for product due diligence arises from a dealer’s regulatory obligations, and that while those obligations may differ between different types of dealers or customers, “no dealer member that trades with or for clients is automatically exempt from needing to conduct product due diligence.”

It also points out that dealers are responsible for meeting their regulatory obligations, and that they can’t simply rely on the work of others. Also, as part of the obligation to have effective internal controls, all dealers that sell new products must have formal written policies and procedures appropriate to their business to ensure that no new product is introduced to the marketplace before it has been thoroughly vetted from regulatory, risk management and business perspectives.

IE