The Mutual Fund Dealers Association has clarified the obligations of fund dealers and reps concerning the approval and sale of investment products by MFDA firms.

In a notice published today, the MFDA says that dealers and reps are required to ensure that each order accepted or recommendation made for any account is suitable for the client and in keeping with the client’s investment objectives. “Know-your-client requirements are a fundamental part of meeting basic suitability obligations. However, these obligations can only be properly discharged if [reps] and supervisory staff of the member also fully understand the products that are being recommended to clients,” it says.

Therefore, dealers must perform a reasonable level of due diligence on products prior to their approval for sale, it says. MFDA members must have written policies and procedures in place that describe in detail the steps to be followed in the due diligence process. It suggests that these procedures should provide for different levels of analysis for different types of products. Conventional mutual funds may not need an extensive review. “However, a more comprehensive review should be performed on products that are novel or more complex in structure,” it says.

The notice adds that dealers should not merely rely on the representations of the issuer, or on the fact that the product appears to be similar to others, or that other firms are already offering the product. “In all cases, the approval process must be independent and objective,” it says.

“Members are advised that simply making inquiries will not be sufficient to discharge their responsibility to conduct due diligence. Members must properly follow up on any questions they have raised until they have been satisfied that they have a complete understanding of the products they propose to sell,” it adds.

“It is critical that the member develops an understanding of all features of the product,” the notice says. “Issues such as liquidity of the product and the nature of any underlying investments and their inherent risks must be examined before assigning a risk ranking to the product.”

It recommends that firms develop guidelines or an investor profile for which the product would be generally suitable, including risk levels, time horizon, income and net worth. Dealers should also clearly identify investors for whom the product is not suitable, it adds.
Concentration limits should be assigned to products and/or general classes of products.

As a best practice, a committee involving senior management should be empowered with ultimate authority in the product approval process, to ensure that all business units of the member have signed off on the product prior to sale, it suggests. Also, significant changes in market conditions may require firms to revisit already approved products.

Dealers should be particularly careful when examining suitability issues in relation to exempt securities, the MFDA says. It notes that the classification of an investor as a “sophisticated purchaser” or an “accredited investor” does not negate the obligations to perform a suitability review.

“Members should also have policies and procedures in place with respect to the information to be provided to clients, to help ensure that clients fully understand the products being offered before entering into any transaction,” it adds. “The client should be clearly advised where a security is being sold under an exemption. It is important that the client also understands the implications of any restrictions that may apply with respect to liquidity and the potential absence of a secondary market for the securities.” Also clients should be warned that certain protections, rights and remedies that may exist under securities legislation for prospectus offerings may not be available for exempt securities.