The NAAF And Know Your Client

The know-your-client (“KYC”) process is one of the most fundamental obligations under securities legislation and one of the most important elements of investor protection. It is designed to provide a basis for the suitability of advisor investment recommendations. The information is also used when assessing the validity of a client complaint. The KYC process commences with the completion of a New Account Application Form (NAAF) or New Client Application Form (NCAF). It is very important that the NAAF be completed thoughtfully, accurately and completely. The Investment Industry Regulatory Organization of Canada (IIROC) Opening Your Retail Account brochure [http://www.iiroc.ca/industry/continuingeducationmember/Documents/RetailAccountBrochure_en.pdf] is available for download on their website. It explains why certain personal information is needed by the dealer to meet their KYC obligations. The NAAF is an important document so don’t be fooled by its benign sounding name.

Completing this form is mandatory when opening client accounts at Mutual Fund Dealers Association (MFDA) or IIROC dealers. In general, there should be a separate form completed for each account (and possibly quite different investment objectives for each account). The form must be accurate and complete as of the date that the account application is submitted. This is also true when transferring accounts between dealers.

NAAFs contain a clause obligating you to update the firm when there is a ‘material change’ in your personal situation. Most retail investors don’t understand the implications of non-compliance. In the event of retirement, loss of job, divorce, receiving a large inheritance, death of a spouse or similar changes, make sure your advisor is notified in writing and that a new KYC is prepared and jointly signed. If you don’t, you may receive unsuitable investment recommendations and any resulting complaint may be dismissed.

Tools Supporting KYC And Suitability

KYC alone is not a reflection of a relationship. It is the account information that the advisor requires to evaluate the client’s objectives, risk profile, tax status and other factors, without which the advisor cannot determine the suitability of any investment recommendation. The relationship element can be documented via a Letter of Engagement (LOE). The LOE can be used to define the client-firm relationship—the delineation of services and fees and client obligations. Sadly, too few advisors use this risk mitigation tool, perhaps because it forces a disclosure on fees and takes time to prepare.

An Investment Policy Statement (IPS) is another tool used by professional advisors to clarify the nature of the investments that will be made for the portfolio. It should establish: risk and loss tolerance; return objectives; income needs; liquidity requirements; investing time horizon(s); tax considerations; legal, estate and regulatory concerns; and unique needs and circumstances. Both the LOE and IPS support the overall financial plan.

A Word About Suitability

Investment dealers are required to determine the suitability of every proposed transaction in your account, whether or not your firm or advisor recommended the trade. Discount brokers have obtained exemptions from this rule because they do not provide recommendations, offering execution-only services instead. The Mutual Fund Dealers Association offers an excellent set of general Guidelines on Suitability in support of consistent and objective industry standards for assessing investment suitability (available at). It outlines how a dealer should establish a suitability framework to comply with their obligation to ensure each order accepted or recommendation made is in keeping with clients’ KYC information. It provides further guidance on assessing suitability where borrowed funds have been used to invest. The principles of this guide, while written for mutual fund dealers, apply equally well to IIROC licensed advisors. The MFDA has also developed a Discussion Paper on the use of investor questionnaires (titled Improving the Know Your Client Process). The Discussion Paper includes a Sample Investor Questionnaire attached as Appendix “A”. These documents are well worth a read. Download at http://www.mfda.ca/regulation/bulletins14/Bulletin0611-C.pdf

Limitations Of The NAAF

The stated theory behind KYC is based on the view that the more an advisor knows about a client, the better he/she can serve them. If you peruse the annual enforcement reports from regulators, you see that more than half the investigations opened were about investment issues – and the largest category was suitability. Unsuitable investments, along with inappropriate leveraging and unauthorized trading make up the bulk of investment disputes. Suitability complaints are prevalent because of commission-driven/incompetent advisors, low levels of financial literacy among Canadians and a growing complexity of financial products. Many problems can be avoided with a robust KYC process in place.

Prevailing “Know Your Client” forms cannot truly safeguard the suitability of a transaction because it cannot effectively relate the transaction to financial needs, existing investments, risk capacity or current risk/return relationships.

The NAAF form is a necessary but insufficient vehicle to meet the suitability standard established in IIROC Regulation 1300 or MFDA Rule 2.2.1. Both of these rules are principle-based, intended to ensure that advisors conduct a meaningful investigation rather than simply fill in a subjective and jargon-laden form.

Cynics believe that the NAAF is more for the benefit of firms rather than a real attempt to know the investor and understand his/her needs. KYCs are notoriously inaccurate and often outdated and may be retroactively fabricated or altered to legitimize them. Investor Advocates question whether the form captures the facts necessary for a retiree/RRIF account.

New Account Application Forms try to obtain your investment profile through checking off a few boxes on the form. The industry has not agreed on a standard form or terminology. Too often it’s like putting a square peg into a round hole. The client might have goals to save for a house or an education, but the forms only allow advisors to check off objectives like “growth”, “income” or “safety of principal”. They come without definitions or any description of the associated risks. Nevertheless, this is often the primary basis used by many advisors in deciding on suitable investments and justifying recommendations when a complaint is filed. That is why you need to be really clear about your investment profile.

In practice, several forces conspire to reduce the value of the NAAF. Some unethical advisors ask clients to sign blank forms, and then fill in whatever they want that would justify their recommendations. In other cases, advisors have altered entries on the form or even generated a form and forged the client signature. Just plain sloppiness can corrupt the KYC process if certain data elements are left blank or ticked off without understanding.

Filling In The Form

For your own protection, make sure you fill in the New Account Application Form with great thought. Less sophisticated investors might get talked into block ticking "flexibility" that only benefits the advisor. The NAAF is not just a “piece of administrative paperwork”.

Stating your income:

The income question on the NAAF form seems simple enough to answer until you are faced with filing a complaint. Several issues that arise from the source and reliability as well as the definition of the income and consistency of reporting. Ensure you define in writing the source(s) of your income and not just a single number. For instance: Is your income from employment, government social programs, a company pension or a windfall inheritance? If it is employment income, is there a bonus, stock option or commissions structure? Is your employment stable? If from investments, are these investments speculative stocks—or are they from a balanced portfolio of conservative investments?

Net worth:

Ensure you understand how to calculate this before filling in a number. Clarify whether or not it includes the principal residence or whether the dealer is interested only in net investable liquid assets. You should also consider inserting the amount and nature of any debt if it is material.

Describing your risk profile:

NAAF forms are severely limited by the embedded subjective terminology and the use of industry jargon used on these forms. Generic terms such as “moderate risk” are meaningless on their own. While investors may fit neatly into boxes labeled aggressive, moderate, or conservative, such categories ignore their response to short-term risk—that is, volatility—and their fear of the unknown. Risk is multi-dimensional. Behavioural aspects include fear (selling everything at the worst time) and greed (buying stocks / mutual funds after a huge rise). You should take no more (and no less) risk than is needed to achieve your goals. Furthermore, an overriding constraint is loss capacity—the amount of money you can afford to lose without putting the achievement of financial goals in jeopardy. Loss capacity assessment needs actual income and expenditure data modelled against a proposed portfolio solution. The financial plan will show what rate of return is necessary to achieve your goals, and then this rate of return drives the asset allocation and individual security selection.

Investor Questionnaires are often used in conjunction with the NAAF. An example of a relatively good investor questionnaire can be found at https://personal.vanguard.com/us/planningeducation/general/PEdGPCreateCompInvQuestContent.jsp Some advisers are developing questionnaires aimed at getting a more nuanced picture of a client's likely reaction to a wider range of real and perceived risks. A more accurate psychological reading, the reasoning goes, means investors will be more likely to stick with the portfolio strategies through a bear market.

Risk tolerance is sometimes confused with loss tolerance. How somebody feels about taking a risk in choosing between alternative courses of action (risk tolerance) is one thing. How somebody feels if a loss actually occurs (loss tolerance) is another. Risk tolerance is relevant to how someone makes decisions. Loss tolerance is relevant to how someone reacts to an event. An assessment of risk tolerance is not a prediction of loss tolerance. How an investor will react to an unfavourable outcome (loss tolerance) is not predictable with any certainty. At a minimum, you should be given an idea of the range of expectations and the nature of the risk(s) being taken. Although nobody enjoys an unfavourable outcome, there is a significant difference between being unhappy with the outcome and being unhappy with the decision process that led to the outcome.

The Ontario Securities Commission Investor Advisory Panel has released a research report into the practices used by investment dealers to provide an investor risk profile – it is available at http://www.osc.gov.on.ca/documents/en/Investors/iap_20151112_risk-profiling-report.pdf. While risk questionnaires are widely used in the mutual fund dealer channel, the report found that the vast majority (83.3%) of these questionnaires “are not fit for purpose.”

Define Your Time Horizon:

Your investment time horizon is a critical investment factor. If you have the time—say 10 years—to let your money grow and the discipline to leave it alone, stock market volatility should not be a daily worry. The more often an investor counts his money (or looks at the value of his mutual funds in his account statement), the more likely he/she has a lower risk tolerance. Communicating the goal of the investments helps define the applicable time horizon for your profile.

Describe your investment knowledge and experience: Academic research shows there is a natural tendency to overestimate investment knowledge, particularly among men. Don’t let your ego drive your responses. If you overstate your knowledge, this could harm any case you might have in the event of a dispute.

Conclusion

The duty to know your client goes far beyond the questions on the KYC form—make sure you engage your advisor so that he or she obtains a more accurate profile than can possibly be obtained by ticking off boxes on a form. A detailed discussion of the relationship between risk and return is critical to establishing realistic expectations. Document any information you provided the advisor and any information the advisor told you. When given the KYC to sign, consider writing in a box of your own design, in plain language English, exactly what you expect, i.e., “I want low-risk investments to produce an income for my retirement”; or, “I am seeking growth and willing to accept some (low, medium, high) degree of risk with 20% of capital.” The NAAF Form should be signed and dated, and a copy retained and updated as required.

Be aware that “advisors” are not fiduciaries. They are not required to act in your best interests—they need only recommend investments that are suitable. Canadian regulators are trying to deal with the client/advisor fiduciary relationship (sales commissions platform vs. unbiased professional advice), a movement taking hold in the U.K., Australia, the U.S. and elsewhere. Until the regulations change, it’s caveat emptor.

Ken Kivenko, PEng, President , Kenmar Associates, Etobicoke, ON (416) 244-5803, kenkiv@sympatico.ca, www.canadianfundwatch.com