Legally speaking: The KYC process

Harold Geller / January 08, 2008

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(January 2008) The Know Your Client process is the bedrock on which financial advice is built. This is a process, not just a form. This process is not simply a static snapshot you take when opening a client's account. This process is highly subjective, the minimum industry standard, and should reflect the client's circumstances and needs.

The KYC process may begin in the MFDA and IDA worlds with the completion of a New Client Application Form or New Account Application Form (NCAF). Completing this form is mandatory when opening any and all client accounts. There must be a separate form for each account. The form must be accurate and complete as of the date that the application is taken. This is also true when transferring accounts between dealers.

The NCAF form is a starting point but it is not, in and of itself, sufficient to meet the KYC standard established in IDA Regulation 1300 or MFDA Rule 2.2.1. Both of these KYC rules are principle-based, intended to ensure that trained financial professionals conduct an investigation rather than simply complete a subjective and jargon-laden form.

To complete the form as a substitute for engaging in a process to learn the client's essential facts is, in the words of T.S. Eliot, "to have the experience but miss the meaning." This experience without meaning may leave the financial intermediary high and dry, compromising their ability to service the client. The process will likely not survive scrutiny if there is a regulatory complaint or a lawsuit for compensation.

Given internal firm processes, it is common for financial intermediaries, branch managers and dealer compliance officials commit the inexcusable sin of signing off on KYC forms without knowing the client — the forms contain only barebones and generalities. The client might have goals to save for a house or an education, but the forms only allow advisors to check off "growth" or "income." Moreover, it is common to see financial intermediaries fail to update these forms when material changes occur in the client's life or finances, when economic conditions change or when the quality or value of the client's investment portfolio changes.

More KYC...

• Know your KYC
• Legally speaking
• Aggressive strategies and your own risk tolerance
• Links and resources

Return to the Know Your Client mainpage

Such failure is negligent and unprofessional. Financial intermediaries are required to update KYC forms immediately when material changes come to their attention, and should err on the side of caution. The financial intermediary is not the judge of material changes, but they will be judged harshly if they fail to update upon the occurrence of a potential material change. This requirement stems from the KYC rules but is also embedded in the reputable dealer's compliance policies. It is up to the financial advisor to ensure that material changes are noted and dealt with on a timely basis.

Furthermore, this requirement is necessary for the branch managers and dealer compliance officials to fulfil their duties since the compliance process flows from updated and accurate KYC forms.

KYC forms are severely limited by the embedded subjective terms and the misdirected use of industry jargon used when drafting these forms. Generic terms such as "moderate risk" are meaningless on their own. How is an individual member of the public to interpret their risk tolerance in general or as compared to those of the investing public?

The client has no idea how to accurately and meaningfully evaluate their risk tolerance, investment knowledge, or investment objectives. It is fallacious or unsound reasoning for a financial intermediary to impose their own subjective views of the client's risk tolerance for that of the client. It is only through a communication process whereby the professional financial intermediary educates the client about their range of options and digs into the holistic financial plan for the client that the KYC form can have any value for a financial intermediary or for the rest of the dealer's compliance chain.

This communication process should be documented to ensure that the KYC form completed at a particular time accurately reflects the discussion and the client's understanding. Again, the rules require a KYC process, not the mechanical completion of a form by the client or financial intermediary.

The KYC process must also create joint expectations between the client and the professional financial intermediary that govern communication between the two when circumstances change.

The "responsibility" will remain with the professional, but the client should agree to truthfully and fully report material changes in their life, such as marital status, children, employment, savings and investments, goals, health and more.

The professional financial intermediary should conduct a meaningful update of the KYC process at least annually and following any significant external changes.

For example, given the potential upheaval stemming from the asset-backed commercial paper, subprime and structured investment vehicle fiascos, most retail clients should have been contacted by their professional financial intermediaries to discuss the significant change in risk in the marketplace, since even conservative investments in Canadian banks may be directly and indirectly affected by the increased risk. With newspapers, commentators and central bankers all reporting on this risk, surely the retail client is also entitled to warning of risk and sound advice.

More KYC...

• Know your KYC
• Legally speaking
• Aggressive strategies and your own risk tolerance
• Links and resources

Return to the Know Your Client mainpage

Adopting and adhering to a complete and holistic KYC process is a must for all professional intermediaries. This must also apply to the "wild west" of financial regulation — the weakly regulated insurance sector. There is no rational argument to say that this same process does not apply to Universal Life investments. Although the courts have ruled on this, the regulators remain eerily silent.

To adopt and adhere to fulsome and holistic KYC processes raises your professional bar, focuses clients on the value-added service you provide and adds significant legal and reputational protection to your business when the good times end. A proper KYC process protects your client, but also you and your dealer.

Harold Geller is an expert on legal issues affecting financial intermediaries. Harold assists and represents dealers, MGAs, branch managers, compliance officers and advisors dealing with their compliance, regulatory and negligence issues. Harold also helps financial intermediaries with internal business and their clients' legal issues. Harold is a well-known industry commentator, a CE provider and administrator with foradvisorsonly.com. Harold's law firm, Doucet McBride LLP, also provides advice on tax issues, Succession Planning, Retirement Planning, Estate Planning and buying and selling books of business. Harold can be reached at hgeller@doucetmcbride.com.

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(01/08/08)