This Guidance Note:
- describes borrowing-to-invest strategies, 1
- sets out applicable IIROC requirements, and
- summarizes best practices for Dealer Members (Dealers) when supervising this activity.
- 1For the purposes of this guidance “borrowing-to-invest strategies” includes any strategy where the client borrows money to invest, including strategies where other client assets are used to secure the client loan.
Borrowing-to-invest is a strategy that may be employed to enhance potential returns in investment portfolios, but it involves more risk than paying for an investment outright with cash. The use of borrowed money will magnify losses in situations where the value of the investments decline. Whether the investment makes money or not, the client must still pay back the money borrowed plus interest. The use of borrowed money in retail client accounts is, therefore, an important investor protection issue.
Clients may engage in borrowing-to-invest strategies either through margin loans advanced by the Dealer (“on-book” borrowing) or through loans advanced by third parties (“off-book” borrowing). In either case, where:
- a recommendation is made, or
- the Dealer becomes aware of a client’s intent to use, or that a client has used, a borrowing strategy,
the Registered Individual2 and the Dealer have a responsibility to ensure the following are satisfied:
- the suitability determination obligation,
- the supervision obligations, and
- other applicable requirements under the IIROC Rules.
Know-your-client and suitability
All Dealers, regardless of their business model, must take reasonable steps to learn and remain informed of the “essential facts” relative to each order, account and client they accept.3 More specifically, paragraph 3202(1)(iii)(a)(II) of the IIROC Rules4 requires the Dealer to ensure it has sufficient information about the client’s financial circumstances. This includes, where applicable:
- annual income,
- liquidity needs,
- financial assets,
- net worth, and
- whether the client is using leverage or borrowing to finance the purchase of securities.
When financing a client’s acquisition of a security, Dealers may need to collect some or all of this information to assess a client’s creditworthiness, even in circumstances where they are not assessing suitability.
Any time a borrowing-to-invest strategy is recommended by a Registered Individual or a Dealer, or the Registered Individual or Dealer becomes aware that borrowed money is to be used or is being used by a client, that recommendation or usage is subject to the supervision and suitability determination requirements under IIROC requirements.
Even if borrowing is determined to be suitable for the client, Dealers must make a determination as to an appropriate loan amount to extend to the client, within the maximum amount permissible under IIROC’s margin requirements.5
Registered Individual obligations and best practices
Registered Individuals should keep in mind the following obligations and best practices when recommending borrowing-to-invest strategies:
- they must fully understand the consequences of a client using borrowed money to invest,6
- they must continually update their knowledge and training to ensure a sufficient understanding of the products, borrowing-to-invest strategies and the associated risks,7
- they should apply their education and training in a thorough and meaningful discussion with the client about borrowing-to-invest strategies, and
- they should properly document any recommendations they make regarding the use of a borrowing-to-invest strategy.
The following checklist sets out some issues that Registered Individuals should consider before making a specific recommendation or agreeing to a specific client request to invest with borrowed funds:
- Has the Registered Individual:
- collected sufficient information about the proposed loan, including amount and term of the loan, loan interest rate and the securities/assets to be used as collateral for the loan?
- determined on a pro-forma basis the impact of the proposed loan on the client’s financial situation?
- determined that the loan arrangement is suitable, and, if not, informed the client that they do not believe the loan arrangement to be suitable for the client and/or, in the case of a proposed Dealer loan, refused to advance the loan to the client?
- provided the client with and received client acknowledgement of receipt of the leverage risk disclosure statement or equivalent margin account agreement disclosure pursuant to subsection 3217(1)?
- In determining the impact of the proposed loan on the client’s financial situation and in determining the suitability of the proposed loan, has the Registered Individual considered:
- how the client’s total monthly debt service costs (taking into account the proposed loan), combined with the client’s other monthly expenses, compares to the client’s monthly income?
- whether the resultant client’s overall debt to net worth leverage ratio (taking into account the proposed loan) is appropriate for the client?
- whether other client assets are to be used to secure the loan and, if so, whether the client fully appreciates the encumbrance placed on these other client assets?
Leverage risk disclosure statement
Prior to making an initial recommendation to purchase securities using borrowed money, or first becoming aware of a client’s intention to purchase securities using borrowed money, the Dealer must:
- provide the client with a leverage risk disclosure statement, and
- obtain the client’s positive acknowledgement of this statement.8
To ensure that a client fully understands both the positive and the negative aspects of the borrowing-to-invest strategy, clients should be informed of the following:
- using money borrowed from others to purchase investments involves greater risk than a purchase using the client’s own money,
- the client has a continuing obligation to repay principal and interest even if the value of the investment goes down, and
- use of a borrowing-to-invest strategy could result in far greater losses than an investment strategy that does not involve the use of borrowed money.
The amount of on-book client borrowing is restricted by IIROC’s margin requirements,9 even in the case of order-execution-only accounts that are exempt from the suitability determination obligation.10 Dealers approved to provide order-execution-only services should not advise on or promote the use of borrowing-to-invest strategies, nor engage in referral activities to lenders.
Third party loans and referral arrangements
Additional issues arise when Registered Individuals make recommendations for the use of a borrowing-to-invest strategy where the loan is to be obtained from a third party. In such circumstances, Dealers should:
- have adequate systems and controls to flag accounts that involve recommended off-book loans,
- ensure these accounts are properly supervised, and
Additionally, Dealers should have controls designed to identify accounts that may be funded through the use of undisclosed off-book loans not recommended by the Registered Individual.
In cases where Dealers seek to put in place referral arrangements, National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103), requires that:
- the terms of the referral arrangement be set out in a written agreement between the Dealer and the other party,
- the Dealer maintain records of all referral fees paid,
- written disclosure of the referral arrangement be provided to the client before the party receiving the referral either opens an account or provides services to the client, and
- the written disclosure of the referral arrangement must include:
- the name of each party to the agreement,
- the purpose and material terms of the agreement, including the nature of the services to be provided by each party,
- any conflicts of interest resulting from the relationship between the parties to the agreement and from any other element of the referral arrangement,
- the method of calculating the referral fee and, to the extent possible, the amount of the fee,
- the category of registration of each registrant that is a party to the agreement with a description of the activities that the registrant is authorized to engage in under that category and, giving consideration to the nature of the referral, the activities that the registrant is not permitted to engage in,
- if a referral is made to a registrant, a statement that all activity requiring registration resulting from the referral arrangement will be provided by the registrant receiving the referral, and
any other information that a reasonable client would consider important in evaluating the referral arrangement.
Off-book loan instigated by client
IIROC is aware that where an off-book loan is instigated solely by the client, these situations can be very difficult to detect and/or supervise, particularly in cases where the client denies the existence of the loan. IIROC does not expect a Dealer to have an extensive supervisory framework in place to identify and monitor off-book loans where:
- no recommendation to enter into off-book loans is made,
- the loan or loans is/are instigated solely by the client,
- the client is regularly asked about the existence of off-book loans, and
- the loan or loans is/are not disclosed to the Registered Individual and/or the Dealer.
Supervisors and other individuals with supervisory responsibilities should not, however, ignore situations where the existence of:
- an off-book loan comes to light during a supervisory review of the client account, or
- a “red flag” indicates that the client may be using borrowed money to invest.
Examples of such red flags may include:
- large investments or transfers into client accounts (including deposits into margin accounts), where such amounts are inconsistent with the client’s “know-your-client” information, and inconsistent with the Registered Individual’s or the Dealer’s knowledge of the client’s individual circumstances or profile,
- communications from lending institutions regarding the value of the client’s portfolio, or requests for duplicate statements,
- referral fees paid to the Dealer by a lending institution or an affiliate of the institution,
- correspondence found in client files suggesting the use of undisclosed loans, and
- client complaints relating to the use of a borrowing-to-invest strategy.
Dealers should follow up respecting any such situations with questions and/or more testing, as appropriate.
IIROC expects all Dealers to have sound policies and procedures for borrowing-to-invest strategies recommended by the Dealer and its Registered Individuals. These policies and procedures should detail how it will evaluate the risks related to particular recommendations, how suitability will be supervised and how evidence of supervision will be maintained. Dealers are expected to demonstrate that their client lending supervision policies and procedures address all aspects of suitability: loan amount, debt servicing ability and suitability of investments and strategy.
The Dealer’s supervisory framework should capture on-book margin account loans as well as off-book borrowing-to-invest strategies where a recommendation is made, including new and existing client accounts. Dealers should consider whether limits or other controls will need to be established to monitor and supervise the lending activity of their Registered Individuals.
Having sound policies, procedures and controls together with an effective supervisory regime will create an environment where borrowing-to-invest strategies are properly assessed and approved, where appropriate, and where unsuitable borrowing-to-invest strategies are detected and prevented.
As noted above, IIROC does not expect a Dealer to have an extensive supervisory framework respecting off-book loans that were not recommended, are instigated solely by the client and not disclosed. However, a Dealer should not ignore the red flags described above.
The following are minimum controls that Dealers should have in place to identify and supervise the use of borrowing-to-invest strategies:
- Procedures designed to reasonably ensure that client accounts with positions financed by loans can be identified and are subject to an account supervisory review:
- Accounts with investment product positions that are financed by on-book and/or off-book loans (including situations where the Dealer or Registered Individual subsequently becomes aware of the use of an off-book borrowing-to-invest strategy), should be readily identifiable for supervisory review purposes.
- The applicable Supervisor responsible for client account supervisory reviews should conduct specific reviews of accounts where investment product positions are financed by on-book and/or off-book loans.
- Procedures for the maintenance of the evidence of supervisory review.
- Procedures to ensure that accounts that include positions financed by any disclosed or identified third-party loans fall under this supervisory framework.
- Procedures to ensure compliance with the requirements relating to permitted referral arrangements under NI 31-103.
The following are some best practices that Dealers should consider in developing and implementing supervisory controls:
- Developing a borrowing-to-invest suitability checklist, or a similar document, to detail the appropriate client circumstances that might support the use of a borrowing-to-invest strategy.
- Developing procedures to periodically assess the financial performance and the ongoing suitability of accounts that use a borrowing-to-invest strategy and noting the steps to be followed for borrowing-to-invest accounts that have become unsuitable (advising the client, etc.). This should include a more enhanced/frequent review during periods of volatile market conditions.
- Developing detailed guidance for Registered Individuals to help ensure that they explain all risks before recommending or accepting the use of a borrowing-to-invest strategy and requesting that clients provide an acknowledgement that the risks have been explained and are understood.
- Including a process for specifically reviewing borrowing-to-invest accounts as part of the Dealer’s business location examinations.
- Developing procedures for the approval of Registered Individuals outside activities with a view to capturing activities involving third party lenders.
- Developing supervisory policies that may include:
- requiring pre-approval of Registered Individuals before permitting the use of an off-book borrowing-to-invest strategy by their clients, and/or
- requiring that all off-book borrowing-to-invest strategies (new loans or re-financings) be pre-approved by the Dealer.
- Including a review of lending practices at prior firms as part of the due diligence process performed regarding prospective Registered Individuals.
- Reviewing third-party remuneration captured in Dealer records for trends indicative of lending practices.
IIROC Rules this Guidance Note relates to:
- section 3217,
- Part E of Rule 3200,
- section 3402,
- Rule 3900, and
- Rule 5100.
Previous Guidance Note
This Guidance Note replaces GN-3200-21-001 – Borrowing for Investment Purposes – Suitability and Supervision.
This Guidance Note was published under Notice of Approval/Implementation 22-0166.
- 2In this Guidance, the term “Registered Individual” refers collectively to individuals approved by IIROC as Registered Representatives, Portfolio Managers or Associate Portfolio Managers.
- 3Subsection 3202(1).
- 4In this guidance, all rule references are to the IIROC Rules unless otherwise specified.
- 5Subsections 5110(1), 5111(1) and section 5113.
- 6Sub-clause 3402(1)(i)(c).
- 7 Subsection 2602(1).
- 8Section 3217.
- 9Subsection 5111(1) and section 5113.
- 10See clause 3404(1)(i). Order-execution-only accounts are still subject to the account appropriateness obligation under clause 3211(1)(i), where the obligation is limited to determining, on a reasonable basis and putting the person’s interest first, whether it would be appropriate for the person to open this account at the Dealer.