Principal Protected Notes Compliance Review 

GN-3900-21-003
Type: Rules Notice> Guidance Note
Rule connection:
IIROC Rules
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Executive Summary

Effective Date: December 31, 2021

During 2008, volatility and sharp declines in financial markets triggered a “protection event” (monetization) for a number of PPNs sold by Dealer Members (Dealers).

IIROC undertook a compliance review of the sale and the subsequent monetization process by its Dealers. IIROC conducted this regulatory review during 2009 at a representative sample of Dealers, to determine Dealers’ knowledge, training and controls around the sale of PPNs and to assess whether clients were sold suitable products and received the appropriate disclosures. This Guidance Note provides a summary of the key findings and deficiencies identified during the review.

Table of contents
  1. Key features of Principal Protected Notes

A key feature of a principal protected note (PPN) is that an issuer, usually a bank, guarantees to return 100% of the invested capital as long as investors hold the notes until maturity. PPNs offer investors the opportunity to share in the increase in value of the underlying portfolio investments (a stock, an index, or a mix of equities, commodities or hedge funds) while paying for the protection of their initial investment either through fees and/or ceding a portion of the return.

PPNs are often sold as fixed income alternatives to low yielding investments such as guaranteed investment certificates. They are often marketed as a buy-and-hold investment strategy that allows investors to share in the upside potential of the investment without risk to their principal investment. Most often, the return is only achieved at maturity. However, some PPNs do provide a return of “cash flow” that is usually drawn from the equity.

PPNs are products that are distributed within the non-prospectus or exempt market by a wide variety of financial institutions (including but not limited to Dealers). An Information Statement must be provided to the client upon the initial purchase of a PPN. Most PPNs have a medium term to maturity, typically between 4 to 8 years. However, some of these notes have a maturity date of up to 15 years.

The value of a PPN, although a debt instrument, is expressed in units represented by a net asset value or NAV. A typical debt instrument is normally expressed in terms of its face value with a coupon or interest rate. The term NAV is most commonly used in relation to mutual funds.

The NAV of the PPN can be affected significantly by volatility in the value of the investment portfolio assets. Safety strategies are built into the product structure of the notes to guard against this. If the NAV of the PPN hits a value trigger, often when the cost of protection is equal to the NAV of the PPN, a reallocation of the holdings occurs. When such a reallocation action occurs, known as a “knock-out scenario” or a “protection event”, then the PPN becomes “monetized”.

Monetized notes no longer carry any exposure to other underlying investments and will deliver minimal or no return on investment. Return of capital is still guaranteed, but only if the notes are held to maturity.

  1. Background to the review

A representative sample of Dealers were audited to determine whether:

  • the selling Dealer’s knowledge of the product was adequate,
  • the Dealer’s training for their sales personnel was adequate,
  • the product was suitable for clients who purchased the PPNs,
  • there was appropriate disclosure to investors at the point of sale, at the time of monetization of some of the PPNs, and on client statements, and
  • the standards and controls around the sales of these products were generally adequate.

For this review, IIROC gathered security record data concerning PPNs from Dealers as at December 31, 2008, disclosures relating to the monetization events, marketing material provided at the time of purchase, and client account data for PPN purchases. The compliance review of Dealers and their registered representatives entailed the following:

The compliance review examined 15 IIROC Dealers. The data collected eventually allowed IIROC to survey approximately 41,000 client accounts. Of the approximately 41,000 client accounts, IIROC confirmed the prevalent view that retail clients were the main holders of PPNs:

  • individuals accounted for 96% of the accounts, and
  • corporations accounted for approximately 4% of the accounts.

Using the security record data received and using predetermined selection criteria, IIROC identified a sample size of 174 client accounts to review in detail for disclosure and suitability.

IIROC identified a total of 169 known monetized PPNs as of December 2008. IIROC was able to determine that 12 institutions were involved in the issuance of the 169 PPNs that were known to have experienced monetization events as at the end of 2008.

Based on the data from Dealers for the 169 known monetized PPNs, IIROC observed that in those situations where a parent firm issued PPNs that were subsequently monetized, the parent firm’s Dealer subsidiary had the largest relative exposure measured by the number of clients.

The IIROC business conduct review included the sales and disclosure practices of the selected Dealers. The key considerations included the assessment of the suitability of the PPN investments for each of the relevant 128 client accounts (selected from the 174 samples), the disclosure made to clients, and the extent of the registered representatives’ product knowledge and training. In addition, IIROC reviewed the accuracy of the valuations disclosed on the December 2008 month-end statements for the 174 client accounts.

  1. Summary of key findings and deficiencies for Dealers

For each of the 169 monetized PPNs, IIROC examined the marketing material at the time the notes were distributed and the notification documents at the time the notes were monetized. Throughout its review, IIROC assessed whether Dealers discharged their due diligence obligations, specifically in meeting their know-your-product and know-your-client obligations as they related to PPNs.

The findings listed below are limited to those that directly apply to Dealers and their obligations to their clients. Other findings or deficiencies that are directly attributable to the PPN issuer or to a third-party service provider have not been included in this summary.

  1. Client receipt of the issuer disclosure documents

The review found that the dissemination of the required disclosure to clients was inconsistent amongst Dealers. Although Dealers indicated that they believed it was the issuer’s responsibility to deliver the disclosure documents to clients, many Dealers had no clear due diligence process in place with the product issuers to ensure that the Information Statement was indeed distributed to clients. Most Dealers did not have a sufficient evidentiary record to establish that this information was delivered by the product issuers to their clients.

Section 39451  requires a Dealer to have, maintain and apply written policies and procedures, which establish a system of internal controls and supervision in support of investment suitability advice and recommendations for retail clients. Dealers are required to have a “new product due diligence” policy, and are required to implement procedures to ensure that any of their clients who purchase a PPN receive the required disclosure. In addition, all Dealers who sell these products must maintain evidence of the dissemination of this material to their clients for IIROC examination.

  1. Monetization notice

IIROC reviewed 33 Dealer/issuer agreements to determine how monetization notices were distributed to clients. The majority of Dealers appeared to rely on product issuers to distribute the monetization notices (protection event notification) directly to unit holders of the security without benefit of a contractual agreement requiring the product issuers to distribute on their behalf. Further, the Dealers were unable to produce adequate evidence to assure IIROC that the Dealer’s clients actually received the required monetization notices. IIROC was, therefore, not able to confirm that all clients received monetization notices.

All Dealers should review their contractual agreements with issuers to ensure they clearly delineate which party is responsible for the distribution of protection event notification. Further, as part of the due diligence procedure, where a Dealer relies solely on a third party for the distribution of the material to their clients, the Dealer should obtain and retain in its files confirmation that this protection event notification has been given.

  1. Marketing material

Not all Dealers who were examined produced their own marketing material for distribution to potential investors. Where marketing material was produced, it made reference to the issuer-provided Information Statement as the source of additional and more detailed information. Most of the Dealer marketing material was not adequate on its own as some key information was absent, such as information about the possible protection events (monetization events). Much of the marketing material examined also did not contain adequate information regarding charges and fees.

While product issuer disclosure in the form of the Information Statement is the main offering document for the principal protected notes, section 3603 requires Dealers to ensure any sales literature or other advertising and correspondence does not fail to fairly present the potential risks to the client or contain omissions of a material fact.

All Dealers who sell PPNs to their clients must ensure that any marketing material they produce is accurate and fairly presents the potential risks (which includes but is not limited to possible protection events and early trading fees) to the client.

  1. Suitability obligation

IIROC determined that the PPN products were suitable for the 128 accounts tested.

IIROC suitability rule in Rule 3402(2) requires each Dealer to use “due diligence to ensure that before any order is accepted from the client, the order and the client’s investment portfolio that would result from accepting the order are suitable, based on factors including the client’s current financial situation, investment knowledge, investment objectives and time horizon, risk tolerance, and the client’s current investment portfolio and composition and risk level.”

It is important that all Dealers take into consideration all factors which one might reasonably conclude will affect the assessment of suitability. This includes, and is not limited to, the financial situation, investment knowledge, investment objectives, risk tolerance, age, investment time horizon, and the goals of the client when the Dealer or the Registered Representative (RR) recommends an investment product.

  1. Education and training

This review found that there was no uniformity in the level of training offered to RRs on PPNs and indicated that the training and education programs on structured products at many Dealers could be improved. Some Dealers required their RRs to educate themselves and to seek out the product information independently without the Dealer’s assistance. Other Dealers developed and provided extensive education and training materials to their RRs prior to the sale of these products.

IIROC rules relating to suitability and guidance relating to best practices for product due diligence clearly indicate that recommendations to clients require knowledge of the products sold to those clients. It is clear that Dealers must ensure that their RRs and sales staff are educated on and understand all of the important features of any products the Dealer allows them to sell prior to marketing the product to their clients.

  1. Security as disclosed in the client statement

Some clients may have had difficulty in monitoring their PPN investment due to a lack of clarity of information in monthly statements. Deficiencies were found in the identification of the product as a PPN, the identification of the issuer, the full name of the PPN investment and the maturity date of the PPN investment.

The review found that the information contained in the monthly client account statement generally was not adequate for the client to understand the full name of the security purchased. Specifically, the account statements did not clearly identify the security name of the PPN position since it was abbreviated or shortened often making it unintelligible to an ordinary reader. In addition, the maturity date of the PPN was not noted on the client account statement. These inadequate descriptions made it likely that most clients would not be able to readily understand what they held or know when to redeem the PPN investment.

A client must be able to understand their account statement and must be able to identify their security holdings. Abbreviations of the security name are common. However, they must be used with discretion and should not render the disclosure to be of limited or minimal informational value. Pertinent and necessary information, such as the PPN’s maturity date, must be included. The maturity date of the PPN is a critical piece of information that could affect a client’s decision to either hold or redeem a security.

IIROC also noted that a few Dealers incorrectly classified the PPNs they sold as “mutual funds” or as “alternative strategy funds” on the client statements. A mutual fund is in a different asset class and has different product attributes from that of a PPN, which is a structured debt instrument. “Alternate strategy fund” is not a defined term. Using this term together with a PPN can lead to confusion or add ambiguity for the client.

Dealers must ensure that the disclosure or characterization of the security position on the account statement is accurate, clear and informative, specifically by providing the full security name, the maturity date and its asset class.

  1. Applicable rules

IIROC Rules this Guidance Note relates to:

  • section 3945, and
  • subsection 3402(2), and
  • section 3603.
  1. Previous Guidance Note

This Guidance Note replaces Notice 10-0233 – Principal Protected Notes Compliance Review: Findings, Requirements and Recommendations.

  1. Related documents

This Guidance Note was published under Notice 21-0190 - IIROC Rules, Form 1 and Guidance.

  • 1In this guidance, all rule references are to the IIROC Rules unless otherwise specified.