We have seen some hedge funds and their respective dealers take the position that they have transactional, not ongoing, relationships with the funds’ investors and, therefore, they only have to collect KYC information to determine suitability at the time of investment. But are they right?
Answer: In our experience, securities regulators think that most EMD distribution models create ongoing, not transactional, relationships. Ongoing relationships create an obligation to, among other things, conduct KYC/suitability determinations at least annually.
The FAQs that the Canadian Securities Administrators (CSA) published with respect to the CRM2 amendments to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) are consistent with this interpretation. For example, Staff Notice 31-345 Cost Disclosure, Performance Reporting and Client Statements (NI 31-345) states that ongoing client relationships are typical of most registrants’ operating models. Then, by way of example, staff indicate that a transactional relationship might exist between an EMD and a client in connection with a specific transaction (such as the purchase of securities in a private placement) that does not involve:
- a security specified in paragraph 14.14(1)(c) of NI 31-103 (e.g. a security issued by a mutual fund where the EMD is the dealer of record for the client on the records of the issuer or issuer’s investment fund manager);
- any trailer fee or similar, ongoing compensation in relationship to the client’s ownership of a security;
- an EMD holding client assets;
- any expectation by the EMD that there might be future transactions with the client or further services provided to the client; or
- any expectation by the client that the EMD will continue to provide services.
Although the guidance described above is ostensibly focused on CRM2 obligations, in our experience regulatory staff apply this guidance when determining whether registrants are subject to other ongoing obligations with respect to their clients, such as, for example, determining whether an existing client’s investment in a hedge fund is still suitable for that client.