Regulators roll out 'best-interest' concept

Proposed reforms cut slack for full range of industry's business models.

Rudy Luukko 26 June, 2018 | 5:00PM
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Trailer commissions for mutual funds are here to stay. But the broader investor-protection issues of conflicts of interest, suitability, advisor proficiency and relationship disclosure aren't going away either, according to one of the two major policy papers released on June 21 by the Canadian Securities Administrators.

Had they decided to ban all embedded commissions, not just deferred sales charges and trailers paid to discount brokers, the regulators would have completely eliminated the conflict that arises when advice-givers are paid by fund companies, rather than directly by their clients.

Instead, the industry's referees are taking a broader approach to improving investor outcomes. In doing so, they recognize that conflicts of interest are about much more than trailer commissions.

Advisor-investor conflicts can arise in both third-party and proprietary sales forces, and involve commissioned, salaried and fee-based advisors. Consider, for instance, a heavily indebted investor who would be best advised to pay down their loans, even if that leaves the advisor with fewer assets to manage.

Likewise, an advisor who doesn't want to see an elderly client's account size shrink might be tempted to advise them to hold higher-yielding, riskier securities so that they can live off their investment income alone. This may conflict with what's in the client's best interest, which is to draw down from their retirement savings.

It's these and other types of anti-investor behaviour, rather than just commission conflicts, that the regulators seek to address in their proposals for client-focused reforms. The changes fall far short of a statutory best-interest standard, which Ontario and New Brunswick had been leaning toward but have now abandoned because of the lack of a national consensus.

Still, the proposed reforms that the regulators have published on June 21 represent progress. At the very least, they establish the principle that the best interests of investors must be taken into account, and spell out in some detail what best practices would look like. However, the proposals cut the industry a lot of slack by avoiding specific requirements concerning how to address conflicts of interest, and what constitutes suitable investments. The proposals are industry-friendly, in that they accommodate all legitimate business models, including proprietary, embedded-commission and robo-advice.

The proposed reforms, for which the regulators have set a 120-day period to receive comments, cover five main areas of advisor relationships:

Know your client (KYC). Advisors must have a "meaningful understanding" of their clients, the regulators say. It's not good enough to ask clients if they fall into one of a short list of product-focused options such as growth, balanced or income. A proper KYC process involves obtaining details of financial circumstances, investment needs and objectives, investment knowledge, risk tolerance and time horizon. Advisors must take into account whether there are priorities, other than investing, that are more likely to help clients achieve their goals. The regulators warn that a client's risk profile should not be "manipulated" to justify recommending higher-risk products. Though these are all best practices that advisors should already have in place, spelling them out in detail is a welcome development. In a nod to robo-advisors, the regulators say that KYC requirements can be met through online questionnaires, and do not require face-to-face contact.

Know your product (KYP). There are new requirements for firms to analyze and monitor securities that they intend to make available to clients. They must establish and maintain written KYP policies and procedures, and apply these consistently. In a nod to embedded trailer commissions, the KYP requirements include knowledge of the initial and ongoing costs of a security, and the impact of those costs on investors. Individual advisors are subject to KYP requirements for any approved securities that they offer to clients. As part of their process, firms must understand how their approved securities compare to others available in the market. This requirement applies even if the firm deals only in proprietary products.

Suitability. The most significant suitability reform being put forward is the emphasis on a portfolio approach, as opposed to trade-by-trade review. There are new requirements to assess whether investors are overly concentrated in illiquid exempt-market securities, or in a single issuer, industry sector or asset class. In making recommendations, advisors will also be required to consider multiple accounts that investors may hold. Suitability requirements will also apply to the different business models. Advisors must explain to clients the difference between commissioned and fee-based accounts, and why it's in the client's best interest to be placed in a particular compensation model.

Conflict of interest. There are new proposals to address conflicts arising from proprietary products. But for the most part, the regulators make suggestions about what firms "could" do as opposed to what they must do. One of the many suggested courses of action, for example, is that periodic due diligence be conducted to assess whether proprietary funds are competitive with alternatives available in the market.

On the issue of trailer commissions or other third-party compensation, the CSA sets out the principle that firms should be able to demonstrate that their fund and recommendations are based on the quality of the security, rather than any third-party compensation associated with that security. The regulators spell out various ways that this could be accomplished, but again they are only suggestions, not specific requirements.

The regulators also say the investment firm's consent concerning a conflict of interest does not automatically let an individual employee off the hook. Advisors are still responsible, as they should be, for assessing whether the conflict has been managed in the client's best interest.

Relationship disclosure: The reform proposals aim to ensure that investors are better informed about what investments they'll have access to, the services they can expect to receive, and the impact of fees and commissions. If there are limits on the scope of securities offered, this should be spelled out. Most mutual-fund dealers, for instance, don't offer exchange-traded funds. Firms and advisors would also be required to explain how any fees or sales charges, including embedded commissions, will reduce investment returns.

None of the proposed reforms will be taking effect anytime soon. Industry stakeholders and other interested parties have until Oct. 19 to comment, and it will take many months for the regulators to review the feedback and engage in consultations. According to the regulators' own timetable, implementation of most of the reforms is two years away. What remains to be seen is how closely the regulators and the self-regulatory organizations for brokers and fund dealers will monitor and enforce all the new requirements. For that, it looks like we'll have to wait until at least 2020.

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About Author

Rudy Luukko

Rudy Luukko  Rudy Luukko is a freelance writer who contributes to on topics involving fund industry trends and regulatory issues. He retired in May 2018 from his position as editor, investment and personal finance, at Morningstar Canada, where he had worked since 2004. He has also worked as an editor and writer for various general, specialty and institutional media, and he has co-authored courses for the Canadian Securities Institute. Follow Rudy on Twitter: @RudyLuukko.

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