In a long-awaited decision released today, Canadian securities regulators stopped short of an outright ban on trailer fees and other forms of embedded commissions associated with mutual funds.
However, the Canadian Securities Administrators (CSA), the national umbrella association for provincial regulators, proposed the abolition of two well-established investment industry sales commission practices.
It plans to ban all forms of the deferred sales charge (DSC) model, as well as the payment of trailing commissions to discount brokers and other dealers who do not make a "suitability determination" on client transactions or give advice, according to a staff notice entitled Status Report on Consultation on Embedded Commissions and Next Steps.
The CSA indicated it will issue a formal notice and request for public comment on these proposals in September.
Rather than ban embedded commissions, the regulators are proposing to make broad client relationship reforms through amendments to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations and companion policy 31-103CP. These proposals, outlined in a separate notice also issued on June 21, would enhance investor protection and address conflicts of interest, the CSA said.
To the extent that advisors receive third-party compensation, including embedded commissions, registered firms will be required to show that both product shelf space and client recommendations are based on the quality of the security and not compensation, the CSA said.
Circumstances where advisors receive greater third-party compensation to sell or recommend one product instead of other comparable products would constitute a conflict of interest, the notice said. "The reforms effectively raise the bar for registrant conduct and achieve the gains sought for investors," the CSA said in a press release.
While the reforms require a beefing up of suitability procedures such as Know Your Client and Know Your Product practices for advisors, the regulators did not go as far as introducing a statutory best interest standard in Ontario and New Brunswick, the only two provinces considering the measure.
The CSA would require expanded disclosure on proprietary products sold to clients, as well as the impact of costs and charges. It is requesting public comment by October 19, 2018 on the new set of client-based proposals contained in the notice.
The CSA's decision to ban the DSC is in line with a gradual decline in the practice in the industry. Point-of-sale commissions to dealers of up to 5% of the purchase value of fund assets can be excessive, particularly in an era of lower investment returns and the brighter regulatory spotlight shining on fees under the set of reforms known as the Client Relationship Model, Phase 2.
While the commission on DSC funds is not paid directly by investors, typically the fund sponsoring firms recoup the costs of the commission through higher management fees imposed on the funds. DSC funds also come with redemption fees that decline over a period of several years and may act as a deterrent for investors in selling a fund that they might otherwise wish to redeem.
The CSA said it received 142 public comment letters from various industry and investor stakeholders since it introduced its consultation paper on discontinuing embedded commissions in January 2017. Of these, 84% were from industry stakeholders such as dealers, investment fund managers and industry associations and 16% were from non-industry stakeholders such as investors and investor advocates.
The majority of fund industry stakeholders were strongly opposed to any decision to discontinue all forms of embedded commissions and a mandated move to direct-pay arrangements such as fee-based accounts, the CSA said.
Although embedded commissions have been banned in some jurisdictions such as Australia and the United Kingdom, the Canadian industry had recommended that further research be completed before moving forward. One of the fears was that an outright ban could have significant unintended consequences such as reduced options for investors and increased concentration in a market already dominated by bank-owned firms.
The CSA said in its notice that rather than discontinue all forms of embedded commissions, it has chosen to pursue a "harmonized" package of reforms that address a range of investor protection and market efficiency issues, and responds to all types of conflicts that "incentivize poor registrant behaviour and subvert investor interests."
In banning embedded commissions paid to discount brokerages, it said the fees paid by DIY investors in this channel don't appear to align with the execution-only nature of the services they receive.
"We also observe no justifiable rationale for the practice of paying discount brokerage dealers an ongoing trailing commission for the sale of a mutual fund," the CSA said.
It noted that other securities such as exchange-traded funds are purchased and sold by way of an upfront transaction fee, and any ongoing payment that encourages the distribution of certain mutual funds could give rise to a conflict of interest. This is especially true when the discount brokerage receives the same trailing commission as a full-service dealer that provides investment advice to clients, the CSA said.
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