IIROC calls on discounters to resolve trailer-commission conflicts

Rebates if necessary, but not necessarily rebates.

Rudy Luukko 11 April, 2018 | 5:00PM
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The Investment Industry Regulatory Organization of Canada (IIROC) has served notice to no-advice discount brokers that collecting full-service trailer commissions from mutual-fund companies is unacceptable. Less clear is what discounters will need to do to comply. Also uncertain is whether the self-regulatory organization's initiative on behalf of self-directed investors will be overtaken by events because of the possibility of a nationwide ban on all embedded mutual-fund commissions.

In a notice to member firms released on April 9, IIROC said order-execution-only (OEO) brokers must address compensation-related conflicts of interest concerning mutual-fund sales. But IIROC is leaving it up to the discounters to come up with the appropriate remedies.

The conflicts arise because mutual funds that pay full-service trailers -- typically 1% a year for equity and balanced funds and 0.5% for fixed-income ones -- are far more profitable for discounters to hold in their clients' accounts than those that pay much lower trailers or that pay no compensation whatsoever to them.

"A large majority of the publicly available funds include a trailing commission," IIROC said in its notice to dealer members. "Management of the conflicts of interest relating to trailing commissions by OEO firms allows investors continued access to the widest possible range of investments."

One way to do so, as mentioned in the IIROC notice, is to provide rebates of the portions of trailer commissions that are intended to compensate full-service dealers. Under the terms and conditions of their registration, OEO firms are prohibited from making recommendations or otherwise giving advice.

"The suggestion of a rebate is just that," Wendy Rudd, IIROC's senior vice-president, member regulation and strategic initiatives, told Morningstar in an interview. She added that IIROC is open to other actions that the discounters might take. "We intentionally left our options open on this, as long as they address the conflict."

IIROC also notes that it may need to make further revisions in its guidance on trailer commissions, depending on what policies emerge from the Canadian Securities Administrators (CSA), representing provincial and territorial securities regulators across Canada.

The CSA has indicated that it will make public sometime this spring its policy proposals concerning embedded mutual-fund commissions, with one possible alternative being a complete ban. For now, IIROC's guidance is in line with the CSA's position that do-it-yourself investors whose mutual funds pay full-service trailer commissions to discounters are indirectly paying for advice that they don't receive. But to date, securities regulators have taken no action to ban these excessive payouts.

Nearly a year ago, in May 2017, IIROC sent letters to all 21 OEO brokerage firms, asking them to come up with an action plan on trailer commissions. Over the coming months, IIROC will hold discussions with these firms. The goal is to have them come up with "a reasonable action plan within a reasonable time," Rudd said. No specific deadline has been set for implementation of these plans. As Rudd explains, IIROC wants to take the time needed to ensure that it takes a consistent approach with all OEO firms.

One investor-friendly service that discounters can provide is online alerts to notify investors, who are about to buy a full-trailer Series A fund, if a lower-fee Series D is available. Series D funds, which are designed for do-it-yourself investors and pay much lower trailer commissions -- typically 0.25%.

Trailer commissions on Series D funds are currently deemed acceptable by regulators, and by IIROC, on the grounds that they compensate discounters for the trading platforms and related services that they provide. IIROC said in its notice that, whenever possible, it expects discounters to make available funds that do not pay full-service trailer commissions.

Though there are roughly 650 Series D funds on the market, they are far fewer in number than funds, commonly designated as Series A, that are distributed primarily through commissioned-advice distribution channels and that pay full-service trailer commissions.

In the interests of providing discount-brokerage clients with the widest possible range of mutual funds to choose from, IIROC won't prohibit discounters from offering Series A or other series of funds that pay full-service trailers. But it does expect the discounters to rebate to their clients the portion of the trailer commission that is intended to pay for advice, or take other action that would achieve a similar result.

For example, assuming that an investor holds $10,000 worth of a Series A mutual fund that pays a 1% trailer commission, the brokerage would normally receive $100 a year from the fund company. This suggests that, to be compliant with IIROC, a discounter might have to rebate $75 of that amount. This would presumably alleviate the discounters' conflict of interest by bringing its trailer-commission revenues in line with Series D payouts. That level of rebate would make a material positive difference to investor returns, and greatly erode the fund-related revenues of most discounters.

Rebates are currently in place at Questrade, which to its credit has recognized that discounters shouldn't benefit from full-service trailers. For investors who sign up for Questrade's Mutual Fund Maximizer service, the discounter will rebate the entire trailer commission. The catch: Questrade charges a flat monthly processing fee of $29.95. So your mutual-fund holdings with Questrade would need to be large enough to make the rebate program worthwhile.

On its website, Questrade provides the example of $100,000 invested in mutual funds that pay 1% trailers. Under the rebate program, clients would be reimbursed $640.60 a year. If the rebate, determined quarterly, was less than Questrade's processing fee for the same period, no processing fee will be charged.

Perhaps the most controversial consumer issue concerning discounters' trailer commissions is the extent to which self-directed investors should be reimbursed for years of paying for advice that they didn't receive. It appears highly unlikely that IIROC would seek retroactive rebates. "We have to find an appropriate balance," says Rudd, "between doing the right thing for investors while minimizing the negative impact on the dealers."

No such reluctance to address past trailer-commission payouts is being shown by class-action litigators Siskinds LLP of London, Ont., and Bates Barristers P.C. of Toronto. Their target isn't the discounters themselves. Instead, they are planning to sue TD Asset Management Inc., the trustee and manager of TD mutual funds.

"Canadians entrust their hard-earned savings to the trustee of their mutual funds on the understanding that the trustee will protect and maximize the value of their investments," Michael Robb of Siskinds said in an April 9 release. "Paying trailing commissions to discount brokers as compensation for advice that is never provided to investors is not just or fair."

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About Author

Rudy Luukko

Rudy Luukko  Rudy Luukko is a freelance writer who contributes to Morningstar.ca 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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