Investors Getting the Best of a Bad Situation in Ontario

Ruth Saldanha: In December last year, the Canadian Securities Administrators announced that in most provinces the use of deferred sales charges or DSCs will be banned in 2020. We say most provinces because the OSC will not be banning the DSC option after the Ontario government opposed the ban. Here at Morningstar we talked about this decision a lot. We believe DSCs are not in the interest of investors and should be banned. The OSC has decided to walk a path between banning and really allowing DSCs by restricting these expensive products. It's a compromise. Dan Hallett, VP and Principal at HighView Financial Group, is here with us today to discuss these restrictions.

Dan, thank you so much for being here today.

Dan Hallett: It's a pleasure.

Saldanha: All in all, with these restrictions, is the OSC making the best of a bad situation?

Hallett: Well, they are. I mean, as you pointed out, I think it was Ontario's preference and really all the other regulators to do an outright ban. I think it is the best they can do, because ultimately they think if the – if they thought the best way to protect investors was a ban and that's not possible, at least these restrictions will minimize the harm that can be done to investors.

Saldanha: Are these restrictions enough? Is there anything else that the OSC can do to protect investors from these predatory products?

Hallett: I think they've covered all of the big issues. I think there are certainly a couple of smaller things they can do, but they've really covered things off. So, some of the additional suggestions that we're going to add into our submission or I've seen from others are things like trying to protect vulnerable clients. Now, the measures they've proposed do that to an extent and I've seen at least one suggestion that potentially can add some good protections for other vulnerable people that aren't covered. And then, the other thing is they could put things like a maximum commission percentage rate on there as well. So, there are little tweaks they can do. But I think the OSC has really covered things off pretty well in its proposals.

Saldanha: You said before that the decision to not ban DSCs by Ontario was more political than investor safety-driven. With that backdrop, do you think that these restrictions will pass without opposition?

Hallett: I suspect they will. I mean, you never really know. The finance minister we had when this was first rejected is no longer the finance minister. However, they remain fairly consistent. But I suspect the Ontario Securities Commission would not have put the work into this and started another consultation if they weren't pretty confident that this would pass, because ultimately, it gives the – it kind of gives the industry what it wanted which was avoiding an outright ban. For the industry, it's probably a compromise because they lose the full DSC if everything gets implemented as proposed. But yeah, I suspect that it would be accepted by the government.

Saldanha: The OSC has divided the restrictions into two; fund manager restrictions and dealer restrictions. Let's start with the fund manager ones. What do these restrictions mean for investors?

Hallett: Well, in a nutshell – and maybe it's good context just to quickly go over what the status quo of the deferred sales charge is. Essentially, an investor will purchase the fund. That triggers an upfront commission of 4% to 5% to the dealer which is split with the advisor. And they are typically in that fund for 6 to 7 years and if they sell out of the fund entirely, out of the fund family entirely with that 6, 7-year period, they are hit with an exit fee that declines over time. And so, ultimately, what this would do if these proposals are passed, the upfront commission will be less, it will restrict – it will just protect – I guess protect more people in terms of being exposed to DSC because that won't be permitted to be used for nearly as many people as it has in the past and it will keep people locked in for a shorter period. So, it's kind of a watered-down version of what exists today. But it's better than the status quo.

Saldanha: Now, let's discuss the dealer restrictions. You've said that the restriction on the use of borrowed money to buy DSCs was one of the best measures. Why is that?

Hallett: It's really because of the big conflict of interest that's inherent in that. I think even the rationale that's in the consultation paper doesn't touch on that although I know the OSC is well aware of it. What I've seen in the past over my career it wouldn't be uncommon to see for the advisors that are real advocates of leverage to see them recommend a client is taking out fairly substantial loan up to – I mean, often in the six figures, not uncommon to see 300,000 to 500,000 and all of that being invested in a lump sum in one or more DSC funds. So, that triggers a fairly heft upfront commission. And you are involving – so, you are generating that commission by having the client take on a significant amount of risk and the costs like these is – it just screams conflict of interest. So, to the extent that that can be really regulated into extinction, then I think that's a good thing and probably one of the bigger if not the biggest conflict that I can think of with respect to deferred sales charges.

Saldanha: There are also restrictions on commissions and redemption fees. What do you make of those?

Hallett: So, you know, those are – on the commission and redemption fees, really, it will limit the level of fees that people will see if they do so within the three years versus the current 6 to 7-year period. So, even if they do trigger an exit fee by leaving early, they won't pay nearly as much. And then, the upfront commission according to the consultation paper is really only limited by the account size. So, the OSC is proposing no more than $50,000 in terms of an account that can be invested on a DSC basis. And so, that will limit the commission. Our suggestion as I noted will also apply a maximum commission rate because in theory even if it's limited to $50,000, in theory, there's no limit to the commission rate that could be applied to that. I mean, economically there would be a limit because I can't go to the sky, but I think imposing that percentage rate as well and codifying that I think will help.

Saldanha: Finally, as investors how should we protect ourselves from these products?

Hallett: Well, you know, it's a tough thing. It's a tough question to answer. Because ultimately, it involves people being informed, but I think it just comes back to that. For those who may not be either as interested or have the inclination or really nowhere to look to get informed, at the very least I would say people should follow their gut and just ask questions even if you think they are "dumb questions or naïve." Because if something just doesn't feel right or if you don't feel you know enough, I think you just need to ask. Nobody works for free. I mean, in very rare circumstances unless they're doing you a favour. But for the most part, you have to know that if you are engaging someone to provide a service, they are going to be paid somehow and if it's not clear to you how they are being compensated, you need to ask about it until you get an answer that sounds and feels right to you. The ideal, of course, is that you do a lot of reading inform yourself and you kind of know – you can kind of confirm those things. But for a lot of people, that's not going to be possible. And so, it really is going with your gut instinct to kind of making sure to understand what you're being provided in terms of a service but also how the person across the table for you is being compensated.

Saldanha: Thank you so much for being here today, Dan.

Hallett: You're welcome.

Saldanha: For Morningstar, I'm Ruth Saldanha.