Over the past few years, the Canadian Securities Administrators (CSA) have worked on a broad, sweeping set of changes to regulation designed to better the experience of the investor. The CSA is the regulating body designed to protect investors from unfair, improper or fraudulent practices.
The changes in regulation, which touch on some of the same areas as Regulation Best Interest changes in the U.S., came into effect in December 2019. Firms and advisors have until the end of this year to implement the processes required to adhere to the new regulations.
The largely principles-based requirements can be subject to some interpretation. Meanwhile, the clock is ticking. To further help firms navigate the proposed changes, Ian Tam, the Director of Investment Research at Morningstar Canada sat down for a fireside chat with Debra Foubert, the Director of Compliance and Registration Regulation at the Ontario Securities Commission. He asked questions from the audience on all four sections of the CFRs. Here is an edited excerpt:
Ian Tam: When these regulations (changes to National Instrument 31-103) were originally created, what need do the regulators see in having to update these amendments?
Debra Foubert: The Client Focused Reforms are the culmination of years of consultation undertaken by the CSAs and the SROs (self-regulatory organizations) to enhance the registrant client relationship. Clients already think that their advisors are subject to a best interest standard, and most advisors say they already act in the clients' best interest. But in reality, the regulatory standard was a suitability standard. Therefore, to align with clients' expectations, we developed a solution for the Canadian marketplace, where we infuse the best interest principles into the conflicts of interest requirements and the suitability determination obligations while also enhancing the supporting requirements of KYC and KYP.
Client Focused Reforms Part 1: KYC
Ian Tam: The frequency of updates of KYC information, that's once every 36 months at minimum or 12 months for discretionary accounts. Is that right?
Debra Foubert: Yes. For discretionary accounts, it's every 12 months; for non-discretionary account, dealer accounts, it's 36 months; and then the exempt market dealers are a little different, that it's 12 months after the last interaction.
Ian Tam: One of the things that we've noticed here at Morningstar is that market participants are not as concerned about the changes to the KYC requirement, because some of that has existed before. Is this a cause for concern?
Debra Foubert: KYC is one of the fundamental obligations (of CFR). You need a sufficient amount of information to be able to support the suitability determination. It can't be just be cookie cutter, check the box type thing, because you really have to figure out what meets the clients' needs and objectives. There is work to do. Don't just gloss over the KYC requirements, because you're going to have to update those procedures.
Ian Tam: Could you give guidance for firms to implement consistent compliance screening on KYP information? An example at a firm is the use of a leverage disclosure document for an RRSP contribution made from a HELOC, whereas none is required if deposited from a checking account (even though the latter might have greater debt obligations).
Debra Foubert: Well, to answer that in a short sentence, I don't know that you can have a consistent process. There are a number of factors impacting KYC information collection, including business models and how you interact with your client. Each firm is going to have to assess their business model.
Regarding the question on leverage, the use of leverage is one instance where the new risk profile requirements will be very important when making the suitability determination. We've expanded the risk profile to include a client's willingness to accept risk which is the risk tolerance, and a client's ability to endure potential financial loss, which is the risk capacity. Whether or not you need to collect a separate form for leverage or not doesn't really matter, because what does matter is that you need to know your client's financial circumstances in enough detail to determine if borrowing to make an RRSP contribution is suitable for the client and whether or not it puts the client's interest first.
Client Focused Reforms Part 2: KYP
Ian Tam: Let's move on a little bit to the KYP portion of regulation.
Debra Foubert: Know Your Product rules will require firms to assess, approve and monitor the products they put on their shelves and require advisors to understand the products that they use in their clients' accounts. We do believe that firms will have the flexibility to establish appropriate review, approval and monitoring processes and which will vary depending on the business model, the types of securities they offer, the proficiency of the firm's registered individuals, and the nature of the relationship that the firm has with its clients. A security-by-security process will not be required in all circumstances.
Ian Tam: How will advisors "understand" thousands of products to select in the best interest of their clients?
Debra Foubert: We don't expect advisors to understand thousands of products. We do expect advisors to thoroughly understand all the products they recommend to buy or sell for their clients. This includes understanding the structure, the features, risks, and initial and ongoing costs of the product, and the impact of those costs. We expect advisors to understand a reasonable range of alternatives that are available to them on the firm shelf. Considering a reasonable range of alternatives as part of making the suitability determination for your client, you also may be required to look more broadly at a reasonable range of available alternatives that could meet the needs of your clients when deciding whether to recommend a specific security or not. In order to do this, firms will need to implement a process to make sure the securities they offer, whatever the type, are assessed, approved and monitored. Then the advisors will need to determine what securities meet their suitability determination obligations, and that the security is suitable and puts the client's interests first.
Ian Tam: A question related to that is the requirement to monitor the product shelf or even securities within a retail account for ‘a significant change’. What is ‘a significant change’? Is there a difference between a significant change and a material change?
Debra Foubert: We chose to use the term significant change rather than the defined term of a material change to give firms the flexibility and permit the use of professional judgment when determining what type of change may require consideration by the firm or the advisor to make change for the clients' accounts. I'll give you an example of a significant change. It may be a change in the risk rating of a security on the firm's product shelf. Based on the change in the risk rating, we would expect the firm and representatives to consider whether or not any adjustments should be made to the client's holding in that security.
Ian Tam: Would it be fair to say that the universe of significant changes is much larger than the material changes, larger than material changes?
Debra Foubert: The term significant change is not defined. Use the firm's professional judgment to determine what significant changes they will be monitoring for. And then, then from that subset, the advisor will then have to understand what the changes are and what impacts it would have on the client accounts that hold that security.
Ian Tam: The next question is around how prescriptive firms should be in regard to the advisor KYP requirements of significant changes. What is expected to be researched or documented about each security at the firm level?
Debra Foubert: There isn't a one size fits all process, obviously, for researching and documenting. It will depend on the business model of a firm, the type or complexity of the security or products that the firm makes available to the clients. We expect the firm to put in place a process to determine what significant changes will be monitored for. They will have to determine who will be monitoring for the changes, and then establish a process to notify the representatives of the significant change. Then the representative can then consider whether or not to make any adjustments to the client accounts. As for documentation, it needs to be sufficient enough to evidence the rationale for the action or inaction. And also, we know that there are a lot of technology service providers out there that are developing tools to assist in this area. We're fully expectant that there will be technology solutions to help firms sort through this requirement.
Ian Tam: In terms of creating a shelf of products, is the expectation that every single security on that shelf will need a KYP analysis? Or can they be lumped together, like Canadian equity mutual funds as a group, for example?
Debra Foubert: We've built in flexibility for a firm to set up a KYP process that's tailored to the type of securities being considered, how complex they are and what the risks are. The firm will have the ability to determine the extent of the assessment, the approval and the monitoring process. A security-by-security process will not be required in all circumstances. The firm is going to have to decide what they're going to do based on the nature of the securities being considered, and what an appropriate process will be, and they must document it.
Ian Tam: Must the registrant rely on full form regulatory documents with a fund prospectus or fund facts? Or are they able to take inputs from third-party sources like research or data providers?
Debra Foubert: We expect firms will provide advisors with the necessary information and the tools to understand the products that they're able to offer. The CFRs don't prescribe specific documents that must be looked at in order to discharge this KYP obligation. But of course, regulatory documents can be relied upon. And the firm can assess other sources that they feel are reliable that can allow the advisors to help understand the securities that they recommend.
Ian Tam: What key responsibilities should fall on to the advisor versus the firm in order to avoid the duplication of work?
Debra Foubert: We expect that firms will set up a process that is not duplicative, because that doesn't help anybody. The firms will have the flexibility to determine the KYP process and what works best for their business model. The firm remains ultimately responsible for complying with the KYP requirements for the securities that they offer. But advisors will need to comply with their own individual KYP obligation to take reasonable steps to understand the securities that they recommend to the clients.
Ian Tam: Has the OSC considered the potential harm to clients from dealers addressing this regulatory requirement simply by cutting products off the shelf, and hence giving clients less selection in terms of fund specifically is the question?
Debra Foubert: When we were working on this requirement, our overarching expectation was that firms will maintain a product shelf that meets the needs and objectives of their clients, given their business model and the nature of the relationship they have. We expect firms will add products to their shelves that will better meet their clients' needs and objectives. We also expect that some products will be removed from the shelves once the firms closely review the products and determine that there may be other products that are more suitable for their clients and puts their clients' interests first.
Client Focused Reforms Part 3: Suitability
Ian Tam: Can you comment on the expectations for picking from a reasonable range of alternatives for the advisor in meeting their suitability obligation? What's considered reasonable?
Debra Foubert: At the start, you must make the suitability determinations. And the recommendation must be suitable for the client based upon the factors in which you have to consider a reasonable range of alternative recommendations to determine that the chosen recommendation really puts the clients' interests first. There is CP guidance on this on recognizing that the suitability recognizes that there is a reasonable range of alternative recommendations for our clients will depend on the circumstances, including the securities offered at the firm, and the degree of skill and proficiency of the representatives to the clients' particular circumstances.
It's important to note that you are only required to consider a reasonable range of alternative recommendations available to you at the firm at the time you make the suitability determination. Where the firm only sells proprietary products, you need to consider the proprietary product alternatives that are available to you through the firm. When you're considering individual equities among a large range that the firm makes available to clients, you need only consider a reasonable range of alternatives to discharge your obligations.
Ian Tam: In terms of the fund or managed product space, even within a firm's shelf, these can be fairly large universes of products. How could an advisor start narrowing it down to choose something that's reasonable?
Debra Foubert: What's going to drive the determination is the needs and objectives of the client. When you're going through the KYC, which is then supported by a KYP, to make the suitability determination, you're focused on what’s best for the client.
Ian Tam: What about equities?
Debra Foubert: We have an expectation that you'd use a similar process, to narrow down the range of alternatives that are available even when you're selecting from a larger group of securities that are offered on your firm shelf.
Ian Tam: Does concentration have to be assessed at account level or as an aggregate of all the client relationship as part of suitability?
Debra Foubert: The best course of action is to read the latest FAQs that we published in December. We provided a lot of additional guidance about the portfolio approach to concentration and liquidity factors. But a high-level summary is that suitability can't be determined on a trade-by-trade basis but must be determined based on the client's overall circumstances. And given the relationship with the client and the registrant and the services offered by the registrant, if a client has multiple investment accounts with the firm, in order to put the client's interests first, you must take into consideration whether a recommendation or a decision for one account would materially affect the concentration and liquidity of the client's investments across all the accounts. However, in the guidance, we have said, sometimes some of the accounts can be excluded or you can have different levels between the accounts. We're expecting people to use their professional judgment and align it with the client's expectations. But I would say, go and read the FAQs, because a lot of information is being provided there.
Client Focused Reforms Part 4: Conflict of Interest
Ian Tam: Would it be fair to say that if a firm that only offers proprietary product does not address conflicts that they cannot make a recommendation on that proprietary product?
Debra Foubert: Proprietary products almost always give rise to a material conflict of interest, which means that the firm must be able to demonstrate that they have addressed the conflict in the best interest of the client. We have put examples of a control or steps in the CP that firms can consider when making that assessment and that firms must complete their own assessment of the products that they make available to their clients to comply with the KYP obligations. They can't rely upon their affiliate just to discharge that obligation. It's going to be the responsibility of the dealer. One of the controls that we put in the companion policy was that to look at competitive alternatives to the proprietary products and make an assessment to see whether or not the proprietary product is equivalent, or if there needs to be changes made to the proprietary product.
Ian Tam: In the relationship disclosure information requirement, an advisor must disclose if she only deals in proprietary products. When she discloses that conflict, she does not necessarily have to show a study. The study comparing those products against the universe can be done at head office but does not have to be disclosed to the end client. Is that fair?
Debra Foubert: The relationship disclosure document is going to have to be clear as to the nature of the relationship. So, if a firm is only going to sell proprietary products, then they have to be clear, but they also have to talk about the impact of that and then how they have addressed the conflict in the best interests of the client. The main thing is, they have to be clear, it has to be understandable to the client and whatever tools that the firm thinks is best to make that clear, then they should consider that.
Ian Tam: Is consent of a conflict is not enough to address the conflict?
Debra Foubert: Correct. Disclosure alone isn't going to be enough, but disclosure in conjunction with a pre-trade or post-trade review and analysis is sufficient at that point.
Ian Tam: Can we get some clarification on delivery of conflict of interest disclosures before June 30?
Debra Foubert: We sent out an email blast to all Chief Compliance Officers (CCOs) and Ultimate Designated Person (UDPs), which outlines the practical approach to meeting the June 30 deadline. If you're a UDP and CCO, and you haven't received it, let me know. We understand the timing of statements and when things are being mailed out. We're trying to provide a practical solution. I suggest that you talk to your UDP or CCO to make sure they received the email. If they didn't, you can call me, and I'll resend it to you.
Ian Tam: Do expect that these conflicts of interest requirements will result in lower fees within proprietary products?
Debra Foubert: The firms need to assess and make sure that they are addressing conflicts in the best interest of the clients. I expect that firms will be looking at the products and costs because we do emphasize what the impact of the costs are on the client because we know the cost drives client outcomes. I think firms should take a hard look at that.
Ian Tam: Let's talk about compliance, enforcement and implementation.
Debra Foubert: Conflicts of interest are first. They will be implemented as of June 30th. The rest of the CFRs come into effect on December 31 of this year. There's no grandfathering provision. So, this means that the CFRs apply to all registrant operations as of the implementation date onward. You won't be able to make a distinction between the treatment of clients before implementation and after implementation. However, we recognize that the CFRs will require firms and individuals to make significant changes to their operations. For the first while, after implementations, we're going to be reasonable in our expectations and look for good faith efforts to comply. However, once the transition is over, of course, the normal compliance enforcement tools will be there. But as long as firms and individuals make a good faith effort to comply, to start, we will work with the firms and look through and make sure that we can help support the firms. But once that grace period is up, then it's going to be normal compliance actions.
Ian Tam: How will the enforcement approach from the OSC change after these requirements are implemented?
Debra Foubert: We already have tools in our toolbox to help us address non-compliance where we find it. We call it the compliance enforcement continuum. And we select the tools that are best suited along that continuum to fit the facts and circumstances of the situation. We will be going out doing compliance reviews. If we find that there's issues arising, we'll be publishing guidance and then, working with each individual firm to address any compliance deficiencies that we may identify.
Ian Tam: What are the penalties for non-compliance?
Debra Foubert: Well, they're the normal usual penalties. It's going to be a compliance activity, so which could include compliance deficiency reports, warning letters, imposition of terms and conditions on a registration. And in the most serious cases, suspension. I hope we don't get there.
Ian Tam: What should sales staff fund companies consider to better work with advisors?
Debra Foubert: Registrants are required to comply with the Client Focused Reforms. Sales staff that fund companies can support the registrants by providing information about their products. But obviously, ultimately, that's the registrant that has to comply and determine what information they need to be able to meet their KYC KYP suitability and then address conflicts in the best interest of the clients as well.
Ian Tam: Do you foresee these changes forcing smaller dealers or advisors to consolidate?
Debra Foubert: The short answer is no. I mean, there are plenty of small firms that are already meet or exceed best practices that are codified in the Client Focused Reforms. It's not the right premise to say that smaller firms can't be held to the same standard of conduct compared to the large firms. We've developed the Client Focused Reforms to be scalable to apply to different business models.
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