Canada: Registrants Face Significantly Increased Obligations Under Proposed CSA Rule Amendments

Recently, the Canadian Securities Administrators (CSA) published for comment important rule amendments to National Instrument 31-103 Registration Requirements, Exemptions & Ongoing Registrant Obligations and Companion Policy 31-103CP (Targeted Reforms) that would significantly increase the obligations of all advisers and dealers and their representatives, including IIROC and MFDA members as well as investment fund managers (Registrants).

The Targeted Reforms will significantly impact the economics of existing Registrant business models and Registrant compliance costs and will affect the following key areas:

  • Conflicts of interest
  • Know your client procedures (KYC)
  • Know your product procedures (KYP)
  • Suitability
  • Relationship disclosure information (RDI)
  • Referral arrangements
  • Book & Records
  • Mandatory Training Programs

Comments on the Targeted Reforms can be made until October 19.

The CSA also published a related policy decision on mutual fund embedded commissions (Embedded Fee Policy) which, if adopted, would:

  • prohibit the payment of trailing commissions to dealers who do not make a suitability determination (i.e. discount or "order execution only" brokers);
  • prohibit all forms of the deferred sales charge option, including low-load options and their associated upfront commissions; and
  • implement, through the Targeted Reforms, enhanced conflict of interest mitigation rules and guidance for Registrants requiring that all existing and reasonably foreseeable conflicts of interest, including conflicts arising from the payment of embedded commissions, either be addressed in the best interests of clients or avoided.

The CSA had examined, by way of public consultations and commissioned studies, the option of discontinuing all forms of embedded commissions, but determined under the Embedded Fee Policy and the Targeted Reforms that only trailing commissions to discount brokers would be banned.

THE TARGETED REFORMS – PUTTING CLIENTS FIRST

The CSA proposed an earlier version of the Targeted Reforms in a 2016 CSA Consultation Paper (the 2016 Paper) which we summarized in a previous article. The 2016 Paper included a controversial proposal to introduce an overarching regulatory "best interest standard" which has been abandoned in the Targeted Reforms. The Targeted Reforms will nonetheless significantly  increase the obligations of Registrants in the areas summarized below and incorporate the "best interest" concept in the conflicts of interest and suitability reforms.

Conflicts of Interest

The Targeted Reforms would require Registrants (both firms and registered individuals) to take reasonable steps to identify all existing and reasonably foreseeable conflicts of interest, not only "material" conflicts as is currently the case.

Registrant firms are to identify and address conflicts between the firm, including each individual acting on the firm's behalf, and the client. Individual Registrants are to identify and address conflicts between the individual Registrant and the client, and promptly report that conflict to their sponsoring firm.

Under the Targeted Reforms, Registrants must address, in the best interest of the client, all conflicts of interest between itself and the client. In so doing, the Registrant firm and its registered individuals must put the interests of their clients first, ahead of their own interests and any other competing considerations. Registrants must address conflicts of interest by either avoiding those conflicts or by implementing controls sufficient to address the conflict in the client's best interest. Conflicts of interest that are not material can be addressed in a manner that is proportionate to the limited risk that such conflicts pose to affected clients, for example by establishing policies that limit gifts and promotional benefits received from third parties.

A Registrant must avoid any conflict of interest between itself and a client if the conflict is not, or cannot be, addressed in the best interest of the client. An individual Registrant is also prohibited from engaging in any dealing or advising activity in connection with a conflict of interest identified unless the conflict has been addressed in the best interest of the client and the individual's sponsoring firm has given the individual Registrant consent to proceed with the activity.

Registrants are expected to avoid particular conflicts if that is the only response that would be reasonable in the circumstances and consistent with the obligation to address conflicts in the best interest of clients. Registrants must avoid such conflicts even if that avoidance means foregoing an otherwise attractive business opportunity or compensation.

Subject to limited exceptions, certain conflicts of interest must be avoided altogether by Registrants, including those involving:

  • borrowing money from a client;
  • arranging a guarantee in relation to money the Registrant has borrowed;
  • borrowing securities or any other assets from a client;
  • lending money to a client;
  • providing a guarantee in relation to a loan of money to a client;
  • extending credit, providing margin or lending securities or any other asset, to a client; and
  • having control over the financial affairs of a client.

The Targeted Reforms expand existing conflict of interest disclosure requirements to all identified conflicts of interest that a reasonable client would want to know about. Disclosure must include, in addition to the nature and extent of the conflict of interest, the potential impact and risk that it may pose to the client and how it has been, or will be, addressed. The conflict of interest disclosure must be prominent, specific, written in plain language and must be made before opening an account for the client (if the conflict might be present throughout the relationship between the Registrant and the client) and when the conflict first arises, or before entering into a transaction that presents a conflict of interest.

Importantly, disclosure is not in itself sufficient to satisfy the obligation to address conflicts of interest in the best interest of the client. Under the Targeted Reforms, a Registrant is expressly prohibited from relying solely on disclosure to address, in the best interest of the client, conflicts of interest identified.

The Targeted Reforms also significantly expand the 31-103 CP guidance to NI 31-103, including to:

  • provide examples of controls Registrants might use when determining how to address conflicts in the best interest of clients
  • provide examples of Registrant conflicts of interest, including conflicts arising in connection with proprietary products, third-party compensation, internal compensation arrangements and incentive practices, fee-based accounts, referral arrangements, supervisory staff conflicts and conflicts between clients.
  • articulate the CSA's expectation that registered firms be able to demonstrate, in circumstances involving third party compensation, including embedded commissions, that both product shelf development and client recommendations are based on the quality of the security without influence from any third-party compensation associated with the security.

Know Your Client Obligations

The Targeted Reforms expand and prescribe the minimum KYC information that must be collected by Registrants to enable them to meet their suitability determination obligations. Registrants will be required to collect KYC information regarding the client's:

  • personal circumstances, including:

    • civil status or family situation
    • number of dependents
    • employment status
  • financial circumstances, including,

    • annual income
    • liquidity needs
    • financial assets, including a breakdown of any deposits, type of securities such as mutual funds, listed securities and exempt securities
    • net worth, including all types of assets and liabilities
    • whether the client is using leverage or borrowing to finance the purchase of securities.
  • investment needs and objectives

    • Registrants should consider setting out the investment return that would be required to meet the client's financial goals, taking into account their risk profile.
    • Registrants should take into account whether there are any other priorities, such as paying down high interest debt or directing cash into a savings account that are more likely to achieve the client's investment objectives and financial goals than a transaction in securities
  • investment knowledge

    • Registrants are expected to inquire about the client's level of awareness and previous investment experience and make further inquiries if the information provided by the client appears to be inconsistent with their level of investment knowledge.
  • risk profile
  • investment time horizon

    • Registrants are responsible to assess the feasibility and reasonableness of the client's stated investment time horizon.

The Targeted Reforms would also require Registrants to take reasonable steps to obtain clients' confirmation of the accuracy of their KYC information collected at account opening and when any "significant change" occurs. A significant change to a client's information includes changes to the risk profile, investment time horizon or investments needs and objectives, and changes that would reasonably be expected to have a significant impact on the net worth or income of the client.

A client's KYC information must be reviewed and updated, including

  • when the Registrant knows or reasonably ought to know of a significant change in a client's KYC information, and
  • in any event, at minimum intervals of
  • 12 months for managed accounts
  • within 12 months of making a trade or recommendation for exempt market dealers
  • 36 months for other accounts.

The CSA is also proposing significantly expanded guidance in 31-103CP with respect to KYC expectations. This expanded Companion Policy guidance includes discussions of

  • the CSA's expectations with respect to the establishment of a client's investment needs and objectives, taking into account the client's financial goals, as well as the development of the client's risk profile;
  • the ways a Registrant may tailor its KYC process to reflect its business model and the nature of its relationships with clients, and
  • the collection of KYC information using technology.

Know Your Product Obligations

The Targeted Reforms would impose explicit KYP requirements for Registrant firms and registered individual.

A Registrant firm would be required to

  • take reasonable steps to understand the essential elements of the securities it makes available to clients including the initial and ongoing costs of the security and the impacts of these costs, including how they compare with similar securities available in the market
  • approve the securities it will make available
  • monitor and reassess its approved securities

A Registrant firm would be made subject to a principles-based requirement to maintain an offering of securities and services that is consistent with how it holds itself out.

Registered individuals would be required to take reasonable steps to:

  • understand at a general level, the securities that are available for them to purchase, sell or recommend through their firm, and how those securities compare
  • thoroughly understand each specific security they purchase, sell or recommend to a client, including the impact of all of the costs associated with acquiring and holding the security.

Registered individuals must only purchase or recommend securities approved by their firm and registered firms must ensure that their registered individuals have the necessary information about each approved security.

The Targeted Reforms also introduce tailored requirements and exemptions relating to certain client directed trades and transfers, portfolio manager directed trades, and securities offered through order-execution-only services.

The CSA is also proposing significantly expanded guidance in 31-103CP with respect to the CSA's expectations as to how Registrants may meet their KYP obligations. The guidance is detailed and describes the CSA's views concerning the process of approving a security, product costs, compensation structures, the use of proprietary products, and the importance of taking related conflicts of interest into account.

Suitability Determination

The Targeted Reforms would significantly enhance suitability obligations and introduce a new requirement that Registrants must put their clients' interests first when making a suitability determination.

Enhanced suitability obligations would also include:

  • explicitly requiring registrants to consider certain factors, including costs and their impact, in making suitability determinations,
  • moving away from trade-based suitability to an overall portfolio-level suitability analysis, and
  • prescribing triggering events that will require a registrant to reassess suitability.

Under the Targeted Reforms, before a Registrant acts by opening an account for a client, purchasing, selling, depositing, exchanging or transferring securities for a client's account, taking any other investment action for a client or making a recommendation or decision to take any such action, the Registrant must determine, on a reasonable basis, that the action:

  • is suitable for the client, based on certain factors, including

    • KYC information
    • the registrant's understanding of the security
    • the features and associated costs of the account type
    • the impact on the account
    • portfolio-level concentration and liquidity
    • the analysis of the actual and potential impact of costs
    • available alternatives at the firm
    • any other relevant factor under the circumstances
  • puts the client's interest first

The Targeted Reforms also prescribe trigger events that will require Registrants to review a client's account and the securities in the account and take appropriate action, promptly after these events occur:

  • a new registered individual is designated as responsible for the client's account
  • a change in a security in the account
  • a change in the client's KYC information
  • the Registrant undertakes a required review or update of the client's KYC information
  • the Registrant becomes aware that a security in the client's account or the account does not meet the prescribed suitability criteria.

The CSA is also proposing expanded guidance with respect to the CSA's expectations as to how Registrants may meet their enhanced suitability obligations. In order to ensure that the suitability obligation has been met, the CSA's review will be undertaken on the basis of what a reasonable Registrant would have done under the same circumstances.

Relationship Disclosure Information

Under the Targeted Reforms, a Registered firm must make publicly available information that a reasonable investor would consider important in deciding whether to become a client of the firm, including general descriptions of:

  • the products, services and account types that it offers
  • any material limitations or restrictions on what is made available (e.g., minimum investments, qualified purchaser etc.)
  • charges and other costs to clients
  • any minimum account sizes or minimum charges
  • any third-party compensation associated with the firm's products, services and accounts

Third-party compensation is defined as any monetary or non-monetary benefit provided directly or indirectly by a party other than the registrant's client in connection with the client's purchase or ownership of a security through a registrant.  In 31-103 CP, the CSA states that third party compensation is, in and of itself, a conflict of interest.

The Targeted Reforms would require a Registrant firm to disclose whether:

  • the firm will primarily or exclusively use proprietary products in the client's account
  • there are any restrictions on the products or services the registrant will provide to the client

The Targeted Reforms also introduce a new requirement to explain the potential impact of each of the following on a client's investment returns:

  • operating and transaction charges
  • embedded fees
  • having access to only a limited range of products or services.

The CSA has also proposed additional guidance in the Companion Policy, setting out its expectations as to how registrants can satisfy the new RDI obligations under the Targeted Reforms. Registrants are expected to present disclosure information to clients in a clear and meaningful way in order to ensure they understand the information presented, which is consistent with Registrants' obligation to deal with clients fairly, honestly and in good faith.

Referral Arrangements

Under the Targeted Reforms, a referral fee must not

  • continue for longer than 36 months
  • constitute a series of payments that together exceed 25% of the fees or commissions collected from the client by the party who received the referral
  • increase the amount of fees or commissions that would otherwise be paid by a client to that registrant for the same product or service.

In addition, the Targeted Reforms prohibit payment of a referral fee by a Registrant unless:

  • the party receiving the fee is also a Registrant
  • the terms of the referral arrangement are set out in a written agreement between the firm, and the other party to the referral
  • the registered firm records all referral fees
  • the registered firm ensures that the referral arrangement information prescribed by NI 31-103 has been provided to the client in writing.

BOOKS & RECORDS

The Targeted Reforms provide for specific, detailed requirements and guidance on the records a registered firm is expected to keep in relation to its sales practices, compensation arrangement and incentive practices and those from which the firm, its registered individuals or any affiliate or associate of the firm benefit.

MANDATORY TRAINING PROGRAMS

The Targeted Reforms will require registered firms to develop, implement and maintain training programs that will provide their registered representatives with training in relation to the following:

  • compliance with securities legislation, including,

    • conflicts of interest requirements,
    • KYC and KYP obligations, and
    • the obligation to make a suitability determination, and
  • in the case of dealers and advisors only, prescribed elements of the securities that are available through the registered firm, including the structure, features, returns and risk and ongoing costs, and the impact of those costs.

EXEMPTIONS

The Targeted Reforms would not apply in the following situations:

  • for Registrants dealing with certain permitted clients, the Targeted Reforms relating to suitability and KYC requirements would not apply
  • for registrants dealing with clients in the context of order-execution-only ("discount brokerage services"), and portfolio manager directed trades, suitability and related KYP requirements would not apply
  • for registered investment fund managers, conflicts of interest obligations would not apply in respect of investment funds that are subject to National Instrument 81-107 – Independent Review Committee for Investment Funds.

IMPLEMENTATION OF TARGETED REFORMS

The CSA is considering a phased implementation schedule for the final Targeted Reforms as follows:

  • Referral arrangements: immediately upon coming into force, or 3 years for pre-existing arrangements
  • RDI: 1 year to provide publicly available information under new requirement and 2 years for the other new requirements
  • KYC, KYP, suitability and conflicts of interest: 2 years.

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