A chapter in the Canadian Securities Administrators' long drawn-out mutual fund "embedded commissions" project ended with the publication on February 20, 2020 of amendments to National Instrument 81-105 Mutual Fund Sales Practices. These amendments will ban the compensation practices associated with the distribution of deferred sales charge and "low load" (DSC) securities in Canada (other than in Ontario) effective June 1, 2022. On the same date, the Ontario Securities Commission (OSC) released proposed OSC Rule 81-502 Restrictions on the Use of the Deferred Sales Charge Option for Mutual Funds, which outlines its proposed approach to permit certain DSC sales and associated sales practices to continue. The proposed OSC Rule is out for comment until May 21, 2020, and if adopted, would significantly restrict the availability of the DSC sales option in Ontario on and after June 1, 2022.
While the CSA will continue to permit DSC securities (including low load) to be sold, and the associated compensation practices to continue until June 1, 2022, the CSA appear to suggest that the supersized conflicts of interest provisions that come into force on December 31, 2020 provided in National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations, will restrict those practices due to the conflicts of interest they create for dealers and their representatives and the need for those conflicts to be managed in the best interest of clients. The CSA explain that they will entertain applications from dealers for an exemption from those provisions, on the condition that the existing conflicts of interest rules continue to be complied with. We are working to understand this statement by the CSA, given that the implementation of the new conflicts of interest rules do not, in our view, necessarily mean that there will be insurmountable conflicts of interest associated with DSC compensation practices.
The CSA also indicate that they will not be requiring any adjustment to the redemption schedules agreed to be paid by clients acquiring DSC securities – those redemption schedules will be allowed to run their course, even if they extend past June 1, 2022.
The OSC's proposed restrictions will affect investment fund managers and dealers in a number of respects. Fund managers will be required to establish DSC securities as a separate series or class of a mutual fund (rather than as a purchase option alongside other purchase options in the same series or class of the fund). These DSC securities must have the following features:
- A maximum DSC redemption schedule of three years.
- Investors must be able to redeem up to 10% of the value of their investment without redemption fees annually, on a cumulative basis.
- No redemption fees can be levied for investors facing certain financial hardship exceptions, such as death of the investor, involuntary loss of full-time employment, permanent disability and critical illness. We note that this feature is described by the OSC as a dealer restriction, but it will be more clearly a feature of the fund itself, given that a dealer does not have any ability to waive redemption fees payable to a fund manager.
- Managers will be permitted to pay upfront commissions on new investments only and not on amounts transferred within the client's account to a new security. No commissions will be paid on reinvested distributions.
Dealers will be required to abide by the following restrictions:
- No sales of DSC securities to clients who are aged 60 and over.
- Only clients with account sizes of less than $50,000 may acquire DSC securities.
- No sales of DSC securities to clients whose investment time horizon is shorter than the DSC redemption schedule.
- No sales of the DSC securities to clients who intend to use borrowed money to finance their purchase.
- No receipt of commissions in the circumstances described above.
Some fund managers have taken steps to cease offering DSC options for any new sales. For those managers that continue to offer DSC securities, they will need to include specified disclosure in fund prospectus documents, particularly in 2021 and 2022, as the effective date of the ban and the Ontario restrictions draws near. It remains to be seen if it will be operationally feasible for fund managers to continue to offer DSC securities for sale in Ontario after the ban takes effect elsewhere in Canada, given the need to create a separate series and the other restrictions that will apply to the funds and to the dealers distributing these securities.
The final chapter in the CSA's "embedded commissions" fees project is still being written – we expect to see amended rules designed to implement the ban on trailing fees being paid to discount brokers later in 2020. These rules are expected to be national in scope.
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