The Canadian Securities Administrators' ("CSA") long-standing initiatives to deal with the investor protection issues they consider associated with today's retail client-registrant relationships and current methods of mutual fund compensation finally coalesced with the June 21 release of two significant publications:
- CSA Notice and Request for Comment Reforms to Enhance the Client-Registrant Relationship (Client Focused Reforms) Proposed Amendments to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations and Companion Policy 31-103 CP (NI 31-103 Reforms) and
- CSA Staff Notice 81-330 Status Report on Consultation on Embedded Commissions and Next Steps (the Mutual Fund Fee Reforms).
Both of these projects are entering their sixth year of intensive regulatory analysis and review. Both arise out of principled concerns expressed by the CSA that the status quo is not serving retail investors appropriately, which requires changes to be made.
Although this is the first publication of actual draft amendments to NI 31-103 and the Companion Policy, the NI 31-103 Reforms are the third version of the CSA's proposals. It is clear that the CSA have considered the many thoughtful comments which were provided on the previous proposals and have made fairly significant — and, in our view, some positive — changes. Some of the earlier proposals from the April 2016 publication, including the most controversial, have been shelved for further consideration and review, either concurrently while moving forward with the NI 31-103 Reforms or at an indefinite future date. These include:
- A "regulatory" best interest standard for all registrants will no longer be pursued and will not be considered further, at least as long as the CSA see that the NI 31-103 Reforms "achieve the outcomes they are seeking for investors". However, the CSA use the term "best interests of the client" liberally throughout the NI 31-103 reforms.
- Proficiency requirements for registrants and their representatives will be developed in a separate track.
- Titles and designations, including the use of the word "advisor", will also be considered in a separate track, although we note that the NI 31-103 Reforms touch on titles and designations.
- Imposing a "statutory" fiduciary duty for discretionary asset/portfolio managers will be developed in those provinces where one does not already exist.
- Clarifying the role of Ultimate Designated Persons and Chief Compliance Officers will be considered in a separate track.
Comments are due on the NI 31-103 Reforms by October 19, 2018.
The CSA also signaled their policy direction in respect of the Mutual Fund Fee Reform project. Three significant reforms are proposed:
- Expanded conflict of interest guidance around the payment of "embedded commissions" by investment fund managers and the receipt of such commissions by dealers and their representatives. This is provided for in the NI 31-103 Reforms.
- A proposed prohibition on all forms of deferred sales charges in connection with the purchase of publicly offered mutual fund securities.
- A proposed prohibition of trailing commissions payable to discount (or "order execution only") dealers in respect of their distribution of mutual funds.
The Mutual Fund Fee Reforms are not being published for comment at this time. The CSA will publish draft rules for comment, which are expected to be released in September 2018.
Notably, the CSA also explain their support for the MFDA/IIROC work to expand disclosure to investors about the cost of ownership of mutual funds (total costs, inclusive of management fees). We anticipate that more information will be released surrounding the concepts in the MFDA's discussion paper, which was published for comment on April 19, 2018.
NI 31-103 Reforms: Supersizing Existing Regulation and Regulatory Guidance
The NI 31-103 Reforms generally either incorporate SRO regulation and regulatory concepts or expand on them and apply them to all registrants. The CSA have also codified "best practices" as promulgated by CSA staff in earlier publications and compliance audit findings. In many cases, the regulation and concepts have been so supersized that we have significant concerns about their practicality and reasonableness, and regard some of them as creating nearly impossible standards of perfection for firms and their representatives.
The reforms are said to be "client-focused reforms" that are designed to encourage firms and their representatives to put the interests of the retail client before any other consideration relevant to the client-registrant relationship. This is a very admirable goal and one with which we, and presumably all registrants, would agree. We do not, however, necessarily agree with the extent to which it has been proposed that today's regulation be amended. Specifically, a number of the proposals may lead to unintended consequences, including narrowing the choices of investment service providers available to investors and the selection of investments offered by those service providers. Our preliminary observations also include the following:
- While the CSA have explained they intend for the proposals to be "scalable" to the size and business of a particular firm, and not "one size fits all," we remain concerned about this issue particularly since not all of the rules/guidance should (or will) apply to the business of all firms. No doubt, further issues about the reforms will be flushed out in the coming weeks and months.
- It is clear that if the NI 31-103 Reforms come into force, much work will need to be done by the SROs (IIROC and the MFDA) to bring their rules into conformity. From the industry's perspective, the NI 31-103 Reforms will necessitate a re-examination of business models and the services and securities made available to the public, in addition to a complete review and overhaul of compliance, books and records and training systems for all registrants.
- It will be important to consider and comment on the proposed transition timing. Most of the new rules/guidance are projected to come into effect two years from the coming into force of the final amendments. Given the minimum amount of time required for rule-making, this translates into 2021 at the earliest. Below we have outlined which rules have a shorter proposed transition.
- We recommend that registrants review the Regulatory Impact Analysis of the Reforms prepared by the Ontario Securities Commission, which can be found in Annex E in the June 21 publication by the OSC. In it, the OSC explains its views on the expected impact, as well as the reasons for the various proposals, in ways that may not be apparent from reading the CSA Notice and the actual proposed reforms.
Overview of Significant Proposals
The most significant proposed NI 31-103 Reforms are summarized below, along with some of our views on their implications. We note that in most cases, the proposed new rules are concise; it is the guidance forming the CSA policy provided in the Companion Policy that is often lengthy and can be expected to give rise to the most significant issues. Our summary is intended to highlight the proposals. We will continue to consider these proposals, together with our clients, over the coming weeks.
New training obligation for registrant firms: Firms will be required to provide training (which can be outsourced) to representatives on compliance with securities regulation, as well as on the securities available through the firm, including the "structure, features, returns and risk, and the initial and ongoing costs and the impact of those costs" of those securities. The training program will be expected to be in writing and the effectiveness of such training programs must be "tested" periodically. Specific training is expected to focus on identifying conflicts of interest and how to put a client's interests first when making suitability determinations. Firms will be required to carry out their own analysis of all securities they recommend and provide product training to their representatives.
New books and records and policies and procedures requirements: Firms will be required to document how they provide training to their representatives; how they address various identified conflicts of interest in the "best interests of clients"; their sales practices, compensation arrangements and incentive practices; and, how they comply with the new "misleading communications" prohibitions and their duty to provide specific information to clients. All of the new increased requirements must be reflected in revised and updated policies and procedures.
Supersized Know Your Client (KYC) Requirements: In addition to taking reasonable steps to establish the identity of clients, and verifying there is sufficient information about a client's investment needs and objectives, a registrant will be required to ensure it has sufficient information about a client's personal circumstances; financial circumstances; investment knowledge; risk profile; and investment time horizon. These are SRO concepts which have been expanded to apply to all registrants. All KYC information must be reviewed (i) by the registrant if the registrant knows, or reasonably ought to know, of a significant change in the client's information, (ii) by the registrant, no less than every 12 months for discretionary managed accounts, (iii) by EMDs, within the previous 12 months before making a trade or recommendation to the client, and (iv) for all other accounts, by the registrant no less than once every 36 months.
There is significant guidance provided on the various elements of KYC in the Companion Policy. In particular, the CSA explain that they will expect firms to develop a process for determining the subjective elements of KYC and how to identify (and what to do in respect of) "significant changes" in client circumstances. Clients will be expected to endorse the KYC information by their signature or through notes in the client file. The CSA acknowledge that the depth to which KYC information will be requested for any client will depend on the nature of the services provided by the registrant, with the most extensive requirements being suggested for discretionary managed accounts. In most cases, there is also some suggestion that registrants should not simply rely on the client's word for the information — there are expectations that registrants will ask probing questions and request further information as a follow-up. Certainly there is an expectation that a simple KYC form completed by clients and taken at face value will no longer be acceptable.
Supersized Know Your Product (KYP) Requirements: The components of expanded KYP on registered firms will include: a requirement that a firm only make a security available to its clients once it has taken reasonable steps to understand the security, including "how the security compares to similar securities available in the market"; approval of the security; and, monitoring and assessing the security on an ongoing basis.
Representatives will have their own KYP obligations, including: a requirement to have taken reasonable steps to understand the initial and ongoing costs of the security; and, the impact of those costs. Representatives must not buy, sell or recommend a security unless they take "reasonable steps" to understand "at a general level" the securities that are available at the firm and how they compare. The firm must ensure that representatives have the necessary information about each security approved by the firm to meet their obligations.
KYP requirements will apply to securities before they are permitted to be transferred into the firm by the client from another firm. Notably extensive KYP expectations regarding proprietary products ("related and connected issuers") is provided. It is clear that a proper KYP process will involve understanding how a particular approved security generally compares to similar securities in the marketplace, which includes approved proprietary products. KYP guidance is extensive, as are the CSA's expectations for both firms and representatives. Training programs will be closely tied to the KYP expectations.
Supersized Expectations for Carrying Out Suitability Determinations: The expanded rules around suitability will require a registrant to determine that an "investment action" on behalf of a client, including the opening of an account, is suitable for the client based on: the KYC information; the registrant's KYP understanding; features and costs of the account; the impact of the action on the client's account (including concentration and liquidity considerations, across all of the client's accounts with the registrant); potential and actual impact of costs; and a consideration of reasonable alternatives.
In addition to the above noted points, any specific action must also "put the client's interest first." Duty to warn obligations are included. There are increased expectations that suitability will be determined on an ongoing basis, including when the registrant becomes aware that a security or the account no longer meets the client's suitability criteria. Permitted clients may still waive the suitability determination, unless they have established a managed account with the registrant.
There is much proposed guidance provided in the Companion Policy on CSA expectations for registrants to meet the expanded suitability expectations. By way of example, the firm will be expected to have policies and procedures to demonstrate the suitability process is consistently applied across the firm and procedures to calculate, monitor and manage concentration risk in a client's portfolio including thresholds. The bottom line is that the CSA will expect registrants to be able to demonstrate that a particular action for a client was made in a way that put the client's interest first. The CSA explain that they will monitor how registrants carry out suitability by looking at what "a reasonable registrant" would have done under the same circumstances.
Supersized Expectations for Identifying and Managing Conflicts of Interest: Under existing rules, material conflicts of interest must be identified (existing and potential conflicts). The new rules will require all conflicts (not simply "material" conflicts), including those that are "reasonably foreseeable," to be catalogued and managed in "the best interests of the client." If the conflict cannot be managed in the best interests of the client, it must be "avoided" [prohibited]. Conflicts must be disclosed to clients, but registrants may not rely solely on disclosure to address conflicts in the best interests of the client. The guidance provided on identifying and addressing conflicts of interest is very broad and extensive. It generally depends on firms establishing well-defined processes, without much guidance being provided on specific conflicts or how those processes should be implemented. Conflicts arising from compensation received from third parties, from internal incentive programs and that arise from offering proprietary products to clients, are specifically called out.
Further clarity is necessary from the CSA about expectations on disclosure to investors regarding compensation, given the discussion in the Companion Policy that a registrant (which would include a representative) "must disclose any commissions or other compensation that they will be receiving in respect of the transaction". It is unclear whether this means that a representative (rather than the firm) must disclose his or her compensation received from the firm; this would be a significant expansion of current CSA and SRO expectations. Specific guidance is provided that "registrants must not recommend a product or service just because it pays them better than other alternatives". Presumably, a registrant could document and demonstrate other factors; however, this remains unclear. A specific conflicts disclosure document is recommended in order to comply with the requirement to disclose conflicts.
New Restrictions on Referral Arrangements: Referral fees may not be paid to a non-registrant, although non-compensated referrals from non-registrants will continue to be permitted. Referral fees cannot be paid for more than 36 months and the referral fee cannot exceed 25 percent of the fees and commissions collected from the client by the party who received the referral. Clients must not bear increased fees or commissions due to any referral fees being paid. It is proposed that the referral fee restrictions would come into force immediately upon the implementation of the new rules, but that existing arrangements could continue for three additional years before having to comply with the new rules.
We anticipate that these restrictions will be problematic for many in the industry. The aforementioned OSC regulatory impact statement is instructive in understanding the rationale behind the CSA's proposals, so that alternatives to the proposals can be suggested as part of the comments on the reforms. The OSC identifies regulatory concerns around individuals giving up registration, and instead referring clients to registrants in exchange for a fee, but without their activities being subject to any regulatory oversight, among other things. Clarity is also needed around a sale of a book of business by a representative, when the selling representative receives consideration for that sale that depends on fees received by the purchasing firm from the client. It is not clear whether or not these consideration arrangements will be caught by the proposed restrictions on referral arrangements.
New Rules and Supersized Expectations for Disclosure and Holding Out: Notwithstanding that the CSA indicate that they will continue to work on a project around "titles and designations", new anti-"misleading communication" rules will serve to moderate titles of individual representatives. All titles must be approved by the firm, and "titles, designations, awards or recognitions" that are based partly or entirely on a registered individual's sales activity or revenue generation are prohibited. Registrants must not hold their services out in any manner that could reasonably be misleading in respect of qualifications or products and services provided. Any "corporate officer" title, such as president or vice-president, cannot be used, unless the individual has been appointed as a corporate officer under applicable corporate law. Other guidance on misleading communication is given, including when a firm exaggerates the products or services made available to clients. Firms offering services to retail clients must make certain information "publicly available" that will support informed decision-making by investors, who may be looking at available investment options. Expansions to the requirements to provide clients with relationship disclosure information (RDI) is also provided.
The NI 31-103 Reforms, coupled with the Mutual Fund Fee Reforms, are the outcomes of one of the most time-consuming and detailed review of existing regulation and industry practices we have ever seen. In addition to understanding the potential impact of the Reforms on your business, including on your representatives, it will be important to consider how you may need to change your business models and practices in order to comply with the new proposed requirements. We suggest that comments on the NI 31-103 Reforms — and on the Mutual Fund Fee Reforms (once published) — include an analysis of what these reforms mean to your firm, to your employees and representatives and to your clients. The Reforms are described as "client-focused reforms" and it will be important to signal what impact the Reforms will have on the service offerings and investment options you will make available to your clients.
For many years we have closely followed the path of the various reforms of registrant regulation, while being fundamentally involved in the discussions surrounding sales practices and incentives, mutual fund fees and disclosure.
We would be happy to discuss the ways you can learn about and analyze the reforms to determine the impact on your business. We plan to provide a comment letter on the NI 31-103 Reforms and, once published, the Mutual Fund Fee Reforms, as we have for every other publication on these topics. We would be pleased to work with you on providing comments.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.