The Canadian Securities Administrators (CSA) have published for comment a much-anticipated consultation on the client-registrant relationship and the appropriateness of introducing a regulatory best interest standard. CSA Consultation Paper 33-404 Proposals to Enhance the Obligations of Advisers, Dealers, and Representatives Toward Their Clients (CSA Consultation Paper 33-404) describes proposed targeted amendments to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (31-103) and its Companion Policy. In addition, CSA Consultation Paper 33-404 describes a framework for a regulatory best interest standard on which all CSA jurisdictions, except British Columbia, are consulting. Comments on CSA Consultation Paper 33-404 will be accepted until August 26, 2016.
Proposed Targeted Reforms
The proposed targeted reforms to 31-103 are comprehensive and range from enhanced conflict of interest disclosure and know your client and know your product requirements to increased proficiency requirements. The Companion Policy to 31-103 would also be amended to include detailed guidance relating to these requirements. In the CSA’s view, the proposed targeted reforms are merely explicit statements of existing registrant obligations that are necessary to meet the CSA’s current expectations for regulatory compliance in the following areas:
- Conflicts of interest. 31-103 would be amended to require that firms and representatives respond to conflicts of interest in a manner that prioritizes the interests of the client ahead of the interests of the firm and/or representative. In addition, firms and representatives would be required to have a reasonable basis for concluding that a client fully understands the implications and consequences of a disclosed conflict.
- Know Your Client (KYC) Requirements. Additional “client-centred information” would be required as part of a KYC process that ensures a thorough understanding of the client. Such additional “client-centered information” relates to the three key elements of the KYC obligation, namely the client’s: (i) investment needs and objectives, (ii) financial circumstances, and (iii) risk profile. Registrants would also be required to take reasonable steps to update their clients’ KYC information and forms at a minimum annually and more frequently where there are material changes affecting the client or the client’s portfolio.
- Know Your Product (KYP) Requirements. Enhancements to the KYP obligations would include requirements for representatives to understand his or her firm’s products in comparison to other products on the firm’s product list and requirements for the firm to ensure that there are adequate policies and procedures, training tools, guides etc. to enable representatives to comply with the KYP obligation. Firms with a “mixed/non-proprietary product list” would be required to select the products they offer based on policies and procedures that include a “fair and unbiased market investigation of a reasonable universe of products” and a product comparison and optimization process.
- Suitability Obligation. Prior to recommending or accepting a client instruction regarding a securities transaction, a registrant would be required to assess three forms of suitability: (a) basic financial suitability; (b) investment strategy suitability; and (c) product selection suitability (including the impact of registrant/third party compensation on performance). Suitability analyses would have to be performed on a transaction-by-transaction basis and at least annually or more frequently as the circumstances warrant.
- Relationship Disclosure. Firms would be required to disclose the actual nature of the client-registrant relationship in “easy-to-understand” terms. Firms would also be required to disclose whether they offer proprietary products only or a mix of proprietary and non-proprietary products. There would also be an additional requirement for mutual fund dealers, exempt market dealers, scholarship plan dealers and restricted dealers/advisers to disclose to their clients that they only offer a limited range of products and that the suitability analysis performed by the registrant is limited accordingly.
- Proficiency. 31-103 would be amended to impose increased proficiency requirements for representatives, including requirements that all representatives must generally understand the basic structure, features, product strategy, costs and risks of all types of securities and how product costs and investment strategies can impact outcomes, and a new continuing education requirement for representatives.
- Titles. The CSA is proposing that 31-103 explicitly prescribe uniform client-facing business titles for representatives. CSA Consultation Paper 33-404 presents three alternatives for consideration.
- Designations. 31-103 would be amended to prescribe the designation that representatives may use when dealing with clients. In addition, firms would be required to have policies and procedures that provide guidance and restrictions on the designations representatives may use.
- UDP and CCO Roles. Amendments to 31-103 would clarify UDP and CCO roles. UDPs and CCOs would reinforce compliance responsibilities and obligations specifically related to managing conflicts of interest and compliance with the suitability obligation.
- Statutory Fiduciary Duty. Securities legislation in British Columbia, Saskatchewan, Ontario, Québec, Nova Scotia, Prince Edward Island, Nunavut, Yukon and the Northwest Territories would be amended to introduce a statutory fiduciary duty for registrants when managing an investment portfolio for which a client has granted discretionary authority.
Carve-outs for “Institutional Clients”
Significantly, registrants dealing with “institutional clients” (a new term that is proposed to be defined in the Companion Policy to 31-103) would be subject to relief from certain proposed requirements. Specifically, the proposed changes relating to the following would not apply: (i) suitability and KYC requirements; (ii) the requirement to identify the registrant’s product list as proprietary or “mixed/non-proprietary”; and (iii) the requirements relating to client-facing titles. In respect of conflicts of interest between a registrant and an “institutional client”, disclosure of that conflict by itself may be adequate if the conflict is not obviously contrary to the interest of the institutional client.
Regulatory Best Interest Standard Proposal
All CSA jurisdictions, other than British Columbia, are also consulting on the introduction of a proposed regulatory best interest standard. The new standard would require that a registered dealer or adviser and its representatives “deal fairly, honestly and in good faith with its clients and act in its clients’ best interests”. The conduct expected of a registrant in meeting the standard of care would be that of a “prudent and unbiased firm or representative (as applicable), acting reasonably”. The CSA expressly note that the regulatory best interest standard is not intended to be a “restatement or formulation of a fiduciary duty” on the part of registrants. Rather, it would be a “regulatory conduct standard” for registrants based on five key guiding principles:
- Acting in the best interests of the client;
- Avoiding or controlling conflicts of interest in a manner that prioritizes the client’s best interests;
- Providing full, clear, meaningful and timely disclosure;
- Interpreting law and agreements with clients in a manner favourable to the client’s interest where reasonably conflicting interpretations arise; and
- Acting with care.
Differences of Opinion among Securities Regulators on the Best Interests Standard
CSA Consultation Paper 33-404 spells out clear differences of opinion among the regulators on the advisability of introducing a regulatory best interest standard over and above the targeted reforms to 31-103.
Ontario and New Brunswick are in Favour of the Best Interests Standard
The regulators in Ontario and New Brunswick are of the view that the introduction of the new best interests standard would serve as an overarching governing principle of interpretation of more specific regulatory requirements. In their view, it would also help to “close the expectation gap” created by the fact that “most investors incorrectly assume that their registrants must always provide advice that is in their best interest”. It would represent a “more objective, client-centred standard of care” and help codify the regulator’s expectations of a “sound ‘tone from the top’”.
Ontario and New Brunswick are the only jurisdictions currently strongly in favour of the best interest standard.
Québec, Alberta, Manitoba and Nova Scotia are Consulting on the Best Interests Standard but have Expressed “Strong Reservations”
Significantly, the regulators in Québec, Alberta, Manitoba and Nova Scotia express “strong reservations” regarding the imposition of a regulatory best interest standard. These reservations include the concern that the standard might exacerbate, rather than reduce, the “expectations gap” and create legal uncertainty, including in interpreting existing fiduciary standards in some jurisdictions for certain portfolio managers and investment fund managers. They further argue that the implementation of the CSA’s CRM2 and Point of Sale initiatives, which are designed to enhance the client-registrant relationship around costs and investment performance, should be measured before layering on a best interest standard.
British Columbia is not consulting on the Best Interest Standard
British Columbia is the only Canadian jurisdiction that is not consulting on the regulatory best interest standard. The British Columbia Securities Commission (BCSC) suggests that the focus should be on the proposed targeted reforms because those reforms specifically and directly address the difficulties identified in the registrant-client relationship. According to CSA Consultation Paper 33-404, the BCSC takes the view that a regulatory best interest standard may worsen one of the challenges of the registrant-client relationship, that being overreliance and misplaced trust by clients on registrants.
A Word from IIROC
The Investment Industry Regulatory Organization of Canada (IIROC) has expressed support for the CSA initiative to better align the interests of registrants and their clients. On April 6, 2016, IIROC published IIROC Notice 16-0068 Managing Conflicts in the Best Interest of the Client (Notice 16-0068). Notice 16-0068 confirms IIROC’s intention to strengthen compliance by IIROC dealer members with the best interest requirements of Dealer Member Rule 42 – Conflicts of Interest, with a particular focus on the management of compensation-related conflicts.
According to Notice 16-0068, IIROC will immediately enhance its compliance test procedures to “more closely examine compensation grids, supervisory oversight of advisors recommending products with high commissions, and the monitoring of advisors approaching compensation thresholds”. IIROC will also conduct a survey of dealer members to gather information on oversight and monitoring of compensation-related conflicts of interest and conduct targeted examinations of dealer members following up from the survey. Possible rule amendments are contemplated.
It is arguable whether the CSA’s concerns and conclusions are well-founded in the research and whether further regulation as set out in CSA Consultation Paper 33-404 will address these concerns. We expect that there will be a great deal of discussion on these proposals as market participants submit comments on CSA Consultation Paper 33-404.
CSA Consultation Paper 33-404 follows the publication of CSA Staff Notice 33-316 Status Report on Consultation under CSA Consultation Paper 33-403: The Standard of Conduct for Advisers and Dealers: Exploring the Appropriateness of Introducing a Statutory Best interest Duty when Advice is Provided to Retail Clients in December 2013 and, prior to that, in October 2012, CSA Consultation Paper 33-403 The Standard of Conduct for Advisers and Dealers: Exploring the Appropriateness of Introducing a Statutory Best Interest Duty When Advice is Provided to Retail Clients. As noted above, CSA Consultation Paper 33-404 is open for comment until August 26, 2016.