With the release of Consultation Paper 33-404 Proposals to Enhance the Obligations of Advisers, Dealers and Representatives Toward Their Clients on April 28, 2016, the Canadian Securities Administrators have embarked on a consultation regarding proposed regulatory changes that would touch virtually every aspect of business that is carried on in Canada by registered dealers and advisers and their registered representatives. Although the Consultation Paper continues to be consultation only in that it is not a proposal to amend National Instrument 31-1031 at this time — the CSA provide detailed explanations as to a number of key rule changes they are considering and have attached the form of detailed guidance (presumably destined for the companion policy to NI 31-103) for each of the specific areas. The CSA invite comments on the matters discussed in the Consultation Paper by August 26, 2016, with a request to respond to 68 different questions outlined in the Consultation Paper. The Consultation Paper is available here.
The Consultation Paper explains the perceived need for continued regulatory reform in the area of registrant conduct and compliance, as well as the proposals of the CSA, which are described as "targeted reforms". Unlike the Consultation Paper released in October 2012, which focused primarily on the need for a "statutory" best interest duty when registrants deal with retail clients in more academic and theoretical terms2, the 2016 Consultation Paper outlines the various pieces of research conducted by the CSA and by others that have lead them to the conclusion that "the status quo must change", as well as discusses 11 specific regulatory initiatives and enhancements that they suggest are necessary to achieve a fairer result for Canadian investors.
Significantly, the CSA are unanimous on the need for change, as well as what must be done in 10 of the 11 areas of proposed regulatory change. The 11th initiative relates to the proposal to implement a "regulatory" best interest standard. Significant disagreement exists amongst members of the CSA regarding the necessity for this standard. The British Columbia Securities Commission has expressly concluded that a regulatory best interest standard is not desirable, particularly if the other 10 regulatory elements are implemented. CSA members, other than the Ontario Securities Commission and the New Brunswick Securities Commission, are taking a "watch and wait" approach before committing to implementing such a standard, and the Alberta, Manitoba, Québec and Nova Scotia securities regulators, in addition to the BCSC, have "serious reservations" regarding the benefits of such a standard. Only the OSC and the NBSC are in favour of implementing the form of best interest standard described in the Consultation Paper, in addition to the other initiatives.
The CSA appears motivated to implement some or all of the regulatory changes discussed without necessarily waiting to see the impact of the mutual fund "point of sale" Fund Facts delivery rules coming into force on May 30, 20163 or the CRM-2 regulatory changes, the last elements of which come into force on July 15, 20164, although the CSA explain they have commenced the processes to determine how to measure and research the impact of those initiatives. However, the timelines for any of the Consultation Paper regulatory changes are unclear and the CSA explain that they are already focusing compliance initiatives on conflicts management, including compliance sweeps "to target incentives that may favour the sale of one family of funds over another".
There is no discussion of the next steps that are being considered for the 2012 CSA Consultation Paper 81-407 Mutual Fund Fees other than in passing and to describe the follow-on research commissioned by the CSA/OSC in that regard. Throughout this 2016 Consultation Paper are references to the continued receipt of trailing commissions and other incentives paid to dealer firms by fund managers, however, we understand that a separate group at the CSA continue to consider issues around mutual fund fees and we may see some developments on this front shortly.
It will be critical that firms and representatives consider the potential impact of the regulatory changes being considered by the CSA and join in the process (either directly or through the various trade associations) to help mold the direction of any rule and policy changes. The regulatory changes are extremely ambitious and have potentially significant implications for firms carrying on an advisory business model, including advisory models involved in the sale of proprietary products. Considerations of the financial services industry include whether the CSA's proposals are capable of practical, cost-effective implementation, with a viable means of achieving the CSA's stated objectives, as well as their effects on the overall market-place and availability of advice for Canadians. It will also be important to focus on transition timing for any of the regulatory changes, which are not addressed.
The lines between "trading" and "advising" on securities, which is the backbone of our current securities regulatory regime will be even more blurred if these proposals are adopted, with registrants being held to very high standards, although no changes are being proposed to the specific categories of registration. The changes are being proposed to all categories of registration, although there is some appropriate recognition that the business of exempt market dealers, scholarship plan dealers, as well as order execution-only brokers (discount brokers) warrant some tailored regulation.
We note that the CSA recognize that two self-regulatory organizations regulate investment dealers and mutual fund dealers, but also that the CSA expect those SROs will amend their rules to conform to any amendments the CSA make to NI 31-103. This approach is consistent with the approach taken by the CSA with the SROs in their implementation of the CRM-2 changes.
The 10 (unanimous) areas of regulatory change proposed by all members of the CSA (described as "targeted reforms") are as follows.
- Conflicts of Interest — Firms and representatives will be expected to catalogue conflicts of interest and determine how each conflict of interest will be managed in a way that "prioritizes" the interests of the client ahead of the interests of the firm and/or representative. Although disclosure continues to be considered important and enhanced disclosure is recommended, disclosure to clients may not be used to "manage" a conflict where the client's best interest is not paramount. Firms will be expected to establish a "reasonable conflict management system" in the ways described in the accompanying guidance.
- Know Your Client — Registrants will be required to ensure that the KYC process results in a thorough understanding of the client and information on three additional elements be collected:
- Investment needs and objectives — these include investment constraints and preferences such as "socially responsible investing and religious constraints".
- Financial circumstances — these are defined to include "the basic features of a client's indebtedness" and "basic tax position".
- Risk profile
KYC information must be updated at least annually and more frequently if enumerated circumstances occur (or change).
- Know Your Product — Representatives — Representatives must have sufficient knowledge of a product, together with the KYC information about the client, to support a suitability analysis. Representatives must understand and consider various elements of "each security" on their firm's product list and compare the recommended product to each of those other securities.
- Know Your Product — Firms — Among other things, firms would identify whether they have a proprietary or a mixed/non-proprietary product shelf. Proprietary firms will trade/advise only in proprietary products, while mixed/non-proprietary either trade/advise in no proprietary products or in a combination of both. Firms that are “mixed” will have a potentially significant burden in ensuring that the range of products they have on their shelf are "appropriately representative" of the products most likely to meet the investment needs and objectives of their clients. According to the draft guidance, firms must undertake a “fair and unbiased” investigation of the overall universe of products that the firm is registered to trade or advise in in order to "satisfy itself it has a range of products" that will most likely meet the investment needs and objectives of its clients based on its current client profiles. Firms will be expected to annually review its shelf against enumerated benchmarks to ensure that its shelf continues to meet this representative standard.
- Suitability — Firms will be required to ensure that any investment decision (including a decision to continue to hold a security) satisfies three elements in respect of a client:
- "Basic financial suitability" — Are there other strategies (including paying down debt) that are more suited for that client other than a transaction in securities?
- Investment strategy suitability — Does it meet a basic asset allocation strategy for the client that is most likely to achieve the client's investment needs and objectives?
- Product selection suitability — Is the product suitable for the client and most likely to achieve the client's investment needs and objectives?
Firms will be required to conduct a suitability analysis of the “portfolio of securities” in the client's account at the firm, which will include identifying "unsuitable" investments within the account and making appropriate changes.
- Relationship Disclosure — Relationship disclosure information (as presently mandated under the CRM rules in NI 31-103) would be required to be provided in "easy-to-understand" terms and disclosure of the proprietary or mixed/non-proprietary nature of the firm would need to be given. Specific disclosure of the fact that the suitability analysis conducted by the firm (where proprietary products are sold) does not consider the "larger market of non-proprietary products; and whether such non-proprietary products are better, worse or equal in meeting the client's investment needs and objectives".
- Proficiency — Representatives will be required to have additional proficiency in:
- The elements of the above-noted reforms, including generally understanding the basic structure, features, product strategy, costs and risks of all types of securities
- How product costs and investment strategies (eg. active versus passive) can impact investment outcomes for clients
Representatives will also have continuing education requirements, which must include an ethics component.
- Titles and designations — Very specific (and restricted) titles will be mandated for representatives, depending on the business of the firm (discretionary advising or not, proprietary products or not). Three alternatives are provided, with the least restrictive alternative permitting the following four titles: securities advisor — portfolio management, securities advisor, restricted securities advisor and securities salesperson. The latter title must be used by a representative of a firm that has a proprietary product list. Guidance on the use of designations (financial planning and the like) will also be provided.
- Role of the UDP and CCO — Amendments to existing requirements in NI 31-103 will reflect the enhancements to the expectations around management of conflicts of interest and suitability requirements.
- Statutory fiduciary duty (when a client grants the firm discretionary authority) — Legislative amendments will enshrine a statutory fiduciary duty for all firms who manage clients' assets in a discretionary manner. Presumably this would be in addition to the standard of care provided for in applicable securities regulation for investment fund managers.
The last controversial element discussed in the Consultation Paper is around the imposition of a "regulatory" best interest standard for non-discretionary clients of all firms. This standard would be in addition to the existing standard of registrants to deal fairly, honestly and in good faith with their clients and would require firms and representatives to also "act in his or her clients' best interest". The conduct required to meet this proposed standard is explained as being one of a "prudent and unbiased" firm or representative (as the case may be) "acting reasonably", although it does not appear that these latter words and concepts would form part of the enumerated standard. The best interest standard would include the following principles:
- Act in the best interests of the client
- Avoid or control conflicts of interest in a manner that prioritizes the client's best interest
- Provide full, clear, meaningful and timely disclosure
- Interpret law and agreements with a client in a manner favourable to the client's interest where reasonably conflicting interpretations arise
- Act with care.
The CSA members consulting on the best interest standard explain that they expressly do not intend to establish a statutory fiduciary duty for all registrants and explain that, in their view, the proposed best interest standard does not necessarily imply that registrants would be held to a fiduciary duty.
The OSC and the NBSC are strongly in favour of the proposed standard because they consider this will be the "underpinning" to all of the other regulatory reforms. The other CSA members are either reserving judgement, with "serious reservations" as to its benefits (the Alberta, Manitoba, Québec and Nova Scotia regulators) or, in the case of the BCSC, expressly reject the best interest standard as being unnecessary given the other recommended reforms and in light of their other concerns set out in the Consultation Paper.
In our view, given the breadth of the targeted reforms and the proposed guidance on those reforms, a best interest standard is unnecessary. We echo our earlier concerns voiced on the 2012 Consultation, which is that a best interest standard introduces a new uncertain standard with potential adverse consequences. We urge the CSA to move forward thoughtfully with some or all of the other regulatory proposals (which if implemented in the current suggested manner will have significant — potentially very costly — impact on today's financial services industry), and to continue to examine the impact of the point of sale delivery regime for mutual funds, as well as CRM-2. In our view, the status quo for the Canadian financial services industry is ever-changing and is not as static as suggested by the CSA.
Finally we note that the Consultation Paper is directed at "registrants" and not those firms doing business in Canada under exemptions from registration. We intend to comment, however, on one of the questions from the CSA — namely should international advisers and dealers, relying on the exemptions from registration provided for in NI 31-103 be subject to the best interest standard. We will strongly recommend that this not be pursued further, given the regulatory policy behind the exemptions — namely that the exempt firms are subject to regulation in their home jurisdiction and undertake limited activities, generally with permitted clients, in Canada.
We have been active participants in the various debates on the regulatory changes — both implemented and proposed — for registrants for many years, including in connection with the best interest standard discussions. We would be pleased to assist you in providing comments to the CSA on the Consultation Paper's recommendations. The opportunity to formally comment on CSA proposals is an opportunity to help shape future regulation in a manner that best serves the needs of investors and the financial services industry.