On June 21, 2018, the Canadian Securities Administrators ("CSA") published CSA Staff Notice 81-330 Status Report on Consultation on Embedded Commissions and Next Steps (PDF) announcing its policy decision (the "Policy Decision") following the consultation process and feedback received on CSA Consultation Paper 81-408 Consultation on the Option of Discontinuing Embedded Commission (PDF) (the "Consultation Paper") on the option to discontinue the prevailing practice of investment fund managers of remunerating dealers and their representatives for mutual fund sales through commissions, including sales and trailing commissions (the "embedded commissions") as a response to the key investor protection and market efficiency issues identified in the Consultation Paper.
More specifically, and further to their assessment of the feedback received pursuant to the Consultation Paper and insights from research and investor focus groups conducted in certain CSA jurisdictions in 2017, the CSA formulated their Policy Decision which is comprised of the following policy changes:
- the implementation of enhanced conflict of interest mitigation rules (to be included in National Instrument 31-103 - Registration Requirements, Exemptions and Ongoing Registrant Obligations ("NI 31-103") and Companion Policy 31-103CP Registration Requirements, Exemptions and Ongoing Registrant Obligations ("31-103CP")) and guidance for dealers and representatives, as proposed in the CSA Notice and Request For Comment (PDF) published on June 21, 2017;
- the prohibition of all forms of the deferred sales charge option, including low-load options (collectively, "DSC Option") as well as their associated upfront commissions in respect of the purchase of securities of prospectus qualified mutual funds (as defined in securities legislation); and
- the prohibition of the payment of trailing commissions to, and the solicitation and acceptance of trailing commissions by, dealers who do not make a suitability determination (discount brokers) in connection with the distribution of prospectus qualified mutual fund securities.
Below, we present a summary of the Policy Decision. However, this bulletin is not intended to be a comprehensive description of the Policy Decision nor a complete analysis of the potential impacts thereof.
Background and Consultation Paper
Published on January 10, 2017, the Consultation Paper follows the CSA's initial consultation on mutual fund fees, CSA Discussion Paper and Request for Comment 81-407 Mutual Fund Fees (PDF), published on December 13, 2012, where the CSA first discussed their concerns regarding mutual fund fees, including embedded commissions (the "Discussion Paper") and corresponding first status report published on December 19, 2103 which outlined the principal themes that arose from the comment process on the Discussion Paper and following in-person consultations with stakeholders (the "Previous CSA consultations").
The Consultation Paper requested specific insight, including evidence-based and data-driven analysis and perspectives, to probe deeper into the conclusions of the Previous CSA consultations and gather the necessary feedback for the CSA to determine whether to go forward with a ban of all forms of embedded commissions. A number of salient facts in connection with the consultation process are highlighted below:
- The Consultation Paper was subject to a 150-day comment period which ended on June 9, 2017.
- The CSA received 142 public comment letters, 84% of which were from industry stakeholders (including dealers, representatives, investment fund managers, industry associations and industry service providers) and the remaining 16% from non-industry stakeholders (including investors and investor advocates).
- The majority of fund industry stakeholders were strongly opposed to the discontinuation of all forms of embedded commissions and a mandated move to direct-pay arrangements.
- The majority of investors and investor advocates strongly supported the discontinuation of embedded commissions.
Summary of the Policy Decision
Abandonment of the option to ban embedded commissions
Taking into account the preoccupations of many stakeholders to the effect that the mandatory discontinuation of all forms of embedded commissions could potentially result in a number of adverse impacts and drawbacks on both fund industry participants and investors which could hinder (or even overthrow) the expected positive outcomes of such measure, the CSA have confirmed its renunciation of the option of discontinuing all forms of embedded commissions. Rather, the CSA will be pursuing a bundle of interconnected regulatory measures (described below) aimed to address the investor protection and market efficiency issues raised by the CSA in the previous CSA consultations and in the Consultation Paper.
Enhanced conflict of interest mitigation rules
The CSA consider that embedded commissions create an inherent conflict of interest that misaligns the interests of market participants with those of the investors they serve and encourages suboptimal business practices by registrants which negatively impact market efficiency and reduces results for investors.
Consequently, and as part of a set of proposed regulatory amendments to NI 31-103 and 31‑103CP, the CSA are introducing enhanced conflict of interest mitigation rules and guidance for dealers and their representatives through the proposed amendments to NI 31-103, which will require both registered firms and their representatives to address 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. It should be noted that these provisions impact the distribution of securities beyond prospectus qualified mutual funds and will apply to all securities distributed by a registrant.
More specifically, pursuant to the proposed enhanced conflict of interest mitigation rules, 31‑103CP will, inter alia:
- confirm and formalize the CSA's position that it is a conflict for a registrant to receive third-party compensation (including embedded commissions);
- require that registered firms, to the extent that they offers clients securities that provide third party compensation (including embedded commissions), be able to demonstrate 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; and
- provide examples of controls that registered firms may consider to help mitigate third party compensation conflicts.
Complementary additional regulatory initiatives that are aimed at further promoting the investors' best interests have been proposed by the CSA in the proposed amendment to NI 31‑103 and 31-103CP (collectively the "Client Focused Reforms"). We refer you to our Investment Management Bulletin on the Client Focused Reforms relating to the new obligations for registrants arising out of proposed amendments to NI 31-103 available by clicking here.
The CSA have highlighted the following problematic conflicts of interest and investor protection issues arising out of the DSC Option which, in the view of the CSA, are generally difficult to resolve in the investors' best interests:
- the higher upfront and third-party nature of the compensation on the DSC Option creates a conflict of interest that can incentivize dealers and representatives to promote the DSC Option over other options that may be more suitable for investors and lead to poor suitability assessments;
- the DSC Option can incentivize dealers and their representatives to promote unsuitable leverage strategies or churn their clients' accounts;
- the "lock-in" feature of the DSC Option created by the redemption penalty payable within a certain number of years of purchase can significantly deter investors from redeeming an investment or changing their asset allocation, even in the face of consistently poor fund performance, unforeseen liquidity events or change in their financial circumstances;
- the complicated nature of this investment option can impede investor awareness and understanding of fund costs;
- the DSC Option can lead to higher fund costs, due to the fact that an investment fund manager's cost to finance the payment of the upfront commission on purchases made on a DSC Option basis is funded from the funds' annual management fees.
Based on these considerations, the CSA propose to prohibit all forms of the DSC Option as well as the associated upfront commissions for purchases of prospectus qualified mutual funds.
Prohibition of trailing commissions for discount brokers
The CSA consider that the fees paid by a vast majority of investors in the discount brokerage channel, for investment advice that is not received or desired, are fundamentally inconsistent with the execution-only nature of the services they receive.
The CSA also point out the absence of justifiable rationale for the practice of paying an ongoing trailing commission for the sale of a mutual fund by discount brokerage dealers, rather than by way of an upfront transaction fee as is the case for other securities, including most exchange-traded funds (ETFs), which creates an incentive for the distribution of mutual funds that pay such an ongoing fee over those that do not.
The CSA recognize that similar issues arise in all cases where dealers who do not make a suitability determination receive a trailing commission (such as for example, a dealer who does not perform a suitability analysis in respect of a "permitted client" who has waived the suitability obligation).
As such, the CSA propose to prohibit investment fund managers from paying, and dealers from soliciting and accepting, trailing commissions (whether for advice or any other service) where the dealer does not make a suitability determination in connection with the distribution of prospectus qualified mutual fund securities. This prohibition would therefore apply to both Series A Units (which typically contain the full trailing commission), as well as to Series D Units (which were created by investment fund managers specifically for the discount brokerage channel with a lower trailing commission).
The CSA anticipate to publish a CSA Notice and Request for Comment in September 2018 that will include:
- a regulatory impact analysis, including the potential benefits and impacts of the proposed policy changes on investors and market participants;
- rule proposals for the elimination of the DSC Option and trailing commission payments to dealers that do not make a suitability recommendation; and transition measures.
In order to go into greater depth in the scope of the Client Focused Reforms, including the enhanced conflict of interest mitigation rules forming part of the Policy Decision and to discuss potential issues that registrants may face if they were to come into effect, our Investment Management team will host a conference and discussion period, in Montreal, on September 14, 2018 from 12 to 2 pm.