The Canadian Securities Administrators (CSA) recently released two highly anticipated notices related to CSA’s investor protection initiatives. The proposals are the result of a lengthy consultation process and aim to better align the interests of registrants with the interest of their clients, improve outcomes for clients and clarify to clients the nature and the terms of their relationships with registrants.
The first notice is a request for comment with respect to numerous proposed reforms to the registrant conduct provisions outlined in National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) (Proposed Amendments). The overarching principle of the Proposed Amendments is the requirement for registrants to promote the best interest of clients and put clients’ interest first, including with respect to conflicts of interest and suitability determination. The Proposed Amendments would also enhance registrants’ obligations with respect to know-your-client (KYC), know-your-product (KYP) and disclosure obligations. At this time, none of the members of the CSA are proposing to adopt an overarching regulatory best-interest standard, which was previously proposed.
The second notice sets out the CSA policy decision with respect to mutual fund embedded commissions (Embedded Commission Decision). The Embedded Commission Decision reflects on comments received by the CSA on the Consultation Paper 81-408 Consultation on the Option of Discontinuing Embedded Commissions (Consultation Paper), which considered a ban of embedded fees. After reviewing the feedback received, the CSA propose to allow embedded commissions to remain in place, but prohibit deferred sales charges (including low-load options) and their associated upfront commission as well as trailing commissions where a dealer does not make a suitability recommendation (i.e., discount brokers).
The Proposed Amendments to NI 31-103 are client-focused and will require registrants to “promote the best interests of clients”, including when making suitability and conflicts of interest determinations.
The Proposed Amendments to NI 31-103 would introduce a new core requirement that registrants must “put the client’s interest first” when determining suitability. In addition, enhanced suitability obligations would include:
- Registrants being required to consider certain specified factors, including costs and their impact, in making suitability determinations
- Moving suitability analysis towards an overall portfolio-level approach and away from a single trade-based approach
- Specified triggering events that will require a registrant to reassess suitability
Prior to acting on behalf of a client, including opening an account for them or purchasing or selling securities for a client’s account, a registrant will have to determine whether the action puts the client’s interest first and is suitable for them. Factors set out in NI 31-103 for registrants to consider when determining whether an action is suitable for the client include:
- KYC and KYP information
- The available product alternatives at the firm
- The costs associated with the action, including an analysis of the actual and potential impact of costs
- Portfolio-level concentration and liquidity
- The overall impact the action will have on the client’s account
- Any other factor that is relevant under these circumstances
It is important to note that the proposed companion policy to NI 31-103 highlights that as part of suitability, registrants must assess and document their assessment of the relative costs of various options available to clients at the firm, as well as the impact of such costs. Furthermore, unless a reasonable basis exists, the regulators would expect the registrant to recommend the lowest cost security available to the client that meets the other requirements.
Registrants will have to reassess suitability determinations upon the occurrence of certain triggering events, such as changes in a client’s KYC information or a security in a client’s account.
Conflicts of Interest
The main changes to the conflicts of interest approach proposed by the CSA include imposing a best-interest standard on registered individuals, as well as their registered firms and a requirement that all existing and reasonably foreseeable conflicts must be addressed. We note that the current legislation only addresses material conflicts of interest. The proposed changes do provide that registered firms can satisfy the conflicts of interest rule by addressing non-material conflicts in a manner that is proportionate to the limited risk that such conflicts may pose to affected clients.
The overarching principle in the proposed changes is that a registrant must identify in a timely manner and address, in the best interest of a client, all conflicts of interests and avoid any conflict of interest between the registrant and a client if the conflict is not, or cannot be, addressed in the best interest of the client. While the companion policy currently states that the regulators would consider a conflict of interest to exist in circumstances where the interests of different parties are inconsistent or divergent, it also explicitly states that conflicts of interest would exist in circumstances where: (i) a registrant may be influenced to put their interests ahead of their client’s interests; or (ii) monetary or non-monetary benefits available to a registrant, or potential detriments to which a registrant may be subject, may compromise the trust that a reasonable client has in their registrant.
The proposed companion policy contains examples and guidance relating to particular conflicts of interest, which predominantly relate to sales practices, including sale of proprietary products and compensation and incentive arrangements such as use of fee-based accounts, third-party compensation and referral arrangements. These examples and guidance from the regulators on how to address such conflicts provide a helpful insight into what the CSA would likely consider to be inappropriate behavior by a registrant.
New provisions would also require registrants to avoid certain conflicts, subject to limited exceptions, such as borrowing/lending money from, or to, a client or controlling a client’s financial affairs. Further, existing disclosure requirements will be extended to “all identified conflicts of interest that a reasonable client would want to know about” and will be enhanced to require disclosure regarding the potential impact and risk that the conflict poses and how it has, or will be, addressed.
To support registrants in fulfilling their enhanced obligations under the aforementioned amendments, the following regulatory changes are also proposed:
Know Your Client
The CSA notes that the proposed amendments to the KYC requirements respond to a primary area of concern and provide clarity on the regulators’ expectation of what information a registrant must collect and how frequently. The new provisions would require a registrant to ensure that it obtains specific information on the client, including the client’s personal and financial circumstances, investment needs and objectives, investment knowledge, risk profile and investment time horizon. The proposed companion policy provides examples of the type of information a registrant should collect for each of the items identified above to fulfil the KYC obligations.
Further, to ensure the continued accuracy of such information, registrants will be required to not only obtain such information upon opening a client’s account, but also to confirm such information at prescribed minimum intervals and when a significant change occurs. The relevant minimum intervals are as follows:
- 12 months for managed accounts
- 12 months prior to making a trade or recommendation for exempt market dealers
- 36 months for other accounts
Know Your Product
The Proposed Amendments would introduce an explicit rule applicable at both the registered firm and registered individual levels, which would codify the regulators’ KYP expectations, which have not previously been included in NI 31-103. The KYP amendments would require registered firms to take reasonable steps to understand the securities it makes available to clients, including how they compare with similar securities available in the market, approve the securities it will make available and monitor and reassess its approved securities. The registered individual would be required to take reasonable steps to understand what securities are available through the firm and the essential elements of the securities, such registrant offers (including the costs associated with the security). The proposed companion policy sets out detailed information concerning the process of approving a security, product costs, compensation structures and the use of proprietary products, and the importance of taking related conflicts of interest into account.
The Proposed Amendments would prohibit referral fees where:
- The fee continues for more than 36 months
- The series of payments, in the aggregate, exceeds 25 per cent of the fees/commissions collected by the party that received the referral
- Such fee increases the fees/commissions the client would otherwise be required to pay for the same product/service
Relationship Disclosure Information
To assist clients in distinguishing between and selecting a registrant, the Proposed Amendments seek to enhance the level of information that registrants must provide clients. Such mandated disclosures will include information with respect to:
- Their use of proprietary products and whether the firm will primarily or exclusively use proprietary products in the client’s account
- The products, services and account types that it offers
- Any material limitations or restrictions on what is made available (e.g., minimum investments, qualified purchaser, etc.)
- Charges and other costs to clients
- Minimum account sizes or minimum charges
- Any third-party compensation associated with the firm’s products, services and accounts
Such information must be made publicly available with the expectation that it will be available on the firm’s website, provided by email or included in short, print-on-demand documents.
The Proposed Amendments are subject to a 120-day comment period. The CSA requests specific feedback on the length of the transition period, the impact of the Proposed Amendments on exempt market dealers whose relationship with clients is episodic and not continuous, any non-enumerated conflicts of interest that must be avoided, and whether prohibiting registrants from paying a referral fee to a non-registrant would limit investor access to securities related services. It is the CSA’s intention that any such amendments ultimately be incorporated into the rules of both the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association.
Following the CSA announcement, IIROC announced that it plans to “publish additional guidance on the approaches dealers can use to address conflicts of interest, with particular focus on compensation-related conflicts.”
EMBEDDED COMMISSION DECISION
The Consultation Paper identified three main market efficiency and investor protection issues related to embedded commissions. In particular, embedded commissions were found to:
- Give rise to conflicts of interest between registrants and investors
- Limit investor awareness, understanding and control of dealer compensation
- Be misaligned with the services received by investors
After considering the feedback received, and in light of the Proposed Amendments , the CSA has decided not to ban embedded commissions generally, but to prohibit:
- All forms of the deferred sales charge option (DSC option), as well as their associated upfront commissions in respect of the purchase of securities of a prospectus qualified mutual fund
- The payment of trailing commissions to, and the solicitation and acceptance of trailing commissions by, dealers who do not make a suitability determination in connection with the distribution of prospectus qualified mutual fund securities
In making this decision, the CSA found that “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.” Furthermore, with respect to trailing commissions, the CSA noted that the fees paid by a large number of do-it-yourself investors using discount brokerages did not align with the “execution-only” nature of such accounts. As such, it is the CSA’s position that prohibiting the payment of trailing commissions where no suitability determination is made will serve to align the fees paid by investors with the actual services received.
The CSA anticipates filing a notice and request for comment with respect to the above noted policy changes in September 2018.