As we reported in our special bulletin earlier this month, the Canadian Securities Administrators (CSA) have finalized their client-focused reforms (CFRs) to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) and its related Companion Policy (NI 31-103CP) (Policy). These provisions are expected to come into force on December 31, 2019 and will take effect in two phases, beginning on December 31, 2020.
This month, we highlight the conflict of interest provisions, including the provisions relating to referral arrangements and borrowing from clients. All of these rules are scheduled to take effect on December 31, 2020. To streamline our discussion, we generally will refer to NI 31-103 and NI 31-103CP in their current form as the Current Rules and Policy and to the amended versions as the Revised Rules and Policy.
Stay tuned for a similar article on the know-your-client (KYC), know-your-product (KYP) and suitability requirements in next month’s bulletin.
Section 13.4 of the Revised Rules sets out registered firms’ obligations to identify, address and disclose material conflicts of interest. New section 13.4.1 introduces parallel requirements for registered individuals. Significant elements in the revised conflicts regime include the following:
- Identify Material Conflicts: Under the Revised Rules, registered firms must take reasonable steps to identify existing and reasonably foreseeable, material conflicts of interest between:
- The firm and the client; and
- Each individual acting on the firm’s behalf and the client.
New subsection 13.4.1(1) requires registered individuals to identify existing and reasonably foreseeable, material conflicts between themselves and their clients.
- Expanded Definition of Conflict of Interest: According to the Current Policy, a conflict exists if the interests of different parties (such as the client and registrant) are inconsistent or divergent. The Revised Policy keeps that concept and adds that a conflict also exists where:
- A registrant may be influenced to put their interests ahead of their client’s interests; or
- Monetary or non-monetary benefits available to the registrant, or potential detriments to which a registrant may be subject, may compromise the trust that a reasonable client has in the registrant.
- Address Material Conflicts in Client’s Best Interest: The Current Rules require registered firms to “respond” to material conflicts. Under the Revised Rules, registered firms and individuals must address material conflicts in the client’s best interest and avoid any material conflict that is not, or cannot be, addressed in the client’s best interest.
In the notice accompanying the Revised Rules and Policy (Notice), the CSA reiterated that the CFRs do not impose on registrants a fiduciary duty as a regulatory standard of conduct. Many commenters on the proposed CFRs had asked the CSA to clarify the difference between the fiduciary and best interest standards. The CSA did not, and probably could not, provide a clear, one-size-fits-all answer. It will take time, and the application of the best interest standard to specific fact situations, for a clearer picture of the CSA’s interpretation of this standard to emerge.
In the meantime, the CSA emphasized in the Notice that the standard means that registered firms and individuals must put the client’s interests first, ahead of their own interests and competing considerations. Although this is a very high standard, we interpret the CSA’s commentary to mean that registered firms and individuals do not have to negate their own interests, just subordinate them. As well, there can be more than one way to act in a client’s best interest.
- Disclosure is Required, but Isn’t Enough: The Revised Rules expressly state that providing disclosure to the client does not, in itself, satisfy a registered firm’s or registered individual’s obligation to address material conflicts of interest in the client’s best interest. (We discuss disclosure requirements in more detail in Section B below.)
- General Test for Determining Materiality: The Revised Policy includes a general test for determining materiality. Registrants should consider whether the conflict may be reasonably expected to affect, in the circumstances, the client’s decisions and/or the registrant’s recommendations or decisions.
- Expanded Guidance on Conflicts: In the Revised Policy, the CSA lists situations that it considers to be inherent conflicts of interest that are almost always material:
Inherent, “Almost Always” Material Conflicts
- Trading in or recommending proprietary products
- Receiving compensation from a third party
- Paid referral arrangements
- Client is in a fee-based account that holds securities with embedded commissions
- Registrant has full control or authority over an individual client’s financial affairs or acts as an executor for a client’s estate
- Certain internal compensation practices and arrangements:
- Registered firms creating incentives to sell or recommend certain products or services over others
- Registered individuals receiving greater compensation from their firm for the sale or recommendation of certain products or services over others
- Sales and revenue targets for registered individuals
- Compliance or supervisory staff compensation tied to sales or revenue of the firm overall or the registered individuals they supervise
- Potentially Material Conflicts: The Revised Policy also discusses other types of potential conflicts. Some of this discussion is substantially similar to the Current Policy and some of it is revised or new. Some examples of the new guidance are set out below:
- Purchasing assets from a client outside the normal course of a registrant’s business may create a material conflict of interest.
- Before a registered individual joins a registered firm, the firm should require that individual to disclose all outside business activities (OBAs) and should review and approve such OBAs.
- When a registered individual acts as a director, officer, shareholder, owner or partner of an issuer whose securities the registered individual also recommends to clients, conflicts of interest are exacerbated. The firm and the registered individual have heightened responsibilities to address the conflict due to the severity of the risk to the client.
- Controls to Address Material Conflicts: The Revised Policy also includes extensive guidance on controls that registered firms should consider to address material conflicts. It includes a new section on general control measures (tone at the top, anyone?) as well as detailed guidance on potential control measures for specific types of conflicts. Of particular interest are the suggested controls for registered firms that only trade in or recommend proprietary products such as:
- Documenting how such products fit within the firm’s business model and strategy and how they are aligned with clients’ interests;
- Conducting periodic due diligence on comparable, non-proprietary products and evaluating whether the firm’s proprietary products are competitive with available alternatives; and
- Obtaining independent advice on, or an independent evaluation of, the effectiveness of the firm’s policies, procedures and controls to address this conflict.
- Registered Individuals to Report Material Conflicts to Their Firm and Wait for Consent: A registered individual who identifies an existing or reasonably foreseeable, material conflict of interest between themselves and a client:
- Must promptly report that conflict to their sponsoring firm; and
- Must not engage in any trading or advising activity in connection with that conflict unless the conflict has been addressed in the client’s best interest and the sponsoring firm has consented to proceeding with the transaction.
The Revised Policy provides guidance on how firms can provide consent. For example, if the registered individual acts in accordance with the firm’s policies and procedures relating to the conflict in question, that may be sufficient consent unless the firm chooses to require its representatives to obtain express consent before proceeding with the activity.
- Interaction of Registered Individuals’ and Firms’ Obligations: The Revised Policy doesn’t discuss in detail how registered individuals’ obligations to identify, report and address material conflicts between themselves and clients interact with the firm’s related obligations. In many cases, we expect that firms will prepare lists of material conflicts that affect the whole firm, as well as material conflicts for particular business lines. Registered individuals, in turn, will review those lists and report to their firm any material conflicts involving them that do not appear on the firm’s list.
We also believe that registered individuals will have to consider whether firm-identified and self-identified, material conflicts are being effectively addressed at their individual level. As the Revised Policy emphasizes, registered individuals and their sponsoring firms each have a distinct obligation to address material conflicts in the client’s best interest. For example, what if a firm puts in place measures intended to address material conflicts arising from its compensation practices but a registered individual believes that these practices still influence them, despite the controls, to put their interests ahead of the client? In such a situation, we think the registered individual would have to avoid that conflict until they could raise their concerns with the sponsoring firm so that a solution could be implemented.
- Training: New subsection 11.1(2) of the Revised Rules requires registered firms to train their registered individuals on compliance with securities legislation, including, among other things, the conflict of interest requirements for firms and registered individuals.
- Recordkeeping: New subsection 11.5(2)(p) of the Revised Rules requires firms to maintain records that demonstrate compliance with the conflict of interest provisions in Part 13, Division 2. The Revised Policy states that as the materiality of a conflict increases, there should be greater detail in the records maintained to demonstrate compliance.
- Carve-outs: Sections 13.4 and 13.4.1 do not apply to investment fund managers in respect of funds that are subject to National Instrument 81-107 Independent Review Committee for Investment Funds.
B. Conflicts of Interest Disclosure
The disclosure requirements for material conflicts of interest have been revised and more extensive guidance has been provided about the timing and content of such disclosures. Key features of the new disclosure regime include the following:
Trigger: Material conflicts must be disclosed to a client whose interests are affected if a reasonable investor would expect to be informed of such conflicts. (This is similar to the Current Rules.)
Write It Down: The Revised Rules expressly require written disclosure.
Disclose What? The Current Rules require firms to disclose the nature and extent of conflicts. Subsections 13.4(4)-(6) convert some of the existing guidance into rules and add new elements. The Revised Rules require disclosure of:
Make It Systematic: The Revised Policy states that as part of a registered firm’s practices to address material conflicts, they could consider having a system for confirming that effective disclosure of material conflicts is provided to clients. Despite the surprisingly soft language (i.e. “could consider”), we believe that regulatory staff will expect firms to have systems, appropriate to their business model and scope of operations, that are reasonably designed to ensure this outcome.
Nobody Should Put Conflicts Disclosure in a Corner: Like Patrick Swayze, the CSA wants conflicts disclosure to take centre stage. Like the Current Policy, the Revised Policy indicates that disclosure should not be generic, partial or misleading, and should not obscure the conflicts in overly detailed disclosure. The Revised Policy goes even further, stating that firms should consider using a standalone, succinct conflicts disclosure document.
Presentation: The Revised Rules expressly require the disclosure to be presented in a manner that, to a reasonable person, is prominent, specific and written in plain language. This is different from the disclosure trigger, which uses a “reasonable investor test” test. We think this means that a firm can take its client base into account in deciding whether a material conflict must be disclosed to a particular client. Once the firm concludes that disclosure must be made, however, the disclosure must be presented in a manner that any reasonable person (including an unsophisticated investor) would find prominent, specific and written in plain language.
c. Referral Agreements
Referral arrangements fall within the scope of the general conflict of interest provisions in the Revised Rule and also are addressed in several, standalone provisions in the Revised Rules and Policy.
The definition of “referral fee” has been broadened in the Revised Rules to encompass any “benefit provided” for the referral of a client to or from a registrant. (By contrast, the Existing Rules use the term “compensation … paid” for a client referral.)
In addition to classifying referral arrangements as “inherent conflicts” that are almost always material, the Revised Policy provides more extensive guidance on how referral arrangements should be handled. Among other things:
- No Reliance on Referring Party: A registrant cannot rely on the referring party to discharge any of the registrant’s obligations to the client, including KYC, KYP and suitability determinations.
- Watch out for Registrable Activities: Registrants must not knowingly participate in a referral arrangement where the other party is engaged in a registrable activity without being appropriately registered or exempt from registration.
- Sponsoring Firm to Be Kept in the Loop: Registered individuals must not enter into referral arrangements independently of their sponsoring firms or without their knowledge.
- Recordkeeping: Records relating to referral arrangements should include the name of each client referred, the amount of the fee, the person or company paying the fee, and who provides the disclosure to the referred client.
- Due Diligence on Recipients of Referrals: Although section 13.9 of the Existing Rule has not been amended, the Revised Policy indicates that the CSA expects registered firms to take certain steps, at a minimum, to conduct due diligence on persons to whom they may refer clients. In particular, they should assess:
- Which types of clients the referred services would be appropriate for; and
- The referral party’s qualifications, including taking reasonable steps to determine whether the referral party has been the subject of any civil actions, regulatory or professional disciplinary matters conducted under any legislation, or client complaints, relating to the referral party’s professional activities.
D. Restrictions on Borrowing from or Lending to Clients
New subsection 13.12(2) of the Revised Rules introduces a conflict of interest rule into a section of NI 31-103 that previously focused on limiting registered firms’ financial exposure to clients. In the Revised Rule:
- Subsection 13.12(1) prohibits registrants from lending money, extending credit or providing margin to a client unless certain criteria are met. (This provision is similar to section 13.12 of the Current Rules, with some additional exceptions from the prohibition added.)
- New subsection 13.12(2) prohibits a registered individual from borrowing money, securities or other assets or accepting a guarantee in relation to borrowed money, securities or other assets from a client unless:
- The client is a financial institution whose business includes lending money to the public and the loan is made in the normal course of the financial institution’s business; and/or
- Both the following apply:
- The client and registered individual are related to each other, as provided for in the Income Tax Act (Canada); and
- The registered individual has their sponsoring firm’s written approval to borrow the money, securities or other assets or accept the guarantee.
E. Next Steps
Clearly, it will take some time for market participants, their advisers, and even the regulators to come to grips with how the Revised Rules and Policy can be implemented effectively. As indicated in the Notice, CSA members plan to create an implementation committee that will offer more guidance on how to operationalize the CFRs. And we expect to see industry associations and advisers (like yours truly) publishing commentary on the new regime. It’s still important, however, for firms to start looking closely at how the CFRs will affect their operations so that they can identify and resolve potential implementation challenges, organize resources to effect the required changes, and develop project plans.