When it comes to compensation-related conflicts, IIROC’s message is clear: “disclosure alone is not sufficient to address conflicts.”
And such conflicts can even arise from the trend toward fee-based accounts, which are gaining popularity as advisors move away from commission structures.
IIROC has released the findings of its compensation-related conflicts review, which it began in December 2016, and it finds certain key themes and concerns “came up repeatedly.”
While the SRO concedes that “disclosure has generally been accepted by regulators as a way to address conflicts,” it’s not happy with the results of its review; IIROC reviewed and met with 20 firms that it says represent “a broad cross-section of dealers serving retail clients.”
The main issue, it says, is too many dealers and reps “are increasingly relying solely on disclosure without ensuring that [a] conflict has first been addressed in a way that […] considers the best interests of the client,” and without effort being made to avoid such conflicts.
On top of that, the SRO identified these additional two failures:
- a lack of comprehensive review of compensation programs and their associated conflicts; and
- a shift to fee-based and managed accounts without appropriate supervision and/or monitoring of the unique risks associated with these account offerings.
Here’s a deeper dive into IIROC’s findings and next steps.
1. Disclosure gaps
In its review summary, IIROC says, “We have seen many cases where disclosure [about conflicts] is so vague as to be meaningless,” and many firms are now required to make improvements.
If you’re offering products containing embedded compensation in a fee-based account, IIROC would consider the following to be an example of failed disclosure: “Dealer Member Inc. may receive a fee or other payment from another party, other than me, for certain transactions made for my account. These may include trailer and administration fees.”
Why? The SRO says the statement fails to reveal the nature of the conflict, uses inaccurate wording (“may receive” versus “will receive”), doesn’t clarify that the client will be responsible for the fees, and “assumes that investors are all financially literate and understand industry terms.”
IIROC also found some reps are “recommending certain products for which he/she also receives compensation for services provided in another capacity.” The issue with this is “disclosure is often located in different sections of a document, or in multiple documents,” and this is difficult for investors to understand.
What you can do: Before recommending certain products, IIROC says “it is critical that the disclosure be prominent, complete and in plain language, and [that] the nature of the conflict is evident to the client.” In all cases, you must “confirm that the client has actually read the disclosure” as well as understood it.
2. Dissecting compensation programs
Compensation programs–especially those that involve related-party or proprietary products–can be troublesome, says IIROC. Few of the reviewed firms offered evidence that they’d conducted “detailed review[s] of their overall compensation program[s], including all aspects of the compensation grid together with other incentives.”
Not to mention, IIROC found evidence of conflicted supervision, where “we saw supervisors compensated partly (to varying degrees) on revenue generated by registrants subject to the supervisor’s oversight.” No rule expressly forbids this, but the SRO points to Dealer Member Rule 38 and 2500–the latter “speaks to the need for genuinely independent supervision,” where possible.
What you should know: Going forward, IIROC will request additional information from firms about their compensation programs during audits. They’ll look at compensation grids, and policies and procedures related to compensation programs.
3. Issues with fee-based and managed accounts
As part of its review, IIROC “analyzed the breakdown of account types (e.g., commission-based, fee-based and managed) at each Dealer and the controls in place to ensure that clients are put into the most appropriate type of account. We also looked closely at additional fees and commissions associated with fee-based accounts.”
The bad news is the SRO says there was “a bias on the part of most dealers towards fee-based accounts over commission-based accounts.” It adds, “Most dealers provide the highest possible grid payout to representatives for fee-based revenue.” On top of that, IIROC says, “a significant number of dealers provide additional incentives to representatives in the form of performance bonuses linked to fee-based assets,” leading to clients potentially being moved to these accounts unnecessarily.
IIROC says most firms argued that “fee-based accounts align registrant interests with client interests better than commission-based accounts.” However, the SRO notes, “While this may be true in some cases, there are other cases such as ‘buy and hold’ where the client will be paying ongoing fees without receiving a commensurate level of ongoing service.” IIROC did not define what that service would look like.
The good news is most dealers have a process to figure out whether fee-based accounts are appropriate–and only a small number don’t–but firms failed when it came to “the review of the ongoing appropriateness of fee-based accounts.”
What you should know: There are no specific compensation rules for fee-based accounts, but assessing appropriateness is key, says IIROC. Also, “if a dealer provides any form of monetary or non-monetary incentive in favour of fee-based accounts, it’s essential that the dealer have robust supervisory and monitoring processes in place to ensure that clients are placed appropriately in such accounts.”
The SRO is also requesting information about so-called double charging in fee-based accounts. It notes, “Any failure by a dealer to self-report any issues will result in an automatic referral to IIROC enforcement if we identify significant deficiencies,” noting issues often occur due to manual processes that are “error-prone.”
Overall, says IIROC, “the proper management of conflicts of interest is at the core of the best interest debate,” and the SRO plans to up the ante for its business conduct compliance (BCC) testing. It will also ask dealers to explain the rationale behind sales targets during audits.
Also in the works is IIROC’s risk trend report, which was announced in its latest priorities report. The SRO says, “We are performing a comprehensive review of our risk models, which inform the frequency and content of compliance examinations. […] The BCC risk model will include a new risk factor that considers compensation arrangements.”