Find your footing amid the furor over DSCs

March 25, 2019 | Last updated on March 25, 2019
5 min read

Whatever the outcome of the Canadian Security Administrators’ (CSA) proposed ban on deferred sales charges, advisors with commissions-based books face a shifting industry and uncertain regulatory landscape.

In step with some global regulators, the CSA proposed a ban on deferred sales charges (DSCs) last September, as well as on trailers paid to brokers where no suitability recommendation is made (see “Trailers paid to brokers”). At the same time, the Ontario government announced it didn’t support the proposal.

The result is a kind of limbo.

In rejecting the CSA proposals, the Ontario government made the case that DSC funds provide investors with another option for saving. Critics of DSCs say they unfairly penalize clients who need to exit mutual funds before the DSC term is over.

Even if the Ontario government were to remain offside of the CSA proposals, fund companies likely wouldn’t maintain a separate fund platform for one province, says Jim Hong, a partner at Torys in Toronto. Firms such as Dynamic Funds and Investors Group discontinued the DSC option a couple of years ago.

“I don’t know if a ban will ever happen, but something’s going to change,” says Hong. “The status quo won’t continue.”

Harold Geller, associate at MBC Law Professional Corporation in Ottawa, says regulatory action on DSCs is called for because of the wealth of research that regulators have amassed showing associated conflicts.

“A competitive market is undermined by long DSC trails,” he says, referring to the fees as “cement handcuffs.”

Geller estimates that about 75% of the court cases in which he’s involved feature bad advisors, meaning those who are self-interested and, as a result, whose clients haven’t achieved their financial goals—a situation he says is fuelled by DSCs.

Ross Kappele, head of distribution and client management at BMO Global Asset Management Canada in Toronto, says the firm no longer offers long-dated DSC funds. With the industry shift to fee-based accounts and F-series funds, DSC funds dropped out of favour with clients, Kappele says.

He adds, though, that DSC funds can work well for investors with fewer assets. For example, a financial plan can’t be cost-effectively created when the advisor is compensated by trailers alone, he says. The caveat when using funds with embedded commissions of any kind is that effective disclosure is necessary so clients understand fees, he says.

Therein lies a problem. Geller says court cases typically reveal that conflicts aren’t sufficiently disclosed. In fact, he says he’s never seen disclosure accomplished in an “objectively reasonable manner.”

For example, despite disclosure requirements, investors often mistakenly think that the mutual fund pays the trailer, not the investor, he says. Further, investors are often unaware of the negative compounding effect paying trailers has on returns.

Says Geller: “You can’t say that there is an informed consent to DSCs unless you inform [investors] of the alternatives and risks” in a way likely to be understood.

Part of the solution could include presenting clients with pictorials showing the compounding drag of fees and a one-page, plain-language explanation of DSCs in comparison to other compensation methods—all communicated at the client’s literacy level, Geller says. Advisors should also offer similar, lower-cost products like ETFs, he says.

At BMO, some mutual fund and ETF series access the same pool and, in the case of F-series, are priced similarly, Kappele says. When choosing a mutual fund versus an ETF, advisors consider many things in addition to cost, including how they want to interact with the market, he says.

Kappele also notes that mutual funds are generally more expensive because of the advice portion of the MER—a factor that seems to get lost in the fee debate. The industry must do a better job of educating clients about the value of advice and advisory relationships, he says.

A focus on superior advice—with a premium to match—could be a positive outcome from the proposed ban. As it stands, with DSCs in place, “the worst financial advisor gets paid the same amount as the best,” Geller says.

Hong says proactive advisors should consider the impact of a fee-based model for their businesses. He also notes that client comments on the CSA’s proposal reveal anger where DSCs have been abused and poorly disclosed. “To some extent, it’s up to the advisors to make sure their clients don’t feel that way,” he says. Advisors do that by ensuring they’re “providing real value to their clients,” whatever the fee model, he says.

Trailers paid to brokers: what the class actions allege

Siskinds LLP and Bates Barristers PC have proposed class actions against six bank-owned fund companies, plus Mackenzie Investments (as of press time), for payment of trailers to discount brokers. Among the allegations is that when trustees pay trailers without accompanying service or advice, they’re in breach of trust.

Most mutual fund companies in Canada have chosen a trust structure, says Anthony O’Brien, a partner at Siskinds in Toronto. “When they do that, they have to accept all the trust law principles,” he says.

That includes the fiduciary relationship between trustee and beneficiary (the investor), whereby the trustee must put the beneficiary’s best interest first. (The class actions allege that the fund manager also has a fiduciary duty to investors.)

Jim Hong, a partner at Torys, ascribes greater agency to investors, saying those who buy from discount brokerages have acknowledged they don’t want advice—and that’s why the class actions focus on trustees and managers, not brokerages.

“It’s hard to sue a discount broker,” he says, when the client and broker have an agreement that expressly says the client’s not receiving advice, with the client likely providing indemnity to the broker.

The class actions also allege that mutual fund companies’ typical disclosure that trailers are for “services and advice” is a misrepresentation. Such disclosure is “plainly false in the case of a discount broker who is absolutely not providing advice,” O’Brien says. Trailers for services are also inappropriate because, for example, mutual fund investors shouldn’t have to subsidize services provided to all clients, he says.

None of the proposed lawsuits against the seven financial services institutions has been certified as a class action, and the allegations have not been tested in court.