In a move likely to infuriate investor advocates and mollify fund companies, the Canadian Securities Administrators have signalled that embedded mutual fund commissions are here to stay, so long as they’re not deferred sales charges.

This morning, CSA released an update on consultation paper 81-408, “Consultation on the Option of Discontinuing Embedded Commissions.” Based on feedback, CSA has decided on three main proposals:

  1. prohibiting deferred sales charges (DSC), including low-load options;
  2. prohibiting the payment of trailing commissions to dealers, such as discount brokers, who do not make a suitability determination;
  3. implementing “enhanced conflict of interest mitigation rules and guidance for dealers and representatives requiring that 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.”

The last proposal involves a litany of amendments to National Instrument 31-103 regarding KYC, KYP, suitability, conflicts of interest and relationship disclosure information. These changes, which were developed in consultation with IIROC and MFDA, are out for comment until Oct. 19, 2018.

CSA says it will publish its official DSC and trailers proposals, as well as transition measures, in September. Stakeholders will be able to comment at that time.

Why embedded commissions aren’t banned

CSA says that while it considered a commissions ban, “we are instead pursuing a package of reforms that we expect will respond to each of the investor protection and market efficiency issues we identified, but at the same time, limit potential adverse consequences to market participants and investors.” Such potential consequences were emphasized in fund industry comment letters, and include higher costs for advice, an advice gap for smaller investors, and regulatory arbitrage (e.g., a move to seg funds instead of mutual funds).

The status update also notes that the proposed NI 31-103 amendments are meant to “extend beyond conflicts of interest arising from embedded commissions,” and that they cover “all types of conflicts that can incentivize poor registrant behaviour and subvert investor interests.”

Proposed conduct changes

CSA takes aim at proprietary product sales, highlighting them as an example of a conflict in both the status update document and the proposed NI 31-103 amendments. In general, CSA says these amendments will require registrants to:

  • address conflicts of interest in the best interest of the client;
  • put the client’s interest first when making a suitability determination; and
  • do more to clarify for clients what they should expect from their registrants.

While the proposals do not prescribe a best interest standard, the suitability amendments use the phrase “client’s interest first.”

Here are some highlights; see the full proposals here.

Know Your Client

The proposed amendments would codify how often registrants must update a client’s KYC. At minimum, updates would have to occur every:

  • 12 months for managed accounts;
  • 12 months prior to making a trade or recommendation for exempt market dealers; and
  • 36 months for other accounts.

Know Your Product

CSA has determined that “there should be an express KYP requirement” in NI 31-103; such a requirement is currently lacking. The requirement would include explicit obligations for both dealers and registrants to thoroughly understand the securities they sell, “including how they compare with similar securities available in the market.”

Suitability

CSA proposes extensive changes to this section of NI 31-103, saying “we have chosen a regulatory approach which favours the client’s interest above other considerations.” These obligations would include:

  • explicitly requiring registrants to consider certain factors, including costs and their impact, in making suitability determinations;
  • moving away from trade-based suitability to an overall portfolio-level suitability analysis; and
  • prescribing triggering events that will require a registrant to reassess suitability.

The proposed amendments explicitly say that before a registrant acts for a client, “the registrant must determine, on a reasonable basis, that the action is suitable [and …] puts the client’s interest first” (emphasis added).

Conflicts of interest

These amendments include the phrase “best interest”; specifically, CSA proposes that “if a conflict is not, or cannot, be addressed in the best interest of the client, then the registered firm must avoid that conflict.”

CSA also proposes limiting referral fees, saying such fees cannot continue for longer than 36 months, exceed 25% of the fees or commissions collected from the client by the party who received the referral, or increase what would otherwise be paid by a client to that registrant for the same product or service.

Relationship disclosure information

CSA is “particularly concerned” that registrants do not adequately disclose their use of proprietary products, or the fact that they cannot provide certain products or services to clients based on their registration category (e.g., MFDA advisors are not always disclosing that they cannot sell stocks)—as well as “the impact each of these things can have on investment returns.” As such, CSA is proposing to mandate such disclosures. It is also proposing to define the term “proprietary product.”

Another proposal would require registered firms “to make publicly available the information that potential clients would consider important in deciding whether to become a client.” CSA acknowledges this could be onerous, saying this information would not have to be fully exhaustive, and that some information could be available on demand from a client.

Included in such public information would be whether the firm will primarily or exclusively use proprietary products in the client’s account, and whether there would be any restrictions on the products or services the registrant would provide to the client.

Further, CSA proposes a new requirement to explain the potential impact of each of the following on a client’s investment returns:

  • operating and transaction charges;
  • embedded fees;
  • having access to only a limited range of products or services.

Interested parties have until Oct. 19, 2018, to comment.

No best interest; targeted reforms on backburner

The CSA notice also provided an update on proposals laid out in comment paper 33-404, released in April 2016. The update says the Ontario and New Brunswick securities commissions “are not proposing to adopt an overarching [best interest] standard at this time.” Instead, the two commissions worked with CSA “to develop a harmonized approach that infuses the client’s best interest into the conflicts of interest and suitability reforms.”

The document adds that Ontario and New Brunswick are taking a wait-and-see approach, noting that “to the extent they do not see a change in behavior demonstrating that the proposed [NI 31-103] amendments achieve the outcomes they are seeking for investors, they will revisit this approach.”

As for 33-404’s proposed targeted reforms, including title changes, CSA calls them “separate, longer-term projects” for which they are not currently seeking comment. The notice says today’s proposals “were prioritized, as they are fundamental to addressing the harms identified” in 33-404.

Read the status update here and the proposed conduct changes here.