With the client-focused reforms related to conflicts coming into force at the end of this year, advisors could soon start to see changes at their firms related to incentives, compensation and product shelves.
Kathryn Fuller, a partner at BLG in Toronto, describes the overall reforms, which include enhanced requirements to KYC, KYP and suitability, as “a huge endeavor” for both firms and advisors.
“Most advisors don’t yet know the extent to which this is going to intrude on their day-to-day business,” she said.
The reforms, which consist of amendments to National Instrument 31-103 and its companion policy, require that firms and advisors address material conflicts in the best interests of clients, put clients’ interests first when making suitability determinations and do more to clarify what clients should expect from them.
Reforms related to conflicts, as well as associated relationship disclosure information, take effect on Dec. 31, 2020. The remaining amendments take effect one year later.
The Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association of Canada will amend their rules to comply with the reforms.
Last month in a compliance report, IIROC emphasized its commitment to addressing compensation-related conflicts. And in an update on its priorities published earlier this month, it said it planned to publish amendments, request for comments and guidance related to the reforms in April 2020.
When asked what changes advisors could see related to compensation, incentives and proprietary products, Michael Garellek, a partner at Gowling WLG in Montreal, said the guidance accompanying the amendments is explicit that these things have inherent conflicts. Firms will have to “prove in a positive way that they’re taking the issues into consideration and doing something about them,” he said.
Incentives and compensation
Where the reforms address incentive practices, the regulators are trying to get firms to consider how strongly their incentives motivate advisors to make recommendations that aren’t in clients’ best interests, Fuller said.
With compensation being a key regulatory priority in recent years, firms have likely already started considering their compensation practices; the CFRs will thus require enhancements to existing controls, she said.
The companion policy provides examples of controls that firms could consider to address incentives-related conflict violations. These include prohibiting advisors from future participation in an incentives program, requiring that compensation doesn’t vary based on revenue generation or certain product recommendations, and limiting variable compensation or tying it to an absence of client complaints.
“Some firms will certainly take a closer look at the amount of variable pay,” which can result in churning if the proportion is too large, Fuller said.
She also noted that regulators consider disclosure alone to be insufficient, so they expect advisors to proactively discuss compensation.
Garellek called out a particularly punitive control in the guidance related to incentives: requiring that an advisor repay a portion of compensation where products were recommended to meet an incentives program.
That penalty may be harsh for the average advisor, he said. “We’re not talking about C-class executives with multimillion-dollar salaries.”
Neil Gross, chair of the Ontario Securities Commission’s Investor Advisory Panel, said incentives should focus on clients’ best interests, prompting advisors to create plans or diversify portfolios, for example, versus recommending proprietary products.
“To the extent that we can see practices around incentives legitimize only the incentives that are good for clients, that will be a good thing,” he said.
Controls suggested in the companion policy to address the conflict of embedded commissions include developing client profiles that describe the types of clients for whom funds with embedded commissions would be suitable and refraining from tying advisor compensation solely to commissions.
What next for DSCs?
Since the reforms were published, regulators announced a forthcoming ban on trailers paid to discount brokers and on deferred sales charges (DSCs), with final amendments to be published early this year. The Ontario Securities Commission was the only regulator that didn’t join the ban, saying it’s considering DSC restrictions.
Firms in Ontario will have to update their policies and procedures to reflect those forthcoming restrictions, as well as include additional guidelines they deem appropriate, Fuller said. For example, rules could prohibit using DSCs for a client close to retirement.
With increased regulatory scrutiny, some dealers in Ontario that still offer DSC funds might stop doing so, she said. As a result, “managers may no longer see the point of supporting a DSC option if only a small fraction of their dealer network will put it on the shelf,” she said.
Further, “it may be a greater compliance headache than it is worth for an advisor to justify why it is better to put their clients into a fund sold under the DSC option than under the upfront sales charge option or a fee-based account,” she said. A DSC fund can be better for a smaller client account that would benefit from no upfront sales charge, she noted.
Regardless of whether DSC funds are restricted or banned, they’re now “a pariah product,” Gross said. “Only a fool looking for trouble would sell them to clients from this point forward.”
Other impacts to the product shelf
Advisors’ recommendations overall could be influenced by the reforms’ requirement for greater documentation. For example, because documentation will be a significant burden, “there will be some advisors who make [price] one of their strongest criteria because it’s easy to document” a cheaper fund relative to a more expensive one, Fuller said.
The reforms could also motivate firms to move toward smaller or proprietary shelves, to more easily meet suitability requirements. As it stands, it’s unclear how the broader obligation of ensuring a product is suitable versus simply having a suitable product on the shelf will play out, Gross said.
In the end, whether the CFRs usher in meaningful industry change will depend on oversight.
If regulators “permit business as usual, we’ll get the usual business,” Gross said. “We’ll see how much of a sea change it is at the enforcement level.”