Client-focused reforms and advisor compensation

June 10, 2021 | Last updated on June 10, 2021
6 min read

This article is the first in a series covering the changes taking place this year — some on June 30, others on Dec. 31 — as the Canadian Securities Administrators’ client-focused reforms are implemented.

As regulators require greater disclosure about conflicts, advisors and firms should be considering compensation more carefully.

The client-focused reforms (CFRs) related to conflicts come into effect on June 30. Dealers and advisors must identify and address material conflicts in clients’ best interests, and provide written disclosure of material conflicts to clients. Conflicted compensation, including both embedded commissions and direct compensation for sales, is among the key conflicts to address.

“If you have a material conflict that you’re choosing not to outright avoid, are you comfortable disclosing it?” said Richard Roskies, senior legal counsel at AUM Law in Toronto. “Because the new rule is that it’s going in front of your client.”

Examining compensation will be an important part of the process to address conflicts, Roskies said, but it’s “only one piece” of the reforms, which include know-your-product (KYP) factors such as a product’s risk rating.

Firms must demonstrate “a good know-your-product system,” said Rebecca Cowdery, a partner at Borden Ladner Gervais in Toronto. That means reviewing the product shelf regularly to ensure it has a reasonable range of alternatives suitable for the firm’s range of clients.

Firms can’t put only funds with the highest third-party compensation on their shelves, for example, because advisors wouldn’t be able to make recommendations that put clients’ interests first and meet the CFRs’ enhanced know-your-client and suitability obligations. (Cowdery also noted that third-party compensation may not vary significantly among mutual funds to begin with.)

The point is, “these [CFR] requirements go hand-in-hand,” Cowdery said. “They’re all related.”

While there are downsides to products with embedded commissions, those have to be balanced against the arguments for them, Roskies said.

The reforms’ companion policy offers several suggestions to firms, such as developing client profiles to demonstrate when embedded commissions may be suitable and refraining from tying advisor compensation solely to commissions.

“There needs to be a thoughtful process to work through that balance in a documented manner,” Roskies said.

KYP reforms will ideally result in a “more well-thought-out product shelf, with third-party compensation in mind,” said Daniel Kratochvil, chief compliance officer with Mississauga, Ont.–based Agora Dealer Services Corp., a carrying dealer that provides digital tools to MFDA dealers and advisors.

A dealer can identify products with different levels of compensation and implement controls so that comparisons are independent of that compensation, he said.

Dealers should also be able to justify compensation based on services provided. “If there are products that are of similar characteristic but also have differing levels of compensation, what are the services and how does the business model of the dealer match that?” Kratochvil said.

Regulators have cracked down on embedded commissions that don’t align with services. Trailers paid to discount brokers where no suitability determination is made are banned starting June 1, 2022. 

Even though firms’ KYP processes may result in product shelves that include funds with embedded commissions, advisors are increasingly shifting away from commissions-based revenue.

“Clients should be treated with whole transparency,” said Jason Pereira, senior financial consultant with Woodgate Financial Inc. and IPC Securities Corp. in Toronto.

If an advisor gets paid with embedded commissions, the best-case scenario is “it’s fully disclosed — transparent — and the client acknowledges it and is provided written disclosure,” Pereira said, adding that the compensation would also be shown on the annual statement.

Whether a 1% trailer is fair is another issue, he said, depending on services provided and amounts invested.

For the sake of argument, what if an advisor had to choose between two similar products that differed only in compensation level?

“That would be a red flag for compliance, if an advisor generally only put their clients in recommended products that had higher compensation,” Cowdery said.

The companion policy says that “registrants must not recommend a product or service just because it pays them better than the alternatives” but must put clients’ interests first when making a recommendation.

Cowdery noted that, in most cases, embedded commissions are generally product neutral, because trailers go to firms, which firms then apportion to advisors according to payout grids.

Still, when a product offers indirect or direct compensation, there’s a perception that advisors are recommending it only because they’re getting paid to, Roskies said in a blogpost earlier this year. For their part, advisors can conduct product comparisons to show that the product they’re recommending is a good one, he said.

Documentation will also become more important with the CFRs. “Be very careful that you document why it is you recommended a particular product,” Cowdery said. Funds with deferred sales charges (DSCs), for example, may be fine for some investors, so long as the recommendation is explained and documented, she said.

DSCs are banned starting June 1, 2022. The CSA issued a statement last year warning that regulators will be “highly attuned to inappropriate sales of DSC products ahead of the ban.” 

As far as documentation, “We should have a logical, defined and documented reason for why we use an investment in the first place,” Pereira said, and why the investment is better than other options. That was the case even before the reforms.

In contrast, “If you’re an advisor who sells the flavour-of-the-month fund and goes back to change [client] holdings, you’ve got a lot to answer for in the coming regime,” he said.

Advisors’ documentation should show that objective “metrics of quality” such as risk rating, time horizon and fund size undergird their recommendations — separate from compensation, Kratochvil said.

He also noted that, as accounts increasingly shift to fee-based, continual disclosure will be important.

After the initial disclosure, registered firms aren’t required to remind clients of particular conflicts, Kratochvil said. “However, it would behoove an advisor to constantly consider … the disclosure of the new regime of fees” when an account switches from commissions-based to fee-based, Kratochvil said.

Firms must also consider conflicts related to their incentives programs, allaying client concerns about advisors being incentivized to sell certain products.

“There have to be safeguards in place to make sure those incentive practices achieve the result of any conflict being in the best interests of the clients,” Roskies said.

The companion policy suggests tying some of an advisor’s variable compensation to the absence of “valid” client complaints or to the advisor’s compliance with the firm’s policies and procedures, among other suggestions.

“The firm has to be confident that there is no undue incentive … to recommend one product over another,” Cowdery said, adding that she’s observing more disclosure about compensation generally.

While documenting conflicts is one thing, getting clients to read about it is another. Cowdery said conflicts of interest statements typically require about five pages (for overall conflicts), and the documentation will be part of a client’s account opening package. Otherwise, disclosure is to be done in a timely manner after conflicts are identified.

“Generally, it is an increased amount of material to read,” Cowdery said, which may represent a challenge for clients and advisors — albeit one with a payoff. If a client reads the disclosure, they’ll get a much better sense of how the firm is run, she said.

An important part of CFR implementation will be advisor training, especially with the reforms related to conflicts of interest, Cowdery said. Regulators expect advisors to be trained about what a conflict is, how to recognize it, how the firm addresses it and what advisors’ part is in addressing it.

Dealers and advisors should refrain from thinking about their CFR obligations as a series of boxes to check, Roskies said, and instead consider whether a client would be happy with how they’re addressing a conflict.

He suggested conflicts disclosure could be a point of pride for firms and advisors if clients are left with an understanding that their trusted advisor is looking out for their best interests.