Special Feature

CRM2 Guide 2016

The regulatory revamp of dollar-based disclosure for fees and performance, as well as suitability and risk, is complete. Learn how to respond when clients receive their new reports next year — and what to expect from further regulatory change.
 

There are some hidden shoals in the CRm2 regime. regulators offer advice on how to navigate them

By Jade Hemeon | October 2016

The final brick in the implementation of the client relationship model, phase 2 (CRM2), has been laid. Now, investment industry participants and their clients must adjust to a new era of more detailed disclosure of investment costs and performance - and more scrutiny of the relationship between the two.

CRM2 has been implemented gradually over the past few years. Although the phase-in of the regulatory initiative has allowed for an easier adjustment than an abrupt plunge into uncharted waters, the new, more transparent environment raises some issues and questions. Regulators and industry groups, such as the the Investment Industry Association of Canada (IIAC), the Investment Industry Regulatory Organization of Canada (IIROC), the Canadian Securities Administrators (CSA) and the Investment Funds Institute of Canada (IFIC) have been working hard to help firms clarify the muddy areas.

With mutual funds subject to various types of commissions, as well as management fees, disclosure on this product category in particular is complex and confusing. However, more than 62% of Canadian investors hold mutual funds, and because this product enjoys broad popularity, it represents a crucial piece of CRM2, together with Fund Facts.

Mutual fund clients will be told up front what they're buying and what it costs, and that there may be a further charge if they redeem their investments within certain periods. This disclosure can lead to an informed conversation about what the dealer is being paid and what the client is receiving in return, and can be a valuable tool in deepening the client/advisor relationship, says Chris Jepson, senior legal counsel, compliance and registrant regulation, at the Ontario Securities Commission (OSC).

"One of the themes of the new disclosure is relevant information at the relevant time," says Jepson. "When clients open an account, they are told what the cost model looks like. If they want to make a trade, prior to the trade they must receive specific information on the costs, including any deferred sales charges. If they wish to go ahead, they receive a trade confirmation that clearly shows those costs. And once a year, investors will also receive a summary of what they were charged and what their advisor's firm was paid - including dollar amounts of trailing commission payments."

It's important to note that reports on charges and compensation must disclose only the amount received by the firm. There is no requirement to break down how much an individual advisor is paid because that could result in too much information for the client to digest.

"Disclosing both the fee/charges that the firm charges the client - along with the individual registered representative's portion of these same fees - could confuse the client into thinking they may be paying more in fees than they actually are," says Richard Corner, vice president and chief policy advisor, member regulation, at IIROC.

Although the spotlight has been on new fee disclosure reports required under CRM2 and how clients may respond, Carol Lynde, president and chief operating officer of Toronto-based Bridgehouse Asset Managers, says the performance reports are equally important in providing relevant information for clients, helping them to assess the value they are getting from their advisors.

"Every investor with a financial plan has a target rate of return that they need to achieve their financial goals," says Lynde. "We should all be long-term investors. It's important for clients to see how their portfolio actually did relative to their goals - not relative to their friend's numbers or various market benchmarks."

Firms may decide to issue the new reports on a calendar-year basis or choose another date for their annual measurements. For the firms that will report on a calendar year basis, the first reports will cover the period from Jan. 1, 2016, to Dec. 31, 2016. According to the most recent CSA guidance document, when a firm decides not to report on a calendar-year basis - for example, the firm's most recent annual reporting period ended on July 15, 2016, rather than at yearend - then the information contained in clients' first annual reports must be based on the one-year period beginning July 16, 2015. Other non-yearend reporting dates require a similar adjustment.

The requirements apply to dealers and advisors in all categories of registration, including securities firms, fund dealers and exempt-market dealers that hold client assets and have ongoing client relationships. However, exempt-market dealers that have only transactional relationships with clients, such as distributing a specific private placement, do not have to comply with the same CRM2 standards as other dealers, according to guidance issued by the CSA.

Among the consequences of CRM2 is the disparity in rules for securities and mutual funds vs insurance products, the last of which fall under a separate regulatory regime. Firms and individuals licensed to sell insurance are regulated by provincial insurance regulators such as the Financial Services Commission of Ontario rather than securities regulators; thus, CRM2 rules do not apply to those firms. There has been some speculation within the investment industry that dual-licensed advisors may change their focus to selling segregated funds rather than mutual funds and securities, which require enhanced reporting of performance and costs.

Securities regulators, including the CSA and industry organizations such as IFIC and the Mutual Fund Dealers Association of Canada encourage firms to include non-securities products such as seg funds in their reporting to the extent possible, and many advisors and firms are disclosing information equivalent to CRM2 standards on all products sold.

"While the jurisdiction of the CSA is limited to securities, we encourage registrants to provide their clients with information that meets the CRM2 standards with respect to all their investment [products]," says Debra Foubert, director, compliance and registration regulation, at the OSC. "This way, investors will be in a better position to make informed decisions with regard to different investments."

Detailed question-and-answer documents issued by both IIROC and the CSA earlier this year point to some of the complexities relating to the more detailed disclosure and provide further clarity. Among the issues for which additional guidance is provided:

Pre-trade disclosure of DSCs on mutual funds and other fund costs

The required communication of detailed mutual fund fee information to each client prior to each trade can be challenging, as there are fee variations among funds.

IIROC staff does not believe that a generic deferred sales charge (DSC) schedule meets the requirement to provide a client with fund-specific information. However, IIROC states that DSC information is obtainable for each mutual fund and sees no impediments to the communication of this information to a client before the firm accepts the client's trade instructions. In the circumstance in which DSC information for a proposed mutual fund transaction is unavailable or unknown, IIROC questions whether the transaction should take place until such information is known, as the client may not be able to determine if the transaction is appropriate.

If a DSC is triggered when the fund is sold later by the client, no commission or other payment goes to the fund dealer or advisor at that time, and therefore, there is no requirement to include it in that year's annual CRM2 costs report, according to the CSA's FAQ. (The mutual fund firm pays a commission to the dealer when the fund units are purchased initially, and that commission is shared with the advisor. That commision will appear on the client's CRM2 costs/fee report for the year in which the fund units are purchased under the heading of "third party fees/compensation"). The client is informed before redeeming from the fund that the DSC will be applied and how it will affect the proceeds of the redemption transaction.

Other fund charges that must be disclosed on purchase include trailing commissions or other embedded fees, switching fees and upfront commissions paid to firms, whether by the client or by the fund manager.

New Issue Fees

Fees on new securities issues paid by the issuing company to compensate dealer firms for services provided in relation to the financing. Included in this fee is a "commission" for selling the new security to clients; this commission often is factored into the pricing. IIROC has determined that the commission portion of the fee for the distribution of a new security issue is not subject to pre-trade disclosure requirements.

Calculating the costs of securities acquired by conversion or exchange

Some client positions are acquired by a conversion, an exercise or exchange feature attached to a convertible, exercisable or exchangeable security. But in developing the requirement to provide clients with cost information, the regulatory focus was on standard, consistent definitions that could be applied to the most common account holdings, such as debt and equity securities. In determining the cost of a security acquired by conversion, exercise or exchange, the firm needs to consider the amount a client paid to purchase the original security, as well as the cost to exercise the conversion, exercise or exchange feature embedded in that security.

"Not determinable" disclosure

Sometimes, cost information is simply not available or cannot be determined. However, IIROC says that without a requirement to provide some form of comparative information, clients won't be able to assess whether they have made or lost money on an individual position since its original purchase. This would undermine the intent of the disclosure requirements. Therefore, in the case of positions that are transferred from another firm and have no information of book cost or original cost, IIROC suggests using market value at the transfer date to assess whether the client has made or lost money since the position was transferred to the current firm.

Or, in the case of existing account positions as of Dec. 31, 2015, market value information on that date could help a client assess whether they have made or lost money since that starting point.

To avoid the potential for client confusion or the possibility of a client misusing this determination of value for calculating taxable gains or losses when filing income tax forms, IIROC suggests that firms provide the appropriate disclosure to the client describing what the information can be used for - rather than failing to provide the client with any comparative information on a security's value.

Multiple transferred-in positions

The CRM2 rules do not specifically address reporting on positions created through the accumulation of multiple quantities of the same investment product that is transferred into an account from outside the firm at different times.

IIROC suggests that as each quantity of the same product is transferred in, the firm will need to determine if there is reliable cost information available and, if not, whether the current "point in time" market value of the position will have to be used as an estimate of cost.

In a situation in which a portion or all of the position cost is calculated based on "point in time" market value information or a mixture of different types of cost information - such as "original" or "book" cost - the dealer firm will need to provide, in a note to the position, further details of how the value has been calculated.

"Original" cost is the amount paid to buy a security, plus transaction charges. But "book" cost includes the total amount paid for the security, including any transaction charges, adjustment for reinvested distributions during the time the security is held, any return of capital and corporate actions such as stock splits.

When an investment fund is not valued daily

In this case, the most recent net asset value (NAV) provided by the fund manager should be used, according to the CSA's guidance. If the dealer or advisor believes the NAV is stale or inaccurate, an explanatory note can be included with the client account statement.

THE RECAP

The CRM2 initiative for more detailed disclosure on the sale of securities began with some basic requirements for pre-trade disclosure in July 2014, including a reasonable estimate of all possible charges, the existence of ongoing fees, such as trailing commissions, and an explanation of benchmarks. In December 2015, more detail was required in client quarterly statements, including the market value and cost of security positions.

The final step, implemented on July 15, covers more specific annual reporting to clients regarding dealer fees and compensation, as well as investment performance. Investors must also receive a separate annual report with details on how their investments have performed in both percentage terms and actual dollar value.

Dealers have until July 14, 2017, to begin sending these new reports to clients. However, most investors will receive their reports early in 2017 because most firms will provide the information on a calendar-year basis, according to the Investment Funds Institute of Canada (IFIC). From 2017 onwards, investors must receive their reports every year. Both reports must cover the same 12-month period and be sent together to the client, either with current quarterly account statements or separately, according to Preparing CRM2 Reports for Your Clients, a document found on IFIC's website.

The performance report information must be individually tailored, showing personalized returns for the previous year, as well as three-, five- and 10-year periods - or since inception if that data is not available.

That report must also include the market value of securities at the beginning and end of the annual reporting period, as well as deposits and withdrawals during the period. Also required is the annual change in value and the cumulative change in value since the securities have been held in the account. The performance report doesn't require comparative benchmarks. Rather, it will focus on the individual's personal rate of return as affected by specific deposits into and withdrawals from the account, dividends and interest earned, and changes in the value (money-weighted rate of return) of securities.

Firms also need to provide an annual report on all charges and other dealer compensation, showing in dollars what the firm was paid for each investment, as well as an aggregate amount. Reports must itemize embedded trailer fees or sales commissions paid to the firm, among other fees. Trade confirmations must disclose the dollar amount of each transaction charge, as well as the total amount of all charges.

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