The Canadian Securities Administrators (CSA) published a long-awaited consultation paper on Tuesday that contemplates a ban on embedded commissions structures amid persistent concerns that these arrangements harm investors, requiring the investment industry to move to “direct pay” compensation models instead.
The CSA’s consultation paper says the regulators’ research has demonstrated that “embedded commissions encourage … suboptimal behaviour” among fund managers, dealers, reps, and investors, “which reduces market efficiency and impairs investor outcomes.”
The CSA’s paper notes that embedded commissions incentivize dealers and reps to sell funds that pay higher trailers, such as “higher-risk actively managed funds”; prevent investors from assessing the value they receive from their dealers; and “the cost of the advice and service provided may exceed its benefit to investors,” among other things.
These compensation structures also encourage fund management firms and fund managers to rely on payments to dealers to gather assets rather than investment performance, the CSA’s paper says: “This incentive can, in turn, lead to underperformance and drive up retail prices for investment products due to a competition between investment fund managers to offer attractive commissions to secure distribution.”
These concerns are not new, but after years of on and off deliberation, the CSA has finally concluded that because these conflicts are both pervasive and difficult to manage, “a change to a different compensation model must be considered,” the consultation paper says. “Investors should be provided with a compensation model that empowers them and that better aligns the interests of investment fund managers, dealers and representatives with those of investors.”
To that end, the CSA is formally considering whether to mandate that firms utilize some form of “direct pay” structure that would see investors pay dealers directly for advice rather than via embedded fees. This could include models that utilize upfront commissions, flat fees, hourly fees, or asset-based fees — as long as the model is agreed between the investor and the dealer and involves the investor alone paying the dealer. If adopted, a proposed ban would apply to funds and structured products in both the regulated and the exempt market.
The CSA’s consultation paper indicates that a ban on embedded fees could also lead to increased price competition; lower fund management costs; a shift to lower-cost products, including passively-managed products; and, further innovation, among other effects, in addition to addressing concerns about conflicts.
Yet, despite the regulators’ long-standing concerns and the expected benefits of regulatory action, the CSA stresses in its consultation paper that it hasn’t definitively concluded that it’s necessary to ban embedded fees and to require direct pay models.
Rather, the consultation launched a 150-day comment period on Tuesday (ending June 9), that aims to consider the impact of such a move on the industry and investors as well as possible measures to mitigate any negative consequences and potential alternatives to an outright ban that would alleviate regulators’ concerns.
“We recognize that such a change could have a profound effect on the fund industry and on investors in Canada, including potential unintended consequences,” the CSA says in its consultation paper. “Therefore, a decision on whether to discontinue embedded commissions will only be reached after careful consideration and assessment of the possible impacts on investors and market participants.”
In the meantime, the CSA is calling on the investment industry to “create market-driven solutions and innovations” that would deal with the conflicts and investor harm that the prevailing embedded fee models cause.
This latest round of consultation will undoubtedly, once again, pit the industry, which largely opposes a ban on embedded fees, against investor advocates, who support such a ban. Anticipating that debate, the CSA paper notes that the fund industry has pointed to the other markets, such as the U.K. and Australia, to predict the likely impact of banning embedded commissions in Canada.
Yet, the consultation paper cautions that these experiences may not be directly comparable to Canada: “The unique features of those foreign markets, including the characteristics of their respective market participants and the specific competitive dynamics within which they operate, their market structure, the savings habits of their local investors, as well as the scope of their respective reforms may all play a role in shaping the specific impacts.”
In particular, the CSA says its research suggests that a ban on embedded commissions “is not likely to lead to a significant advice gap for retail investors in Canada.” However, the regulators are seeking input on potential negative effects for investors, the industry, and competition.
The CSA indicates that certain jurisdictions will also be holding in-person consultations on the issues raised in the paper in addition to the formal consultation period.
“Ultimately, our goal is to ensure that any regulatory action we may decide to take will provide a Canadian solution to challenges specific to the Canadian market, will result in more positive outcomes for Canadian investors and will minimize disruption for market participants,” the CSA paper concludes.
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