As daunting as the second phase of the client relationship model (CRM2) can seem, approaching its components in a methodical fashion, based on their year by year phase-in, can help to make the process more digestible.
The new requirements for 2015, with a final deadline of Dec. 31, deal with mandatory reporting to clients of market value, position cost and deferred sales charges (DSCs), as well as a number of other, relatively less complex issues, such as providing an opening balance, the name of the party that controls each investment and indicating whether a product is covered by an investor protection fund.
While these requirements may, at first glance, seem relatively straightforward, 2015 has turned out to be CRM2’s “sleeper year,” says Adrian Walrath, assistant director of policy at the Investment Industry Association of Canada (IIAC) in Toronto. There have been many challenges involved in, first, properly defining the meaning of what regulators mean by the terms “market value” and “position cost,” and then the work involved in changing back-office systems that will be able to provide these new figures.
“It has ended up being a much bigger endeavour than people thought,” Walrath says. “And you really need to have the foundation of the 2015 rules in place before you can start collecting the information for the 2016 reporting, so getting an extension [from the original July 2015 deadline to Dec. 31, 2015] was very helpful.”
Financial advisors need to be aware of, and understand, how market value and position cost are defined under the CRM2 rules, and proactively address these required figures with clients before account statements are sent out, Walrath suggests. Advisors also need to remind their clients about which securities in their portfolios have an associated DSC, and how those fees fit in with a client’s long-term financial plans. “Clients need to understand all of that now, so that they’re not surprised,” says Walrath.
Here is a guide to the new calculations for how market value, position cost and DSCs are to be disclosed under the new rules:
Firms must provide a market value for each security, based on general accounting principles, in which market value is the price at which the security could be sold on any given day. For securities that are difficult to price, a reasonable estimate must be given based on a hierarchy of criteria, using available data to arrive at a reasonable price. If there is no available information to satisfy the criteria, the security is given a value of “not determinable.”
Market value for mutual funds is fairly straightforward; for practical purposes, there’s no change in how market value has been determined prior to CRM2. “In the MFDA [Mutual Fund Dealers Association of Canada, based in Toronto] space, a mutual fund is a mutual fund,” says Richard Binnendyk, executive vice president of enterprise wealth management at Toronto-based Univeris Corp, a technology services provider to financial services firms. “[The industry] has been reporting market value for 20-plus years.”
There may be exceptions for some funds that aren’t priced daily or for exempt-market products that may be challenging to price, both of which represent a small percentage of the overall mutual fund marketplace. “Typically, it’s not that big a deal [to determine a reliable estimated market value],” says Binnendyk. “There are many sources of pricing available for a wide variety of products that dealers offer. If a fund is traded through FundServ Inc., it’s even less of a problem, because you get prices out of FundServ all the time.”
Valuing securities other than mutual funds can be more complex, reflecting the wider variety of products available. If a security is traded on an active market, the published price quotation is used. In general, if a security is illiquid and a reliable price can’t be determined, an estimate would be given by looking at “observable inputs.” For example, if a security such as an option or warrant isn’t trading, an observable input would be the market value of a related and similar type of security that is trading. In the absence of that data, “unobservable inputs and assumptions” are used. This refers to consulting financial documents, such as the security’s prospectus, to determine a market value. Finally, the cost of the security may be used, if cost is the best value estimate within the range of possible values for that security.
If no value can be determined reliably for a security – for example, a private placement – then a value of “not determinable” is given, which, in essence, functions as a zero for performance reporting purposes. That result will affect a client’s performance numbers. Advisors should prepare those clients who have illiquid investments in their portfolios for this outcome, and explain what it means.
“If it’s a sophisticated client and a good advisor who is communicating with that client, then they should understand that while [the security is given a value of] ‘not determinable,’ that doesn’t mean that it really is a zero,” Walrath says.
As the IIAC has noted at times during the consultations on CRM2, some of the new regulations fail to take practical realities into account. This issue arose in the pricing of securities for the purpose of establishing market value; although the regulations mandate the use of values based on “last ask” or “last bid,” those values may be well outside of a security’s value when it was last traded.
The Investment Industry Regulatory Organization of Canada finally agreed to allow firms to use “last trade” to determine market value when the price of the last trade is materially similar to the price of the last ask or last bid. Without this change, a last ask or last bid value that happens to be well outside of a security’s normal trading range would have to be used as the market value unless the reporting firm catches the anomaly and manually changes the value.
Firms will have to report a security’s position cost, which, generally speaking, means what the client paid to purchase the security. Firms can choose to use book cost or original cost. “Book cost” is the total amount paid for a security, including transaction costs, but adjusted for reinvested distributions or withdrawals. “Original cost” is the total amount paid for a security, including any transaction costs incurred by the client.
Practically speaking, virtually all firms are choosing to use book cost, primarily because it’s a number that is believed to be more familiar to clients and thus easier to understand. Book cost also is a number that will be easier for firms to provide.
“Book cost just seems to be the more relevant factor,” says Michael Stanley, president and CEO of London, Ont.-based Quadrus Investment Services Ltd. and chairman of the Investment Fund Institute of Canada’s CRM communication task force. “A lot of dealers today do provide adjusted cost base, so introducing book cost isn’t that big a jump. It seems like the most natural progression.”
A widespread concern within the investment industry is that clients will see the book cost of a security and interpret that number to be book value, the latter of which is a tax reporting number. Book cost, as defined under CRM2, does not include certain tax elections, such as a spousal rollover, that would be reflected in book value. As well, if a client were to own the same security in accounts at more than one dealer, book cost might differ from account to account, with no way for one dealer to know what the client holds with another dealer.
To be sure, book cost could be, in many cases, the same figure as a security’s book value. However, book cost can’t be taken as book value or tax cost, or used as such.
“Clients need to make sure that they understand [the difference],” Walrath says. “Hopefully, advisors are telling clients that they need to keep track of their transactions for their tax cost number for the Canada Revenue Agency.”
It may be inevitable that some clients will use book cost as tax cost. “Clients are going to see a new column called ‘book cost’ and say, ‘Oh, that means that’s the book value’ [and use that figure for tax calculations],” Binnendyk says.
Under CRM2, book cost is meant to be a method of giving more information to clients, thus allowing them to compare the costs of acquiring a security to its current market value. However, this requirement could be a case of regulators’ best intentions resulting in unnecessary confusion, Binnendyk suggests: “The way we ended up interpreting the number [for book cost] is that it’s an indication to the client as to how they’ve done. But with all the other information coming at the end of 2016, which is way more detailed and way better measurements of performance, what’s the point [of requiring a book cost number]?”
If an investment carries a DSC, firms must provide a notation identifying it as doing so as part of the 2015 changes. The firm also must inform clients fully about the DSC rate if those clients decide to sell the investment before the DSC schedule has run out. Firms are already providing pre-trade disclosure of the amount of the DSC, or a reasonable estimate of the amount, as part of the July 2014 round of measures implemented under CRM2.
The DSC information is not likely to be difficult for firms to provide, or necessarily confusing for clients, who will have been told by their advisors that an investment has a related DSC at the time the product was purchased.
However, the DSC disclosure may necessitate a reminder discussion with clients who hold fund units that have a DSC in their portfolio.
“Clients may forget [having discussed the DSC charge with their advisor], and then they get a statement and it’s ‘Wait a minute, what’s going on?'” says Binnendyk. “So, it’s up to the advisor to make sure that he or she explains or re-explains: ‘Hey, we talked about this; it’s a long-term investment.'”
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