financial advisor explaining investment plan to couple on laptop at office desk

The Canadian Securities Administrators (CSA) has decided not to ban embedded commissions after all. Instead, the group of provincial and territorial regulators has proposed new rules for dealers and financial advisors to address any potential conflicts of interest in clients’ best interest or avoid them altogether, as well as to eliminate all forms of deferred sales charges (DSCs).

In addition, the CSA has decided to prohibit dealers that don’t make a suitability determination when selling mutual funds, such as discount brokerages, from receiving trailing commissions.

The long-awaited decisions were delivered on Thursday in a staff notice outlining these measures and in a 120-day comment period proposing amendments to registrant conduct provisions. (The CSA stated in the staff notice that it anticipates publishing a notice and request for comment in September.)

Although the CSA’s staff notice points out that “regulatory action is required to mitigate the inherent conflicts of interest associated with embedded compensation and to ensure the investor’s interest is paramount,” the regulators are instead proposing enhanced conflict of interest mitigation rules and guidance for dealers and advisors on all securities because these conflicts “are not unique to mutual funds.”

Thus, as part of the proposed amendments to the registrant conduct provisions (a.k.a. client-focused reforms), dealers and advisors will be required to: address conflicts of interest in clients’ best interest, including those resulting from compensation arrangements and incentive practices; put clients’ interests first when making a suitability determination; and do more to clarify for clients what they should expect from registrants.

The proposals avoid the introduction of a statutory best interest standard as only the Ontario Securities Commission and the Financial and Consumer Services Commission of New Brunswick had stated they would adopt one.

“Some of the proposed amendments would impose new requirements, while others would codify best practices set out in existing CSA and [self-regulatory organization] guidance,” the proposal states. “The combination of the codification of best practices and the introduction of new requirements will result in a new, higher standard of conduct for all registrants.”

Specifically, the CSA is seeking to amend the know your client (KYC), know your product (KYP), suitability, conflicts of interest and relationship disclosure information provisions in the rules, supported with detailed guidance.

For example, the proposed KYC provisions explicitly set out the information advisors and their dealers must collect from clients to meet their suitability obligations, such as personal and financial circumstances; investment needs, objectives and knowledge; risk profiles; and time horizons. Furthermore, the KYC information must be reviewed and updated when a registrant knows of a significant change in a client’s information and at minimum intervals of once a year for managed accounts, a year before making a trade or recommendation for exempt-market dealers and three years for other accounts.

There also are extensive changes in the proposals regarding the suitability obligation, as the CSA points out that unsuitable recommendations generate the most complaints to the Ombudsman for Banking Services and Investments. At the heart of the proposed rule would be a “core requirement that registrants must put their clients’ interests first when making a suitability determination,” the CSA’s notice and request for comment states. Most notably, advisors and dealers would be required to consider factors such as costs and their impacts when making recommendations.

Meanwhile, to reduce conflicts of interest, the proposals “would require all existing and reasonably foreseeable conflicts, not just material conflicts, to be addressed in the best interest of the client.” As well, registrants would have to report conflicts of interest they identify to their sponsoring firms promptly, and extend disclosure requirements to identify the potential impact and risk a conflict may have on the client and how it has been, or will be, addressed. That disclosure would have to be prominent, specific and written in plain language.

For advisors, proposals regarding the misleading communications provision state that advisors must not represent their services in a misleading or deceiving manner as it relates to their proficiency, experience, or qualifications and the products or services provided. Advisors also must not use a title, designation, award, or recognition that is based on their sales activity or revenue generation, nor can they use a corporate officer title — unless they fulfil such a role.

The CSA also is aiming to enhance disclosure on the use of proprietary products, limitations on the products and services made available to clients and the impact of these on investment returns. Thus, registered firms would be required to make public information that includes the newly defined terms “third-party compensation” and “proprietary product.” Specifically, registrants must disclose any third-party compensation associated with the firm’s products and services, and whether proprietary products will be used primarily or exclusively in clients’ accounts, respectively.

“We expect that these proposals will significantly strengthen the nature of the client-registrant relationship, and will result in recommendations that better align with the client’s interest,” the CSA’s staff notice states.

The proposed new rules would include other measures requiring dealers to train advisors on “compliance with securities legislation, including conflicts of interest requirements, the KYC and KYP obligations, the obligation to make a suitability determination and prescribed elements of the securities available through the firm.” In addition, firms would be required to implement changes to their internal compliance processes to ensure the new measures are met.

As for the other main recommendation, the elimination of the DSCs, the CSA states in its staff notice that even though they are used widely in Canada, the conflicts of interest inherent in this model “are generally difficult to resolve in the best interests of investors.”

The staff notice points out that DSCs are particularly attractive for dealers and advisors because they offer an initial commission of up to 5% of the purchase amount, paid by the investment fund manager rather than the investor, plus an ongoing trailing commission. “The higher upfront and third-party nature of the compensation on the DSC option creates a conflict of interest that can incentivize dealers and representatives to promote the DSC option over other options that may be more suitable for investors.”

In addition, DSCs could impact investors’ behaviour as the redemption fee payable on investments is typically redeemed within seven years of purchase, locking clients in to these funds. “This penalty can significantly deter investors from redeeming an investment or changing their asset allocation, even in the face of consistently poor fund performance, unforeseen liquidity events, or change in their financial circumstance,” the staff notice states.

By eliminating DSCs, the CSA expects the following benefits: to remove conflicts of interest associated with this model; to promote suitability assessments that meet investors’ needs; to improve investors’ ability to make changes to their investments; to decrease mutual fund fee complexity; and to simplify the disclosure of fees.

Finally, the CSA has decided to eliminate the fees paid for the distribution of mutual funds through discount brokerages because they “do not appear to align with the execution-only nature of the services they receive,” the staff notice states. “We also observe no justifiable rationale for the practice of paying discount brokerage dealers an ongoing trailing commission for the sale of a mutual fund.”

The 120-day comment period ends Oct. 19.