Securities regulators have not definitively decided to ban trailer fees, but a new consultation paper from the Canadian Securities Administrators (CSA) challenges the securities industry to come up with compelling new evidence to grant those fees a stay of execution.
In early January, the CSA published a long-promised paper that sets out the regulators’ approach to investment fund fee structures. Although the paper insists that the CSA has not made up its mind on the issue, the paper also reveals that the industry’s existing arguments in favour of the status quo fail to persuade so far. If the industry hopes to avoid a ban on trailers, it’s going to have to come up with a convincing new angle.
To be sure, the industry intends to oppose the idea of such a ban. Industry trade groups, including both the Investment Funds Institute of Canada (IFIC) and the Financial Advisors Association of Canada (a.k.a. Advocis), immediately opposed to the idea of banning embedded compensation.
“Eliminating the ability of investors to pay their fees through what is known as a ‘bundled’ or embedded commission could significantly disrupt access to investment advice for many investors,” says Paul Bourque, IFIC’s president and CEO, in response to the release of the CSA paper.
Yet, the industry faces an uphill philosophical battle in the months ahead in making that case and avoiding a ban on embedded compensation. However, the regulators are convinced that embedded compensation creates powerful conflicts of interest and distorts financial advisors’ incentives, which impedes competition and harms investors.
“Based on the evidence we have gathered, we believe that a change to a different compensation model must be considered,” the CSA’s paper states: “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.”
The CSA paper sketches out the regulators’ vision of a sweeping ban on embedded compensation models, one that would cover not just mutual funds, but would extend to similar products too (such as structured notes) in both the regulated world and the exempt market.
The regulators’ basic goal is to prohibit investment product manufacturers from paying any compensation to investment dealers – such as ongoing trailer or service fees and upfront commissions paid on funds sold with a deferred sales charge.
However, the CSA stresses that it would not mandate fee-based arrangements if trailers are banned. Instead, clients and firms would be able to agree on a variety of compensation models, including commissions, asset-based fees or other, less common approaches, such as fee-for-service arrangements or hourly rates – as long as the compensation arrangement is agreed upon between the firm and the client, and that the client pays, not a third party.
The CSA paper does note that certain types of third-party compensation still would be permitted, including referral fees, co-op marketing arrangements and transfers between related manufacturers and dealers. The paper also suggests that fund firms could be involved in collecting payments for dealers by regularly redeeming units and sending the proceeds to the dealer on behalf of investors – an approach intended to ease administration costs while retaining the virtues of eliminating embedded compensation.
Indeed, the CSA paper acknowledges that banning trailers would be a big step for the industry. Yet, the CSA’s paper also explicitly shoots down many of the industry’s objections to such a ban.
For example, the regulators aren’t buying the industry’s claims that small investors would suffer if embedded compensation is outlawed. The CSA paper also dismisses the argument that other regulatory initiatives (such as the second phase of the client relationship model reforms [CRM2]) and the reforms proposed last year to client/advisor relationships (including a possible regulatory “best interest” standard) will be enough to protect investors. The CSA paper also rejects comparisons to other markets that have banned embedded compensation already.
Even as firms in Canada’s industry like to point to the U.K. and the supposed “advice gap” that developed in the wake of similar regulatory reforms there several years ago, the CSA isn’t convinced a similar situation would evolve in Canada: “While observations about the impacts of relevant reforms in other jurisdictions are informative and insightful, we consider that the potential impacts from similar reforms in Canada might not be the same.” The paper also notes that the markets in Canada and the U.K. are fundamentally different.
Moreover, the CSA paper suggests that the U.K.’s alleged advice gap was not driven by the elimination of embedded commissions and more likely was due to other, concurrent reforms. Notably, U.K. policy-makers are not looking to undo their ban; rather, they have concluded that eliminating embedded compensation was the right move.
The CSA paper also states that the regulators’ analysis of the Canadian market indicates that a ban on embedded compensation isn’t likely to lead to an advice gap here. Most smaller investors in Canada don’t own units in investment funds, according to the regulators’ analysis; and those investors who do typically buy them at a big bank or insurer – firms that the CSA believes probably wouldn’t be affected much by a ban on trailers.
The CSA paper disagrees with the industry’s contention that enhanced disclosure through the CRM2 reforms, along with a possible best interest standard and other “targeted reforms” to client/advisor relationships, make a ban unnecessary. The regulators view these initiatives as potentially complementary to one another, not as substitutes.
That said, the CSA paper also doesn’t give any sense that regulatory action is imminent. The paper is out for an exceptionally long, 150-day comment period, giving the industry and others until June 9 to make their case to the CSA. And, once again, the regulators are planning to hold in-person meetings alongside the usual written submissions for the consultation process. All this time should provide voices on both sides of the issue plenty of opportunity to be heard.
According to John Mountain, director of the investment funds and structured products branch at the Ontario Securities Commission, the feedback that regulators receive is “very important” to the regulators.
“Over the next 150 days, we look forward to consulting with industry and receiving submissions based on quality information, including data specific to Canadian markets,” Mountain says, adding that any actual rule proposal still would have to go through the usual rule-making and comment process.
The CSA’s paper doesn’t actually set out a proposal to ban embedded commissions. Rather, the consultation is being launched to help the CSA decide, once and for all, if it will intervene with fund fee structures and gather input on just how to do so.
If the regulators decide to go ahead with banning embedded fees, there then would have to be a formal rule-making process. And, the paper suggests, a three-year phase-in period would be required if a ban is enacted.
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