The investment industry has long justified trailer fees as compensation for ongoing advice. Now, regulators want the industry to put its money where its mouth is, as they aim to require dealers to show clients exactly what financial advisors are paid and how client investments are performing.

Under proposals released for comment by the Canadian Securities Administrators (CSA) in mid-June, dealers would be required to provide clients with an annual report that shows, in dollar terms, what the dealer was paid for the products and services provided during the year – including the value of any trailer commissions and commissions on fixed-income products.

These proposals are part of an initiative that the CSA hopes will help clients understand what they are actually paying, in terms of embedded compensation. And, to the extent that such compensation is supposed to represent payment for ongoing services, the CSA hopes clients will value the advice they receive.

Mary Condon, vice chairwoman of the Ontario Securities Commission (OSC) and sponsor of this project at the CSA, says the regulators’ goal is really to “promote a great deal more transparency to investors, so they can have a more informed interaction with their advisor in the long term.”

She continues: “We think this is an important way for investors really to get a feel for what that value [of advice] is.”

Of course, the fear of many advisors will be that clients also will more readily recognize situations in which they aren’t receiving value for what they’re paying, and they’ll take their business elsewhere.

The industry has opposed the regulators’ efforts to require this sort of disclosure in the past. The CSA notes that the first time it published these proposals (in June 2011), the industry had argued that disclosing the dollar amount of trailer commissions is unnecessary, costly for the firms and possibly confusing to clients.

The regulators reject this position, saying that although there may be added costs, the benefit of properly informing clients is worth it.

The CSA points to research carried out on its behalf that found that most mutual fund investors don’t understand trailers, don’t realize that they are being indirectly charged on an ongoing basis and don’t know that trailers are paid to their dealer for as long as the investor owns units in the fund.

This revelation shouldn’t be news to regulators. In 2004, when the OSC first began developing its fair-dealing model (which has since morphed into the client relationship model, which encompasses these new proposals), the regulator found that most clients don’t understand embedded compensation and that this compensation has a distorting effect on a client’s asset allocation.

At the time, the OSC had declared that enhancing transparency in this area is the “minimum solution necessary to achieve fair dealing.” Banning embedded compensation, however, would “address all of the concerns” with this practice.

Indeed, banning embedded compensation is the approach regulators in other countries are taking. For now, the CSA is not proposing that approach. Instead, it says, it’s “essential that there be a significant increase in the transparency to investors of the compensation their dealers or advisors receive.”

Whether that’s enough to create a more efficient market for advice, and improve the lot of clients, remains to be seen.

Along with the beefed-up compensation disclosure, the CSA’s proposals also would set performance-reporting requirements for firms, mandating that they show how a client’s investments had performed during the past year (and over other periods) in both dollar and percentage terms.

The proposals specifically require firms to use a dollar-weighted method in calculating the percentage return; and the proposals establish a process for valuing illiquid securities, too.

The hope here is that these disclosures also lead to deeper discussions between clients and advisors. Says Chris Jepson, senior legal counsel, compliance and registrant regulation, with the OSC: “We’re trying to provide neutral information, which will encourage and, if anything, deepen the relationship between a professional advisor and their client.”

The proposed rule also sets tougher disclosure requirements for scholarship-plan dealers, “in order to highlight the unique risks to investors inherent in these products.”

It would require dealers to spell out, up front, the added risks inherent in these products (such as the consequences of failing to keep up payments or failing to choose a qualified course of study). And the required annual reporting to clients also would have to reflect these risks.

These proposals are now out for a 90-day comment period. Condon says the CSA aims to have a final rule by early next year. The current proposal envisions a three-year transition period for the implementation of certain elements of the rule to give firms enough time to make the required systems changes. Other elements would have to be adopted sooner.

It’s also expected that the industry’s self-regulatory organizations (the Investment Industry Regulatory Organization of Canada and the Mutual Fund Dealers Association of Canada) will harmonize their rules on this topic with the requirements being imposed by the CSA.

© 2012 Investment Executive. All rights reserved.