Two business men shouting through megaphones

The move to curb deferred sales charges (DSCs) will surely shake up the investment industry — despite the Ontario government’s stubborn insistence on maintaining the DSC structure in the face of a ban in the rest of the country.

The Canadian Securities Administrators (CSA) and the Ontario Securities Commission (OSC) unveiled their diverging plans for the DSC fund structure on Feb. 21. The CSA, which has been promising a ban on DSCs since 2018, set June 1, 2022, as the deadline for its ban.

Meanwhile, the Ontario government is committed to maintaining the DSC option on the basis that the structure will preserve access to financial advice for smaller clients. Accordingly, the OSC proposed a series of limits on the use of DSCs by funds to combat the long-standing investor protection concerns with the structure — including the inherent conflict of interest that DSCs pose and their ability to lock investors into underperforming funds for years — without banning DSCs outright.

Among other measures, the OSC wants to restrict the sales of funds using DSCs to clients with accounts smaller than $50,000, restrict sales to investors under the age of 60 or with time horizons shorter than fund redemption schedules and ban the use of leverage with DSC funds.

The OSC proposes limiting redemption schedules to three years — essentially requiring that DSC funds be sold as low-load funds rather than as traditional DSC funds, which now have much longer lock-in provisions of five to seven years than their peers.

The OSC also proposes that unitholders be able to redeem 10% of their holdings penalty-free each year and that fund sponsors provide exemptions from redemption fees for unitholders facing financial hardship.

The OSC’s proposals are out for comment until May 21. The regulator anticipates adopting the new limits on the use of DSCs by the same deadline as the rest of the CSA for its outright ban.

Until then, firms will be able to sell DSC funds and the regulators will allow the prevailing redemption schedules to run their course. The CSA’s prohibition and the OSC’s restrictions will apply only to new sales, beginning in 2022.

Toronto-based investor advocate Kenmar Associates’ submission to the OSC compares the OSC’s efforts to limit the harm caused by DSCs to “improving the working conditions of slaves instead of banning slavery.”

Kenmar’s comment also argues that the effects of Ontario’s contrarian stance on DSCs go beyond the direct consequences and will negatively affect confidence in the regulatory structure: “[The decision not to ban DSCs] has impaired the public’s perception of the OSC as an independent regulator, disillusioned dedicated OSC staff and led to the resignation of one of Canada’s greatest thought leaders on retail investor protection” — alluding to the impending early departure of Maureen Jensen, chair and CEO of the OSC. (Jensen stated she was “ready to move on” when she announced her departure.)

Nationwide, about 10.9% of fund assets have been sold using DSCs (7.7% under the traditional DSC structure; 3.2% in the low-load structure), according to a March 2019 report from Toronto-based Strategic Insight Inc. cited by the OSC. However, the reliance on DSCs varies considerably across the industry.

Data from the Mutual Fund Dealers Association of Canada’s (MFDA) 2017 client research project indicates that fund reps with smaller books are much more reliant on DSCs.

For example, among firms that sell third-party funds, reps with books of less than $2 million have more than half (53%) of assets held in DSC funds and another 6% in low-load funds. Further up the advisor food chain, the use of DSCs declines and reliance on front-end load and no-fee, no-trailer funds rises.

For reps with books of $20 million-$50 million, only about a quarter of assets is held in DSCs and low-load funds (21% and 5%, respectively). The majority of these reps’ assets (59%) are held in front-end load funds, with another 11% held in no-fee funds.

At the high end — reps with more than $50 million in assets — just 14% of their assets are held in DSC funds. For these reps, frontend load is the top category (55%), followed by no-fee funds (23%).

Given this disparity in DSC use, fund reps with small books clearly will feel the biggest effects — as will dealers that churn through large volumes of low-end producers.

Fund sponsor companies also will be affected, as their ability to count on DSC sales to accumulate assets will diminish — as will the cost of financing those upfront commissions.

In Ontario (which represents about 45% of fund industry assets), the OSC states, fund companies and dealers still will be able to generate some DSC-driven revenue, and the regulator’s proposed restrictions will limit the risk of harm to investors and the threat of unsuitable sales by dealers: “The extent of the impact will vary and will heavily depend on a firm’s revenue and cost structures, the short- and long-term profitability of serving [lower-value clients], and how competing firms choose to respond.”

As for investors, clients with accounts of less than $100,000 in investible assets have the highest concentration of their assets held in DSC funds, so these clients are likely to be most affected by the regulators’ plans.

The OSC states the greatest impact of its proposed restriction on DSCs in Ontario is likely to be on clients with $50,000-$100,000 in investible assets. Investors with less than $50,000 in investible assets still will be able to purchase DSC funds, subject to the restrictions on age, time horizon and the use of leverage. But investors with investible assets above the $50,000 threshold will have to buy their fund units differently.

The OSC estimates that if its proposals are adopted, investors’ redemption costs will decline by 50%–70% from current levels. Most of the affected investors will shift to front-end sales charges, currently the second-most popular purchase method for smaller investors. Investors may then have to pay an upfront sales commission, although these charges typically are waived by dealers. Still, investors also generally pay a higher trailer fee for front-end load funds.

According to the MFDA, the typical trailer for front-end load funds is 60-100 basis points (bps), compared with 30-50 bps for traditional DSC funds and 40-70 bps for low-load funds.