This article appears in the December issue of Investment Executive.
Efforts to enhance investor protection in Ontario have been undermined by a combination of government interference, industry lobbying and regulatory dissonance, according to a review of the Ontario Securities Commission (OSC) by the province’s auditor general.
Investors have paid a heavy price for these failings, the report suggested. Between 2016 and 2020, Ontario investors paid an estimated $13.7 billion in trailer commissions and deferred sales charges (DSCs) — embedded fees that are banned in other major markets.
The bulk of that total, $13.2 billion, consisted of trailers that would likely have been paid some other way, such as charging investors directly for advice. But investors also paid $400 million in trailers to discount brokers that can’t provide advice (for the period from 2016 to 2019, as 2020 data wasn’t available), and another $36 million in DSC fees.
While regulators have long expressed concern about conflicts of interest, lack of transparency and distorting effects inherent in embedded fee structures, issues may persist even after forthcoming reforms take effect, the AG’s report suggested. Those reforms include the client-focused reforms (CFRs) taking effect at the end of this year, and the bans on DSCs and discount broker trailers as of June 1, 2022.
“The new rules continue to allow trailing commissions so long as dealers have implemented complicated controls to identify, document, disclose and address conflicts,” the AG’s report stated. Other efforts using the same approach “have proven ineffective in deterring such conflicts of interest.”
The report also stated that unlike the straightforward bans on embedded commissions adopted in the U.K. and Australia, Canada’s CFRs are “narrower, more complicated and would allow systemic conflicts of interest to continue.”
Investment industry lobbying and political meddling contributed to the weaker protection measures, the AG’s report stated.
In 2018, after years of study and consultation, the Canadian Securities Administrators (CSA) resolved to address investor protection concerns arising from industry fee structures. Ontario’s recently elected Progressive Conservative government declared its opposition to the CSA’s proposed reforms at the last minute and directed the OSC to consider alternatives to banning DSCs.
That episode showed the OSC is “vulnerable to political interference, which risks undermining its independence and impartiality,” the AG’s report stated.
The government’s intervention on DSCs was made without any “new evidence to counter the weight of reasons and evidence amassed by the OSC and [the other] regulators,” the report stated, and followed industry pressure.
“In our interviews, current and former OSC staff described ‘intense’ lobbying efforts from industry,” the AG reported. Those efforts included “significant lobbying activities and ministry meetings with key industry stakeholders” in the lead-up to the government’s move in September 2018 to undermine the proposed DSC ban.
The AG’s report also revealed that a former industry lobbyist serving on the government staff was involved with the decision to oppose the regulators’ policy.
Political interference went far beyond the DSC incident, the AG’s report said. The government adopted a new “pre-clearance process” for OSC policymaking in September 2018 that required the regulator to provide it with proposed rules before issuing them for public consultation, and again before formally submitting final rules for government approval. The government also demanded an advance look at the regulator’s policy development work.
This increased political involvement “was said to interfere and delay action,” the report stated, citing interviews with current and former OSC staff and commissioners.
The government’s new hands-on approach compromised the regulator’s independence, the AG’s report suggested. While the government has legislative authority to set the commission’s policy direction, the AG found the government’s actions contradicted the requirement that the OSC’s “regulatory and adjudicative decisions ‘must be made and be seen by the public to be made in an independent and impartial manner.’”
In particular, “lobbying interests overrode OSC evidence-based research in the case of deferred sales charges,” the report stated.
To ensure the OSC’s independence in cases in which the government disagrees with the regulator on policy, the report called on the Ministry of Finance to publicly spell out the basis of its position, including the input it received from lobbyists.
The ministry’s response, cited in the report, stated the government would consider the recommendation and “work with the OSC to ensure that [it] continues being able to respond to capital markets developments and exercise its statutory rule-making authority in an effective and timely manner.”
Political meddling also extended to the composition of the commission itself. The AG found that “the government did not follow the established consultative process” for appointing commissioners to the OSC’s board when it named new commissioners in February and April 2019, “resulting in a significant loss of experienced [board] members.”
The OSC board lost nine members between November 2018 and February 2019, including all its board committee chairs, the head of the adjudicative committee and the board’s lead director. As a result, the board fell briefly below its mandatory nine members until those vacancies were filled with appointees who didn’t go through the established process.
This left the regulator’s board significantly weaker, the report noted.
“We interviewed current and former board members who indicated that there was a perception that the appointment process had been significantly politicized,” the AG reported. “They indicated that the loss of experienced members and the appointment of new members not following the consultative process had a significant negative impact on the OSC in all three of its roles: regulatory, governance and adjudicative.”
This, in turn, damaged morale, the report stated, and “materially reduced the quality of policy-making and adjudication, and adversely affected the reputation of the OSC.”
Political interference and industry lobbying weren’t the only factors behind regulator’s failure to adopt effective investor protection measures. The AG also found the fragmented provincial regulatory system played a significant role.
Policy projects take at least a year longer when they involve the rest of the CSA, the report stated: on average, it takes the OSC 1.7 years to craft a local rule, while the CSA takes 2.9 years to develop a new rule. Projects that involve extensive research take regulators even longer. For example, the work on embedded fee structures took more than 10 years to complete, and the work that led to the CFRs took more than 11 years.
“During these extensive delays, Ontario investors continue to be negatively impacted by these industry practices,” the AG’s report noted.
The report recommended the OSC act independently of other CSA members to implement rules more quickly “where involvement by other securities regulators slows key initiatives significantly.”
In all, the report made 26 recommendations that include 57 action items. In addition to restoring the OSC’s independence, the report called for expanded legislative authority, better enforcement tools and enhanced IT systems for the commission. The report also recommended the OSC consider tougher investor protection measures if the CFRs and forthcoming fee restrictions prove inadequate. Such measures include an outright ban on embedded commissions and the introduction of an overarching best-interest standard.
The OSC’s response to the report’s recommendations stated the AG’s findings “will enhance our ability to regulate Ontario’s capital markets.”
As for further investor protection measures, the commission stated, it agrees that “additional and timely action should be considered if these reforms do not serve the best interests of investors.”