Investment Executive July 2018 front cover

The first no-contest settlement between an investment industry firm and securities regulators, reached in Canada in 2014, began a succession of cases in which firms were accused of systematically overcharging retail investors. Now, regulators are setting their sights on the investment industry’s incentive practices as the next target for serial enforcement action.

In mid-June, the Ontario Securities Commission (OSC) announced a settlement with Toronto-based mutual fund dealer Royal Mutual Funds Inc. (RMF) in which the firm agreed to pay a $1.1-million penalty after admitting to violating securities rules. RMF paid financial advisors affiliated with the company higher commissions for selling RMF’s in-house portfolio mutual funds rather than its stand-alone mutual funds or third-party mutual funds.

According to the settlement, RMF paid advisors affiliated with the firm an additional 10 basis points (bps) for selling RBC Portfolio Series funds between 2011 and 2016. That arrangement violated the mutual fund sales practice rules, which are designed to prevent firms from providing their advisors with incentives to favour in-house mutual funds vs third-party counterparts.

Although the RMF case is the latest in a string of recent enforcement actions targeting violations of the sales practices rules, the case is the first to reveal firms utilizing prohibited commissions structures. Until now, the cases the OSC has brought forth alleging sales rule violations involved firms overstepping restrictions on the “wining and dining” of advisors and overspending on the trinkets that investment fund firms give to ingratiate themselves with dealers.

The RMF case was uncovered as part of a joint review of industry compensation practices by the OSC and the Mutual Fund Dealers Association of Canada (MFDA). It also is the first to target potentially troublesome commission structures.

Earlier this year, the MFDA brought an enforcement case of its own against Toronto-based Sun Life Financial Investment Services (Canada) Inc., which included allegations that the firm violated the sales rule by operating certain incentive programs that relied solely on sales of Sun Life’s in-house funds. However, the OSC’s case against RMF is the first to target investment industry commissions structures specifically — and unlikely to be the last.

Karen McGuinness, senior vice president, member regulation, compliance, at the MFDA, confirms there are other enforcement cases in the regulators’ pipeline stemming from the joint MFDA/OSC review of industry incentive programs that unearthed RMF’s situation. She notes that future cases could come from either the MFDA’s enforcement department or from the OSC.

Whether these types of sales-incentive violations are as pervasive as overcharging clients has proven to be is not clear. But cases regarding incentives probably won’t be as costly for the industry as the cases regarding overcharging clients were.

Whereas regulatory actions involving overcharging clients resulted in hundreds of millions of dollars being returned to investors, the OSC doesn’t allege that investors suffered any harm as a result of the distorted commissions structure in the case against RMF.

But just because regulators don’t allege harm in an enforcement case doesn’t mean there wasn’t any harm inflicted. Rather, there may have been harm that was too difficult to prove or unreasonably hard to quantify.

In the RMF case, the regulators found that the extra 10 bps paid to advisors for selling in-house portfolio funds amounted to $24.5 million in additional commissions for advisors during those five years — about $5,500 per advisor per year. This implies that the firm sold approximately $24.5 billion in portfolio funds during that time.

Although regulators don’t allege that the billions of dollars that these funds attracted did any damage to investors, investor advocates question that part of the settlement.

“We remain skeptical that almost $25 million in additional payments were made without affecting the advice provided to clients who expect their best interest to come first, not their representatives’ eligibility for enhanced compensation paments,” says Frank Allen, executive director of Toronto-based advocacy group the Canadian Foundation for the Advancement of Investor Rights (a.k.a. FAIR Canada).

In theory, if clients paid higher management fees for the units in the portfolio funds that were bought than if units in comparable stand-alone funds were bought, or if the funds in which those clients invested suffered weaker performance, then those clients may have suffered as a result of the differential commissions structure.

To assess the extent to which investors may have paid excess fees or suffered lagging performance, regulators would have to determine which funds investors could have bought instead of the portfolio funds. In addition, the regulators also would have to prove that the additional (incentive) commissions for advisors were the reason clients ended up investing in in-house portfolio funds.

In comparison, the damage to investors is much more straightforward to identify and to quantify in the overcharging cases, which have produced – and still are producing – a series of no-contest settlements. In those cases, clients obviously were harmed when they held the higher-cost version of a given mutual fund despite qualifying for a cheaper edition of exactly the same product.

The latest no-contest settlement in these overcharging cases came in early June, when the OSC reached a settlement with a pair of dealers operating under Mississauga, Ont.-based Investment Planning Counsel Inc.’s (IPC) umbrella. In this case, the OSC alleged that the IPC dealers overcharged clients by failing to place these clients in the lower-cost versions of specific funds and by placing clients with fee-based accounts into assets that also carry embedded fees.

OSC approves no-contest settlement with IPC dealers

Having already concluded similar cases with affiliates of all the major banks, the case against the IPC dealers resulted in a $460,000 penalty assessed on those dealers in addition to the $11 million they’re paying back to the clients who were overcharged.

The OSC reports that it has concluded 11 no-contest settlements, resulting in a combined total of $368 million being returned to investors. As the discovery of the systematic overcharging of retail investors by the Canadian investment industry continues to play out, regulators are uncovering other industry practices that may put clients at a disadvantage. For investor advocates, this points to a fundamental vulnerability of investors.

“While OSC staff did not allege any harm [was done] to clients who were sold investments in the preferred proprietary mutual funds,” Allen says, “FAIR Canada believes [the RMF] case highlights the serious concerns that conflicted commission and incentive arrangements present for retail mutual fund investors in Canada.”