businessman with binoculars / Sezeryadigar

As regulators move to ban embedded mutual fund fees, they’re warning the industry against “inappropriate” sales of deferred sales charge (DSC) funds. But deciphering what’s appropriate for a product soon to be a pariah isn’t straightforward.

The Canadian Securities Administrators (CSA) unveiled the final part of their policy targeting embedded fees in mid-September. The first part, announced in February, effectively bans DSC funds — except in Ontario, where the government is opposed to an outright ban. The entire CSA is participating in the second part, which outlaws the practice of discount brokers receiving trailer commissions. Both measures take effect on June 1, 2022.

Ahead of the reforms’ implementation, the CSA is warning the industry against actions that would harm investors and stressing that firms “treat inves­tors fairly and recommend suitable products” as the industry adapts to the new requirements.

In particular, the CSA indicates the provincial regulators and the self-regulatory organizations — the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association of Canada (MFDA) — “will be highly attuned to inappropriate sales of DSC products ahead of the ban.”

Some observers worry the countdown to curbs on DSC funds will lead companies to push those funds more heavily before they go extinct.

“I believe regulators are concerned with seeing a sudden increase in DSC purchases as the effective date approaches,” says Karen McGuinness, senior vice president, member regulation, compliance, at the MFDA.

The MFDA has seen a “material decrease” in DSC assets among fund dealers over the past few years, she says, “so a change in the opposite direction would raise red flags.”

These concerns have only intensified with the effects of the Covid-19 pandemic on the economy and financial markets — effects that underscore the fragility and importance of investor liquidity.

“Covid-19 has highlighted how some products, including mutual funds sold under the DSC option, would not be appropriate for investors who might need emergency access to funds,” the CSA stated in an email.

Indeed, the prospect of paying redemption fees in order to seek safety only exacerbates the pain of plunging markets.

“With these elements in mind, the CSA will be cognizant of any changing trends in DSC sales in advance of the ban coming into effect,” the regulator warned.

Between now and mid-2022, the industry is on notice — and the window for appropriate DSC sales is rapidly closing.

With the imminent demise of DSC funds and heightened sensitivity to the fair treatment of investors during the pandemic, determining an appropriate DSC recommendation is increasingly fraught with complexity.

Dan Hallett, vice president, research, and principal with HighView Asset Management Ltd. in Oakville, Ont., suggests the CSA’s forthcoming client-focused reforms (CFRs) — coupled with the Ontario Securities Commission’s (OSC) proposed restrictions on DSCs — may provide a framework for assessing whether DSC recommendations will be considered offside.

The CFRs are slated to take effect ahead of the DSC/trailer ban in two stages: enhanced conflict of interest provisions will be adopted by June 30, 2021, and the remaining requirements will come into force by the end of next year.

The CSA has granted dealers relief from the CFRs’ enhanced conflict of interest requirements leading up to the DSC ban. Yet, the CSA also singled out the new conflict provisions as being central to resolving its long-
standing investor-protection and market-efficiency concerns with embedded fee structures.

Those concerns led to the CSA’s conclusion, outlined in its 2017 consultation paper, that these structures fundamentally misalign industry and investor incentives, encourage biased recommendations, harm investors and inhibit industry competition.

Banning DSC funds while significantly toughening the rules on conflicts is expected to negate the destructive effects of embedded fees.

The CFR measures will require that “material conflicts” are either resolved in the client’s best interest or avoided entirely. Under the new rules, this won’t be as simple as disclosing a conflict or getting clients to sign off on it.

“Determining what is in the ‘best interest’ of the client is a facts- and circumstances– specific determination, not a check-box exercise,” the CSA’s newly issued guidance on implementing the CFRs explains.

That guidance indicates that the CSA, IIROC and the MFDA will take a principles-based approach to assessing whether a conflict has been addressed in a client’s best interest, and also specifies that disclosure alone isn’t enough to deal with significant conflicts.

The CSA stated it expects firms to use other tools alongside disclosure, such as pre-trade controls and post-trade reviews, to ensure that conflicts are addressed adequately.

The regulator warned that simply securing a client’s consent to proceed with a transaction that involves a material conflict won’t be satisfactory.

“Consent without other action on the part of the registrant will not be enough to address a material conflict of interest in the best interest of a client,” the guidance on CFRs states.

Alongside these tougher expectations for resolving conflicts, Hallett suggests that the parameters outlined in the OSC’s proposed curbs on DSC sales may provide a guide for appropriate transactions.

The OSC seeks to prevent the most egregious uses of DSC funds by prohibiting sales to investors aged 60 and older, banning the use of leverage and capping account sizes at $50,000, among other proposed constraints.

“[The OSC’s proposals] paint a pretty specific and restrictive picture of what may be deemed appropriate DSC sales,” Hallett says. “Everything else would be viewed as inappropriate.”

The OSC, despite taking a softer line on DSCs generally, indicated it shares the CSA’s concerns about the fair treatment of investors ahead of the DSC ban in the midst of a pandemic.

“In Ontario, we are still considering the comments received on our DSC proposals, but we also have an interest in monitoring to ensure that investors, who may have heightened needs for liquidity due to the pandemic, are being treated fairly and sold suitable products,” says Kristen Rose, manager, public affairs, with the OSC.

To that end, the regulators will be reviewing the suitability of DSC sales as part of their ongoing compliance work, notes McGuinness. For now, whether those sales are in Ontario or elsewhere won’t matter. “Pre-ban, the suitability standard is the same across Canada,” she says.

That approach is echoed by IIROC, which stated its “focus is to ensure that there are no inappropriate sales of investment products (including mutual funds) in all jurisdictions, regardless of whether or not a particular jurisdiction has decided to ban DSC products.”

By mid-2022, DSC funds should be on life support. Until then, regulators will be on the lookout.