The retail investment industry’s self-regulatory organizations (SROs) are gearing up for compliance exams that will target many of the underlying fundamental policy issues that continue to stump the provincial securities commissions.
These include growing concerns about investment industry compensation practices, how firms deal with conflicts of interest and the extent to which clients’ interests are given priority.
Recent enforcement cases and regulatory reviews revealed shortcomings in industry conduct, how firms are managing conflicts of interest and disclosure. Concern about such shortcomings underlie the SROs’ compliance plans for the year.
In mid-January, the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association of Canada (MFDA) laid out their compliance agendas for this year.
The MFDA’s compliance exams will target the issue of whether firms are shifting their clients into lower-cost versions of the mutual funds clients hold as is appropriate.
The widespread failure of firms to do so has been revealed in a series of high-profile enforcement cases that the Ontario Securities Commission (OSC) brought forth against a number of large, bank-owned mutual fund dealers and investment dealers over the past couple of years.
Those cases, which affected thousands of clients and resulted in several hundred million dollars being returned to those clients, were addressed in a handful of no-contest settlements with investment dealers that have affiliated mutual fund manufacturers.
However, this issue of placing client accounts in lower-cost product options doesn’t just affect firms offering proprietary products; it also can occur with third-party funds.
As a result, regulators are turning their attention to all dealers – both integrated firms and independents – with the expectation that those firms will adopt procedures to ensure that clients who qualify for lower-cost versions of mutual funds in their portfolios are identified properly and will be switched into those less expensive funds.
Although some fund companies have programs in place to transfer eligible clients automatically into lower-cost funds, not all firms have similar programs, the MFDA notes in a bulletin outlining the SRO’s priorities for the year.
Absent an automatic transfer mechanism, dealers must be able to ensure they have processes in place, both to screen their clients properly to identify when they qualify for cheaper funds and to get those clients’ accounts moved into the lower-cost versions.
Another form of client overcharging revealed by the OSC’s no-contest settlements involves firms utilizing products that charge embedded fees within fee-based accounts.
The same issue was flagged in an IIROC review of compensation-related conflicts last year. Those findings have informed the SRO’s compliance plans for this year.
IIROC’s 2018 agenda indicates that the SRO views these compensation-related conflicts as the central issue in the ongoing policy debate over advisor conduct standards and the related matter of whether dealers and financial advisors are serving clients’ best interests.
Although these issues continue to be debated among the provincial securities commissions, IIROC reports that it has added questions and tests to its compliance exams to search explicitly for these conflicts.
In addition, one of the clearest failings regulators have discovered during their closer examination of embedded fee products in recent years is the practice of discount brokerages collecting trailer fees.
These firms are prohibited explicitly from providing advice – yet they are accumulating trailers that should be paid by clients only for advice received.
As the provincial regulators continue to consider whether to ban embedded fees altogether, the issue of discount brokers collecting trailers now is a priority on IIROC’s agenda as well. IIROC states it plans to issue guidance on the issue this year.
Regulators also still are coming to grips with the effects of the second phase of the client relationship model (CRM2) – the major project to boost transparency that the industry has been tackling over the past few years. The final implementation of the CRM2 reforms took effect last year, and that led to the SROs’ first glimpse at firms’ efforts at meeting these new requirements.
IIROC reports that it has identified a couple of areas in which firms are falling short in their compliance with CRM2 rules.
Specifically, these shortcomings relate to: the requirement to provide clients with disclosure of the fees and charges they incur before a trade takes place; and the failure to collect newly required information about clients’ investment time horizon as part of the “know your client” process.
The MFDA plans to publish its own report soon on the CRM2 deficiencies that the SRO has uncovered.
Ensuring compliance with existing CRM2 requirements will be a priority for both SROs again this year – even as discussions about a possible expansion of certain aspects of the reporting requirements are in the works.
One possible change is revising the requirements to include the full management expense ratio as part of the CRM2 disclosure, which both IIROC and the MFDA are considering.
As well, the MFDA states it plans to examine dealers’ compliance with the existing CRM2 requirements while also working on “expanding cost reporting.”
Another recent initiative that will be driving the MFDA’s compliance work this year is the data the SRO collected as part of its client research project, the results of which were published last year.
Armed with the project’s detailed information on advisors’ businesses, the MFDA plans targeted reviews of advisors’ books to seek indications of possible compliance issues at the level of the individual advisor. The MFDA hopes to flag unusually high concentrations of risky assets (involving senior clients in particular) – as well as more systemic supervisory issues.
This project will be carried out alongside the MFDA’s routine compliance exams.