Insights from an audit of a referral business

Instead, the regulators included referral arrangements on a list of longer-term projects that remain under consideration. As such, firms shouldn’t be complacent about referrals.

Jason Ayres, CEO and derivatives strategist at Croft Financial Group in Toronto, shared what his firm learned about referrals during an audit by the Ontario Securities Commission (OSC). Ayres spoke at the Vantage Series on Monday in Toronto, which was presented by the Investment Industry Association of Canada and the Knowledge Bureau.

Ayres’ investment management firm works with independent advisors and planners through referrals. After the CSA originally proposed the client-focused reforms, the OSC conducted an audit of his firm, he said.

One question asked by the regulator was whether the firm’s portfolio managers were fulfilling their duties as registrants, including how the firm was staying competitive as a referral-based business.

“It was a relevant question,” Ayres said. “If we’ve got to give a portion of our margins to pay a referral partner, what are we doing internally to help save money to continue to facilitate that relationship?”

Another question was whether referrals represented themselves as registrants — a key regulatory concern. The regulators wanted to know what kind of conversations were taking place between clients and the non-registrants with which Croft partnered, Ayres said.

To help answer the question, the OSC checked referrals’ websites to see whether non-registrants offered investment solutions, and contacted some of them, Ayres said.

The regulator also contacted clients, asking them whether they knew who their portfolio manager was. In some instances, clients mixed up their portfolio managers with their planners — an unsurprising result, given the many titles used throughout the industry.

Yet, the distinction is important as a fundamental investor protection matter, because regulators have disciplinary recourse with registrants but not with non-registrants, Ayres said.

While the OSC ultimately accepted the firm’s referral model, ongoing monitoring of the model will continue. “We need to make sure that we are communicating effectively” to avoid confusion about the responsibilities of the firm’s portfolio managers and those of referrals — or else the regulators can intervene, Ayres said. Such monitoring isn’t unique to his firm but is an industry-wide regulatory reality, he said.

To help its referral partners also understand the regulatory reality, the firm has implemented a training program on how regulation impacts the working relationship between professionals.

New guidance on referral arrangements

The client-focused reforms are part of amendments to National Instrument 31-103 and its companion policy.

The CSA added guidance to the companion policy to reflect its view that paid referral arrangements “create material conflicts of interest that must be addressed in the best interest of clients.” Firms must demonstrate how they do that, and why they’ve determined that a specific referral is in the client’s best interest.

The companion policy says referrals shouldn’t be made based solely on receiving a fee, or because a fee is for a greater amount or longer duration compared to another referral.

“If a client pays more for the same, or substantially similar, products or services as a result of a referral arrangement, we would not consider the inherent conflict of interest to have been addressed in the best interest of the client,” it says.

Fees must now be documented, along with who provides disclosure to referred clients. A due-diligence analysis of referrals must also be documented.

According to the companion policy, due diligence at minimum includes an assessment of the types of clients for whom the referred services would be appropriate and an assessment of the referral’s qualifications, including regulatory or professional disciplinary actions, civil actions and client complaints.

The companion policy also says that ongoing monitoring and supervision is required of registrants’ conduct, as well as taking “reasonable steps” to ensure referrals are complying with their obligations under the referral agreement. Such oversight must also be documented.