Regulation: Conflicts still persist

For example, the reports state that compensation-related conflicts still spark concerns, including remuneration models that pay reps more to sell proprietary products than for selling third-party products. Also highlighted are compensation practices that may increase the risk of mis- selling or violating the existing suitability standards.

The MFDA’s report comes off as the strongest. That review uncovered instances of compensation arrangements that, it states, have been referred to the regulator’s enforcement department for possible disciplinary action.

IIROC’s review flags some of the same issues as the MFDA’s report, such as compensation models that favour proprietary products and other incentive structures that may drive sales efforts that aren’t in clients’ best interest. But the IIROC report also indicates that this regulator’s review of firms’ compensation models is ongoing, and that a more detailed report will be published in early 2017.

In the meantime, the MFDA report indicates that the regulator’s research found compensation practices that violate the CSA’s mutual fund sales practices rule, which is designed to ensure that reps aren’t influenced inappropriately to sell a particular fund company’s products, including funds manufactured by a related firm.

That CSA rule got its start more than 20 years ago as an industry-led initiative to put an end to some of the abuses that were prevalent then, including companies holding sales contests and hosting lavish mid-winter conferences in tropical locales in order to curry favour with reps and stoke sales. That initiative, initially a voluntary code, ultimately was made mandatory by the securities regulators.

Although the revised sales practices rule put an end to some of the most egregious conflicts of interest, these problems haven’t been completely eradicated within the mutual fund business.

The MFDA report indicates that the sorts of arrangements that are prohibited under that rule – which applies only to mutual funds – also take place in other parts of the securities market that aren’t subject to the same restrictions – namely, the exempt market.

“Dealers receive compensation and benefits from issuers of other investment products, such as exempt securities, for which the rate of compensation often is significantly higher than the compensation paid for mutual funds,” the MFDA report states.

“In addition, in many cases,” the report continues, “the types of compensation or benefits dealers receive from other investment products or referral arrangements are the types of compensation or benefits that are prohibited [under the mutual fund sales practices rule].”

Specifically, the MFDA report notes, exempt-market issuers often pay large sales commissions (10% and sometimes higher). In addition, these issuers also provide reps with the sorts of incentives – designed to influence reps and drive sales – that regulators have tried to stamp out in the mutual fund industry, including conferences held in the tropics, sales bonuses and equity in the issuer.

Given those findings, the MFDA report states that the regulator is referring these kinds of cases to the provincial regulators that have jurisdiction over the exempt market. Karen McGuinness, senior vice president, member regulation, compliance, at the MFDA, notes that there also has been talk among the regulators about whether to extend the requirements of the mutual fund sales practices rule to other products, such as exempt securities.

These three reports come at a time when the CSA in particular is considering fundamental regulatory reforms, including a possible ban on embedded commissions and the introduction of a “best interest” standard for client/financial advisor relationships.

The CSA’s consultation about a possible best-interest standard is ongoing, and that regulator’s proposals for reforming mutual fund fee structures now are slated to be released on Jan. 10 for a 150-day comment period.

Regulators’ concerns about compensation-related conflicts of interest are at the heart of the initiatives on both fund fees and conduct standards.

The idea of banning embedded fees stems from research commissioned by the CSA that found that trailer fees influence fund sales and negatively affect clients’ returns. There also is a concern that allowing fund companies to pay reps, rather than requiring that clients pay them directly, creates a significant, inherent conflict of interest.

Similarly, the proposal for introducing a best-interest standard stems from a conclusion by some regulators – chiefly, the Ontario Securities Commission (OSC) and New Brunswick’s Financial and Consumer Services Commission – that rather than trying to predict every possible conflict and making a rule for that specific situation, an overarching principle requiring advisors to put clients’ interests ahead of the advisor’s own would oblige advisors to resolve any significant conflict in the client’s favour.

At a roundtable hosted by the OSC in early December convened to examine the issues surrounding a possible regulatory best- interest standard, Ursula Menke, chairwoman of the independent Investor Advisory Panel, stressed that conflicted compensation structures are one of the biggest issues for investor advocates and a central justification for a best-interest standard.

“A key cause of lower returns for investors is the prevalence of conflicted compensation that increases the costs of investing,” Menke said at the hearing.

“The existing compensation grids attest to the industry’s belief in their effectiveness to promote sales. The grids,” she added, “do not, however, promote the best interests of the investor. And disclosure of conflicted compensation is not a solution to the problem.”

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