IIROC focuses on compensation practices

Not so in Canada, which came through the global financial crisis relatively unscathed and has proven rather slow to react to domestic scandals. Indeed, the biggest industry failings in recent history _ the collapse of the nonbank sponsored asset-backed commercial paper (ABCP) market in 2007 and the failure of Portus Alternative Asset Management Inc. before that _ have, so far, seemingly had little concrete impact on regulatory policy.

To the extent that the financial crisis has spawned reforms _ such as new regulatory oversight for credit-rating agencies, and plans to supervise over-thecounter derivatives markets _ these efforts have been initiated at the international level, and are necessary for Canadian firms to maintain access to global markets.

That same pressure doesn’t apply to the retail investment business. And yet, Canadian regulators aren’t immune to the fact that several foreign authorities are coming to the conclusion that some forms of embedded compensation are hopelessly conflicted and should be eliminated.

Although Canadian regulators haven’t followed with their own moves to curb certain compensation models, they are nevertheless paying more attention to compensation issues within the confines of the traditional requirements of suitability and disclosure.

Against that background, the Investment Industry Regulatory Organization of Canada (IIROC) has published new guidance that seeks to ensure that investment dealers’ compensation models are suitable and transparent to their retail clients, and properly supervised by firms.

“The emergence of significant and wide-reaching advisor compensation-related reforms around the world underscores the need for Canadian regulators, industry and investors to be aware of these international developments and to monitor their impact, if and when implemented,” notes IIROC in its proposed new guidance.

Unlike those international reforms, IIROC’s guidance, which is out for a 90-day comment period, maintains dealers’ freedom to use a variety of compensation arrangements with their clients. However, it stresses that those arrangements must be assessed as suitable for the client.

In addition, the proposed guidance requires that firms must supervise ongoing account activity to prevent issues such as double charging or improper transfers between commissionbased and fee-based accounts. It stresses that clients should only be shifted from one account type to another when it clearly benefits them. And if the benefit to clients isn’t clear, dealers or reps could face disciplinary action, it warns.

The notice also sets out the minimum disclosure that dealers should be making about compensation arrangements under new client-relationship model (CRM) rules. The Canadian Securities Administrators (CSA) are also in the midst of considering their own proposals regarding cost disclosure (along with performance reporting) as part of the CRM initiative, which the self-regulatory organizations will also have to follow.

The CSA’s proposals, which were published earlier this past summer, also acknowledge the initiatives under way in other countries _ particularly the fact that regulators elsewhere are moving to ban compensation models that use trailer commissions.

The CSA notes that it is not looking to do that, but it also insists that there must be a “significant increase” in compensation transparency. “We think this means disclosure that is complete, upfront and understandable to the average investor,” it says, adding that a one-time mention of trailing commissions in an offering document “does not meet this test.”

Instead, it is calling on dealers to produce an annual compensation report for clients that discloses the actual dollar amount of all trailing commissions generated by the client’s portfolio, and the fixed-income commissions paid to the rep, during the year. It also broaches the idea of requiring firms to disclose the spread taken by their bond desks on fixed-income transactions.

Although the comment period for the CSA’s proposals was wrapping up as Investment Executive went to press, it’s evident that even these modest proposals are stirring unrest in certain parts of the industry, particularly among mutual fund firms.

In its comment on the proposed amendments, the Investment Funds Institute of Canada (IFIC) indicates that the industry objects to the proposal to require firms to report the dollar value of their mutual funds’ embedded trailer commissions to clients. IFIC argues that this creates an unlevel playing field for mutual funds vs other products. Moreover, it says the CSA’s plans will be costly to implement and won’t provide sufficient benefit to investors to outweigh those costs.

However, the CSA has heard these arguments before. Indeed, many of the comments that industry players submitted on a previous draft of its proposals signalled similar industry resistance. And the CSA explicitly rejects that criticism in its latest proposal, saying that although the industry may face higher costs in order to beef up disclosure, this cost is outweighed by the benefit of more well-informed investors.

Creating savvier investors may be sufficient for the CSA for now, but regulators in several other countries are concluding that standard simply isn’t good enough anymore. Indeed, there is some question as to whether mere disclosure can ever really be enough to protect the average retail investor. The CSA’s own investor testing has shown that most investors don’t understand the industry’s basic compensation terminology; and those who say they do may well be overstating their expertise.

Perhaps Canadian regulators will eventually reach the same conclusion as their global counterparts. But, for now, the modest impact of the financial crisis in Canada is not generating more than modest reforms.

Britain’s FSA set for more changes

One of the welcome side effects of the financial crisis is that, by rattling market orthodoxies, the crisis has freed regulators to undertake fundamental cultural change. As a result, the old ways of getting paid may be set to shift.

In Britain, for example, where regulators are already reforming retail distribution models, they are now also seeking to change the underlying culture of the financial services industry by taking on incentives that can lead to client harm.

Having already moved to eliminate embedded commissions, requiring firms to charge clients directly for advice (a policy that will take effect next year), and proposing to ban payments from product manufacturers to platforms such as wrap accounts (rule proposals are expected by the end of the year), the Financial Services Authority (FSA) is now embarking on a new initiative to eradicate distorting sales incentives as well.

The FSA’s managing director, Martin Wheatley, who is slated to become CEO of the new Financial Conduct Authority (FCA) when it launches next year, announced in September that the FSA aims to deal with poorly-designed incentive schemes. These can result in customers being sold products they do not need, while boosting the earnings of sales reps and firms.

The FSA reports that it carried out a review, which found that risky sales incentive structures are common in the industry, and that most of the firms it reviewed don’t have effective controls in place to manage these risks.

As a result, the FSA says it plans to consider whether new rules are necessary to stamp out the sorts of compensation schemes that it believes can lead to client harm. In the meantime, it has published draft guidance that aims to help firms comply with existing regulatory principles that require firms to have fair incentives and a strategy for mitigating the risk of improper sales.

Wheatley also said that he intends to take on the widespread industry strategy of cross-selling by financial services firms: “We, as the regulator, intend to change this culture of viewing consumers simply as sales targets.”

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