When something appears to go seriously wrong in the financial services industry there’s always going to be blowback hitting the rest of the industry. In the case of Portus Alternative Asset Management Inc., one of the first casualties among dealers appears to be client referrals.

So far it remains unclear exactly what triggered the collapse of Portus, a Toronto-based hedge fund firm with 26,000 investors but it is now in receivership.
Dealers are nervous amid the uncertainty, and eager to ensure that any systemic weaknesses that may come to light be quickly eliminated. This is bad news for firms that may be caught in the crossfire.

For example, investment counsel and portfolio management firms that rely on dealers for referrals — as did Portus — may find their business choked off by nervous dealers. Stepping back from practices that may have contributed to an ongoing industry scandal may be prudent for dealers worried about just what went wrong, but it also means trouble for solid firms that rely on referrals for distribution.

“The referral channel has pretty well come to a full stop,” says Wilfred Hahn, president and CIO of Toronto-based Hahn Investment Stewards & Co. Inc. The decline is occurring despite the fact that “our firm meets and exceeds the best client fair-dealing and compliance standards around the world, and has an excellent record,” he adds.

Early on, the role of referrals was identified as a possible source of concern in the Portus situation. Even before the case became high profile early this year, the Mutual Fund Dealers Association issued a notice to its members in September 2004, outlining its regulatory concerns and dealer obligations regarding referrals, says MFDA director of compliance Karen McGuinness.

The issues first came to light when the Nova Scotia Securities Commission brought an enforcement action against a fund dealer representative, alleging he violated MFDA rules by maintaining an improper referral relationship (in this case, with Portus) without the knowledge of his dealer.

McGuinness says the MFDA is in the process of drafting another notice addressing the same issue, although it will focus more narrowly on referrals that are tied to specific investment products. The original notice, she notes, “is pretty clear about the regulatory concerns and dealer obligations regarding referrals generally.”

The notice warns that there is a potential conflict of interest in all paid referral arrangements, “because the individual that makes the referral has a financial interest in introducing the client to the other service provider.” It counsels dealers to ensure that the potential conflict is addressed by focusing solely on the best interests of the client, and ensuring that clients understand the extent of the conflict before the referral takes place.

It also notes MFDA rules require that securities-related referral arrangements can only be entered into by dealers (individual reps can’t have their own referral agreements, nor can personal firms or insurance agencies); that the referral must be governed by a written agreement; all referral compensation must be paid through the dealer; and firms must provide clients with written disclosure of referral arrangements, including how referral fees are calculated, and the limitations on dealers’ ability to provide advice on securities that fall beyond their registration.

In the wake of the regulators’ concerns, and their own worries about other possible trouble, firms are reviewing their own practices. As a result, Hahn says, the basic response to the Portus case is “everybody seems to have clammed up on referrals.”

It’s hard to tell just how widespread the jitters have become. “I don’t know if [referrals have] dried up, per se, but I’d say some firms would have something of a freeze in place,” says industry analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. The Portus case is “making some dealers totally re-evaluate [their] referral arrangements,” he says.

“I think dealers will want to clarify, in particular, the advisor’s and dealer’s liability in referring their clients to other entities when a fee is paid in return,” Hallett says.

The MFDA hasn’t heard that referrals are being shut down, McGuinness says.
“Although I’d imagine firms are taking a closer look at this issue.”

As necessary and prudent as the move may be, it’s hard on firms that have long relied on such arrangements for distribution without any problem. “For accredited firms such as ours, an ICPM with top-notch compliance and KYC procedures, referrals shouldn’t be a problem for dealers,” says Hahn. “We’re giving them service and an opportunity, as we see it.” It’s particularly bothersome for Hahn’s firm, which is in the midst of launching a new product at what is turning out to be a particularly poor time to do so.