The goal didn’t sound terribly ambitious: create an informative, two-page document to spell out the basic features of a rather straightforward investment product. In the financial services industry, however, things are rarely as easy in practice as they seem in theory.

That is why it is an achievement for securities and insurance regulators to agree on a proposed new point-of-sale disclosure regime for both mutual funds and segregated funds.

In mid-June, the Joint Forum of Financial Regulators, which includes securities, insurance and pension authorities, proposed a new disclosure system that would require fund firms to produce a short document summarizing the salient features of each fund. The paper is to offer brief information on holdings, past performance, fees and investors’ rights, among other things, which must be provided to clients before they buy.

The ostensible reason for reforming the disclosure system is that the regulators recognize that the current regime isn’t working well. The existing prospectus is long and dense and, as a result, many investors have a hard time understanding it — with a good number not even bothering to crack it open. As well, investors don’t necessarily receive the information they need before they make the decision about what to buy.

Under the proposal, the new “fund facts” document will have to be delivered to investors before every purchase, with the exception of pre-authorized transactions. The regulators considered adopting an “access equals delivery” approach, but ultimately decided to insist that investors be given the document in hard copy, by fax or electronically.

What will no longer have to be delivered, however, are the old-style prospectuses. Investors who request a full prospectus will be entitled to one, but the assumption is that many investors won’t bother.

The new summary document will be incorporated by reference into the prospectus, which still must be approved by regulators annually. The summary will also carry the same legal weight as a prospectus, in that firms can be sued for misrepresentations that occur in the two-pager, the same way they can for false statements published in a full prospectus.

The possibility of printing and distributing far fewer long prospectus documents is the carrot for the industry. The stick is the fact that they will have to produce the new summary document in addition to their current publication requirements. Regulators are seeking comment from firms on how they expect it to wash out, from a cost perspective, which will be incorporated into a pending cost/benefit analysis of the proposal.

While a reduction in the industry’s paper burden is a welcome side effect, it’s not the initiative’s primary goal. The main objective is improving investor protection, says Patricia Callon, project manager, investment funds branch, at the Ontario Securities Commission in Toronto, by introducing a new regime that results in well-informed investors who are better able to make intelligent investing decisions.

To that end, the proposed document will be very standardized, which will allow buyers to compare funds. The regulators plan to prescribe the elements that must be included, the order in which they appear and on which page they appear. Certain language and section heads will be common for every fund, a minimum font size will be required and the language used should test at no more than a Grade 5 level.

There will be some flexibility within the fairly prescriptive requirements, but, ultimately, regulators imagine every firm will produce a very similar document. A sample has been tested with small groups of consumers and advisors, and it reportedly received positive reviews. Callon says some changes were made as a result of the feedback, but investors of different levels of sophistication generally found the new documents clear and useful. Even experienced investors didn’t find the document to be patronizing.

Indeed, the needs of investors seem to have largely won out over industry interests. The new disclosure document will be required for each fund — not for each fund family, as the industry suggested in response to a consultation paper on disclosure reform.

Regulators are not moving to an “access equals delivery” model, as the industry would have liked but which investors opposed. The consultation paper also contemplated removing investors’ rescission rights if disclosure was made at the point-of-sale. The industry supported that idea, but investors vehemently opposed it. Regulators are siding with investors here, too, proposing a two-day cooling-off period during which investors can decide to cancel a purchase.

@page_break@There will surely be quibbles with the proposed content of the new documents. Two that stand out immediately, from the investors’ perspective, are the lack of benchmarking of performance information and inadequate disclosure of trailer fees.

The sample document published as part of the proposal includes a table that sets out the sales charge options in both percentage and dollar terms, yet it simply mentions the existence of trailers without explaining how much they are or why they are paid. This is a significant item because the OSC’s own research has found that most investors don’t understand trailers.

IMPACT OF FEES

“It appears, for example, that few retail investors really understand what a trailer fee is, or its impact on their long-term investment,” the OSC said in the fair-dealing model concept paper, published in 2004. Moreover, the same paper found “there is reason to believe that advisor compensation, rather than the best interests of investors, is driving asset-allocation choices to a significant extent, even though all the relevant information is publicly disclosed.”

Now regulators appear to be hoping that advisors will step in and explain the significance of trailer fees to their clients. It seems unlikely, however, that investors will get a full explanation if, indeed, advisor compensation is truly driving asset-allocation decisions.

The other obvious weak point in the proposed document’s content is a lack of benchmarking of performance data. Without the context of underlying market performance, it is hard for investors to tell whether the fund they’re considering buying is really adding value above and beyond the overall market’s performance, or if they are paying active management prices for mere index-quality returns.

Callon says the OSC did consider both benchmarking and more explicit trailer disclosure, but chose not to include the former for the sake of simplicity. As for the latter, it is opting to “facilitate a conversation” between investors and their advisors about compensation issues.

Some of the details may yet change, depending on comments the regulators get. But it can be difficult to get meaningful comment from investors, particularly in an endeavour in which the intended beneficiaries of the reform don’t bother to read prospectuses, let alone regulatory proposals.

Nevertheless, the fund industry appears to be applauding the proposed disclosure regime as a necessary improvement on the current system. Joanne De Laurentiis, president and CEO of the Investment Funds Institute of Canada in Toronto, notes that IFIC conducted consumer research last year that found investors prefer simpler disclosure. She says IFIC is pleased with the regulators’ effort.

“We like the two-pager,” she says. “We are very supportive of simpler, more meaningful disclosure to investors because if you have informed investors, they’ll be more knowledgeable and more confident. They’ll make informed choices and they’ll be happier. So, we’re very much in favour; we think this is a good idea.”

While De Laurentiis has few objections to the proposed content of the new disclosure document, she does suggest that the delivery requirements may have to be tweaked. In particular, she suggests, it is unnecessary to demand that dealers provide the new document to investors simply buying more units of a fund they already own. “We want to get the delivery part right,” she stresses, without client service suffering.

Such details can be easily resolved. A bigger possible stumbling block is whether securities regulators and insurance regulators will actually agree on a common approach for their respective niches. If they do, that will be a first.

Demands for a more level playing field between mutual funds and seg funds have been around for years. Some in the mutual fund industry have complained that fund companies face more restrictive rules than seg fund dealers and manufacturers do. For example, the sales practices rule fundamentally changed the way mutual funds were sold, but left seg funds alone. More recently, fund governance obligations have been imposed on mutual funds and other investment funds but not on seg funds, adding to the former group’s operating costs. Of course, seg funds have their own unique regulatory burdens to bear, with the most significant being the capital reserves required to back up their guarantee feature.

COMPARABLE PRODUCTS

Nevertheless, from an investor’s point of view, mutual and seg funds are comparable products — despite the fact that they hail from very different business, legal and regulatory traditions. As the 1995 Stromberg Report pointed out, the issue of operating different regulatory regimes for functionally equivalent products was identified by an industry committee as far back as 1969: “The concerns arising from the substantial regulatory differences go beyond the lack of a level playing field. They go to the heart of investor expectations and protection.” The report also questioned whether it makes economic sense to maintain separate regulatory regimes.

So, since the late 1990s, securities regulators have been making noise about the need to level the playing field. Since then, progress on harmonizing the two regimes has been slow. It took four years from the creation of the joint forum, in 1999, to get a consultation paper on such disclosure reform published. And now, it has taken another four years for the regulators to produce a proposal. It remains to be seen how long it will take to bring the proposal to fruition.

The proposal is out for a 120-day comment period. From there, how quickly it moves will depend on the comments regulators receive, says Callon, adding that there is no set timeline for bringing the new initiative to market.

One hopeful sign is that the insurance industry seems to be on board. “We are open to any opportunities that will make disclosure more meaningful to our policyholders, and we are looking forward to working with the regulators on their proposals over the months ahead,” says Wendy Hope, vice president, external relations, at the Canadian Life and Health Insurance Association.

As to whether the CLHIA is prepared to embrace the same requirements for seg funds that are imposed on mutual funds, Hope adds: “Substantially similar disclosure requirements are entirely appropriate — as long as, of course, any fundamental product differences between mutual funds and segregated funds are recognized.”

IFIC’s De Laurentiis sees the initiative as a good start. But, she says, it gives rise to a broader question: should regulators attempt to create a more level playing field among all retail investment products, “so that investors can really compare, and determine what is the best investment product for them?”

Arming investors to understand their full range of investment options would certainly be a worthy goal for the future. As a first step, however, securities and insurance regulators must show they can agree on a common disclosure model for their very similar fund products. IE