Canadian advisors can probably breathe easy for now, but elsewhere in the world there’s a paradigm shift underway in retail financial services regulation. Traditional deference to the industry is giving way to determined intervention, and compensation models are in peril.

The global financial crisis has revealed a vast array of market failures, industry shortcomings and regulatory missteps, but relatively few of them have their roots in the retail advice business. The seizing up of the money markets did expose the fact that retail investors had been sold products — such as asset-backed commercial paper in Canada and auction-rate securities in the U.S. — that were riskier and more complex than clients, or their advisors, understood. But many of the most egregious regulatory failures were in areas such as capital rules and leverage limits — not to mention institutional structures that allowed important market players to avoid oversight entirely.

Many of the reforms now being contemplated focus on closing these major gaps, but there are sweeping regulatory changes looming for the retail investment business as well. Although the retail end of the industry may not have been a major contributing factor in the global crisis, it is not about to be spared by the authorities.

For one thing, the crisis has given regulators the political capital needed to make changes. No one wants to see a repeat of the series of events that saw the global financial system seemingly on the brink of complete collapse — which gives both the regulators and their political masters traction to pursue reform.

To some, the global financial crisis has brought the entire premise of capitalism into question. But even free-market ideologues have to concede that unfettered markets are not practical — particularly if governments are unwilling to allow them to fail, as they have demonstrated in this case.

Moreover, the situation has revealed how things such as perverse, or misaligned, incentives can have far-reaching implications. Compensation structures in businesses such as securitization and trading and in the industry’s executive suites had led to both excessive risk-taking and too much activity that had no underlying economic purpose. Mortgage brokers that were induced to shill large, subprime mortgages — even to people who qualified for ordinary prime-rate mortgages — didn’t just end up hurting a few families by saddling them with excessive debts; the subprime mortgage debacle also helped feed a near-total systemic collapse.

In the face of these lessons, it’s hardly surprising that regulators are no longer prepared to ignore long-standing industry practices and compensation structures that they now believe may lead to perverse outcomes.

Indeed, in Britain, the Financial Services Authority is plowing ahead with fundamental reforms to the way its retail side of the industry operates, including a planned ban on embedded product commissions (such as trailers).

In short, the FSA is planning to require firms to categorize themselves as providing either independent advice or restricted advice (the latter means the firm provides advice only on a line of proprietary products); to require all firms that provide advice to agree to charges for their services with their clients; and to impose tougher proficiency standards on advisors.

Even before the financial crisis took hold, the FSA was working on an overhaul of its retail industry regulation in an effort to stamp out what it saw as long-standing problems in this segment — many of which boil down to advisors not always acting in their clients’ best interests. Now, in the wake of the events of the past year, the FSA is not being shy about carrying out that renovation — even if it means massive disruption to the investment industry.

The FSA is proposing to ban product commissions. The reason is that the commissions-based system of advisor remuneration “creates a potential conflict of interest that can be damaging to consumers and undermine trust in the investment industry,” the FSA explains in the consultation paper setting out its plans.

Here in Canada, the Ontario Securities Commission considered the potential biases that can be created by the use of embedded compensation almost 10 years ago, when it established an advi-sory committee to study retail regulation, which resulted in the proposal of its fair-dealing model.

That project identified prevailing industry compensation models as a source of bias in investment advice, and the OSC contemplated a ban on embedded compensation — stressing that this would eliminate a major source of compensation bias, clarify client/advisor relationships and help investors understand what they are paying for advice.

@page_break@Ultimately, the OSC didn’t pursue that step. Instead, it rolled some of the committee’s ideas into the registration reform project that was recently completed and the client relationship model initiatives that are still underway at the self-regulatory organizations.

But the FSA is now moving ahead on similar theories. Britain’s financial regulator wants to abolish the current commissions-based system and require firms to charge directly for their advice. Firms will still be free to set their own fee structures, including charging a percentage of funds invested, but they won’t be able to rely on existing up-front or ongoing commission structures.

Additionally, industry players won’t be allowed to earn recurring trailer commissions; they will only be allowed to charge ongoing fees for ongoing service.

“We want to avoid recreating the difficulties that consumers face at present,” the FSA paper explains, “in trying to assess what services they are entitled to [if they are entitled to any at all] in return for the continuing payment of trail commission out of their investments.”

Nor will dealers be allowed to receive commissions from product manufacturers that the dealers then rebate to their clients. “This is a deliberate decision,” the FSA paper stresses, “as we do not believe that the potential for product provider commission to bias advice, or to undermine trust, can be properly dealt with while product providers continue to set commissions receivable by advisor firms.”

The FSA would also ban the creation of products that aim to cover the cost of advice to the client by offering, for example, initial allocations worth more than the client’s investment and then recouping that cost through higher management fees.

Not only is the FSA taking on something as fundamental as the commissions-based compensation system, the regulator is also proposing to take a rather hard line with the application of its new rules.

For example, the FSA is proposing that vertically integrated firms would be required to follow the new rules in the same way as independents — charges for products and advice would have to be separate, even when they are delivered by in-house advisors.

Similarly, in establishing new proficiency standards for advisors, the FSA will not simply grandfather existing advisors; veterans will be required to qualify under the new standards in the same way rookies will.

And the FSA is pursuing this agenda while accepting that it is likely to be quite costly — at least, initially. The FSA’s cost/benefit analysis estimates that the added compliance costs of the new regime will amount to £430 million initially, and £40 million annually. (This in addition to £2 million initially and £1.2 million annually for the FSA itself.)

However, the regulator doesn’t plan to impose these costs on the industry while it is still suffering through a recession. The proposals are out for comment until the end of October; they are expected to be finalized in the first quarter of 2010, and are then expected to take effect by the end of 2012.

In addition to the bottom-line costs, the FSA concedes that there could also be structural costs to its plans. In the short term, it expects that some independent financial advisors will leave the business and that product prices may rise; in the longer run, the FSA contemplates an unwinding of cross-subsidies that currently exist among clients (which would presumably benefit larger investors but harm smaller ones).

Balanced against these costs, the FSA sees benefits from better quality advice for clients, fewer suitability issues and, therefore, less compensation that must be paid to wronged investors. The FSA believes the new regulatory regime “is also expected to improve consumer confidence by removing some negative perceptions of the advisory process, which undermine confidence and often deter people from seeking advice.”

But British advisors aren’t the only ones facing a fundamental regulatory overhaul. The U.S. is also looking to reform its regime in the wake of the financial crisis — and advisors there are also likely to be affected by sweeping reforms that focus on big issues such as capital rules and regulatory structure.

In mid-July, the U.S. Treasury published draft legislation that would strengthen the U.S. Securities and Exchange Commis-sion’s authority to ramp up requirements on advisory firms. Among other things, the proposals give the SEC authority to impose a fiduciary duty on any firm (broker, dealer or investment advisor) that gives advice about securities.

Currently, brokers and advisors may be subject to different standards, even though they may be providing the same basic service to clients.

Along with imposing that duty, the proposals would also give the SEC the power to establish standards of conduct, including disclosure requirements about the terms of the client/advisor relationship. The bill also calls on the SEC to examine and possibly outlaw sales practices, conflicts of interest and compensation structures that may be detrimental to investors.

In the Treasury’s words, the SEC would be asked “to examine and ban forms of compensation that encourage financial intermediaries to steer investors into products that are profitable to the intermediary, but are not in the investors’ best interest.”

The U.S. effort is not nearly as far advanced as the FSA’s initiative, and it’s far from certain that it will lead to similar moves to restrict long-standing compensation practices. Nevertheless, the proposals highlight the sorts of issues that the world’s major regulators are grappling with when it comes to the retail investment space.

These issues are not particularly new, as regulators in Britain, the U.S. and even Canada had identified the potential for industry compensation practices to bias advice long ago; and they have previously considered measures to deal with it, primarily by enhancing disclosure. Now, it seems, regulators are set to get tougher with what they see as compromised compensation models.

In Canada, it seems unlikely that these issues will be back on the agenda anytime soon, given that the provincial securities commissions have yet to approve the customer relationship model and that the registration reform rule will still have to be implemented over the next two years.

Canadian advisors can probably breathe easy for now. But regulators will surely be watching their international counterparts with interest in the years ahead. IE