With a relatively innocuous missive, securities regulators have seemingly opened the proverbial Pandora’s box. Addressing the proliferation of proprietary products — and the added conflicts they can create — the regulators have raised some important questions about the investment industry’s evolution that have yet to be addressed.

In February, the Investment Industry Regulatory Organization of Canada published a draft notice for comment that deals with so-called “non-arm’s-length investment products.”

When a dealer sells products issued either by itself or by one of its affiliates, regulatory concerns about conflicts of interest arise. The question is whether dealers can carry out effective due diligence or assess suitability.

The IIROC notice aims to provide some guidance to dealers. It describes some best practices to follow; proposes adding a new requirement that dealers notify the regulator when they intend to begin selling a new proprietary product; and promises to ramp up its monitoring of compliance with the rules in this area.

At first glance, there’s nothing earth-shattering about the initiative. But it goes to the heart of some fundamental industry issues that have never been properly addressed — including, for example, the uneasy marriage of product manufacturing and distribution in the investment industry; the conflicts this marriage engenders; the threat this situation poses to advisor independence; and the quality of advice that clients receive as a result.

In the days when dealers and manufacturers were largely separate, they were more manageable. Then, when the two sides of the business began to converge, some industry participants feared that independence and credibility would be compromised. Now, clients and regulators have seemingly accepted the shift with little protest — and the marriage between manufacturing and distribution has gone from being seen as a troubling exception to being standard operating procedure.

At the same time, the range of proprietary products has grown significantly to include everything from investment funds and managed accounts to structured products and exempt securities. So, while these issues have always existed, they have become more prevalent as the business has evolved.

The IIROC notice indicates that the distribution of products created by connected issuers is a worry to the regulator. Says the notice: “At the core of the concerns identified is the fact that a connection between the [dealer] and the issuer may result in conflicts of interest that are similar in substance to those that arise when a [dealer] or its employee borrows money directly from a client.”

When conflicts of this sort exist, the IIROC notice adds, it is difficult for dealers to meet their legal and regulatory obligations to clients. Moreover, the notice suggests that contingency fund coverage may not be available for these products in certain circumstances.

The Mutual Fund Dealers Association of Canada has indicated that it shares IIROC’s concern about firms dealing in related products. However, Karen McGuinness, the MFDA’s vice president of compliance, says that the MFDA’s primary concern is with dealers selling exempt-market securities issued by an affiliate: “These securities generally are high-risk and are not subject to the same transparency as prospectus-qualified securities.”

McGuinness notes that the MFDA has addressed the issue by issuing a notice to deal with the concern in 2007. The regulator also surveys firms about their product lineups “to identify anything new requiring further review” and monitors firms’ compliance with rules regarding conflicts of interest. (The MFDA recently brought forward an enforcement case that included allegations of improper conflicts in the sale of exempt securities.)

Regulators aren’t alone in these concerns. Independent manufacturers have long worried about the phenomenon, too — although they may be reluctant to criticize the integration of manufacturing and distribution too fiercely, as they rely on many of these same dealers for their own sales.

@page_break@Some independents have dealt with the issue by joining the trend, either buying distribution or selling out to it. Others have remained doggedly independent, but these are now in the minority — just three of the 10 largest mutual fund companies are still independent.

Nevertheless, one of those remaining independents, Toronto-based Invesco Trimark Ltd., articulates its concern in its comment on the IIROC notice: “We believe that a clear inherent conflict of interest exists where a [dealer] purports to be independent — but recommends affiliated investment products to its clients…. It is generally not possible to ascertain if that recommendation was made in the best interests of the client.”

The Trimark comment further suggests that the existing rules don’t adequately address the risk of self-dealing, and that the IIROC guidance simply requires firms to assess the conflict, which is unlikely to actually alter behaviour: “It would be absurd to assume that there will ever be an instance where the [dealer] determines that the conflict is so great that it will not distribute the affiliated investment product.”

Moreover, advisors may face some powerful incentives to sell proprietary products. The regulators effectively stamped out overtly dodgy industry practices such as sales contests designed to sway advisors’ recommendations long ago. But other, more insidious influences persist.

As the Trimark comment points out, advisors may have some portion of their compensation determined by their company’s overall results. Publicly traded firms, in particular, don’t need to impose quotas on proprietary products when advisors can see for themselves that the market values assets under management much more highly than assets under administration. Thus, advisors can boost the value of their stock holdings in their firm by steering clients into in-house products.

As well, the Trimark comment suggests, advisors may sell in-house products for fear of losing their jobs if they don’t. And an advisor’s retirement payout could be tied to the proportion of his or her book that is in in-house funds when he or she leaves the industry. Trimark is currently facing a situation in which an advisor near retirement is “systematically redeeming clients out of [Trimark] product and into affiliated investment products.”

Ultimately, the Trimark comment suggests, these factors are affecting sales. Looking at the in-house products offered by dealers over the past five years, the firm has “difficulty concluding that the entire growth in those products is based solely on investment merits and not the result of other influences.”

Fund industry statistics make it clear why independent firms should be concerned. Trimark, in particular, has seen its funds’ AUM drop to $28.2 billion in April 2010 from more than $43 billion in April 2005. Most of the other large independents have seen their funds’ AUM remain more or less unchanged at a time when overall mutual fund assets have grown to $620.4 billion in 2010 from $511.5 billion in 2005, according to the latest industry statistics from the Investment Funds Institute of Canada. (The notable exception is Toronto-based Fidelity Investments Canada ULC, which has seen AUM grow to $45.9 billion from $31.2 billion five years ago.)

The Trimark comment says the firm doesn’t want proprietary products outlawed, nor does it want regulators to force firms to become independent. It wants regulators to recognize the depth of the conflicts involved, and reflect that in the rules by: requiring full disclosure to clients of all incentives; mandating that reps recommending a proprietary product to a client also present three independent alternatives; and prohibit dealers from putting any of pressure on reps to sell in-house products.

Not surprising, the other industry comments on IIROC’s proposed guidance — from a dealer, an integrated fund firm, and bank and securities industry trade associations — take the opposing view. They question the need for the IIROC notice at all, arguing that the existing rules on conflicts are sufficient. They argue the regulator is offside by effectively imposing a new requirement without going through the typical rule-making process, among other issues.

Concerns about whether a new requirement is being introduced via guidance rather than as a proper rule is shared by the Canadian Foundation for Advancement of Investor Rights, a Toronto-based investor advocacy group. But FAIR Canada also raises the issue of whether advisors should owe a higher duty to their clients than merely assuring suitability when selling related products.

In FAIR Canada’s comment, the advocacy group doesn’t explicitly call for a full fiduciary duty to be imposed on dealers. But it does indicate that the standard should be higher than mere suitability. It calls on IIROC to make it clear in its rules that dealers should not sell in-house products unless it’s in the client’s best interest. IE