This is the first of a six-part series on legal issues facing financial advisors.

If you are a financial advisor, dealer or broker, get ready for plenty of change, courtesy of increasingly vigilant regulators. Just don’t expect those turns in the road — in key areas ranging from commissions and conflicts of interest to liability for bad advice — to be clearly marked.

In fact, legal experts suggest, many people who give financial advice in one form or another have yet to comprehend the full scope of what they will probably face in the months and years ahead.

That’s particularly true when it comes to the new registration regime, established last year and which comes fully into force this month.

“I think there is much more to NI 31-103 [the new regulations] than the industry realizes,” notes Sonia Struthers, a securities partner with McCarthy Tétrault LLP in Montreal. “For example, the overarching conflict-of-interest rules and the straight prohibitions [on certain types of trading]. I don’t think the industry has really digested them yet.”

Although any of these issues is likely worth extensive discussions, it is helpful to stand back and survey the regulatory landscape, with an eye to noting potential potholes for your organization. Struthers says that, for instance, although some larger financial services institutions have begun the process of developing responses to the new conflict-of-interest principles in NI 31-103, much remains to be done.

“It’s not a simple exercise,” she says. “You have to sit down, put yourself in the shoes of a client and think, ‘What could possibly be a conflict?’ And it’s very difficult, because at the same time, all your people are out there trying to sell stuff.”

But, Struthers adds, this is not something that can be avoided forever: “It’s an exercise that has to be gone through very carefully. Some people have been. It’s a question of resources. Bigger places are doing a better job.”

Struthers suggests that in the long run, there will be benefits for the industry: the new regime, which also requires registration for a wider range of dealers and activities (see page 8), will bring more professionalism and proficiency to the industry. The downside is that some smaller players — and those with fewer qualifications — may be pushed to the sidelines.

Another regulatory watershed linked to conflicts of interest and the long-debated “client relationship model,” which is likely to be finalized by self-regulatory organizations later this year, includes the probable end of embedded commissions.

Richard Austin, counsel with Borden Ladner Gervais LLP in Toronto, predicts that moves to prohibit these types of commissions in other countries could be duplicated in Canada. These moves include recent bans on embedded commissions — similar to trailer fees and back-end loads — to come into force within a few years in Australia and Britain. The U.S. Securities and Exchange Commission has also taken steps in this direction, voting in July to draft proposals that would restrict these types of fees.

Austin notes that although such a prohibition may be a year or more away in Canada, it’s looking more and more likely. Many large brokerages, in fact, are already moving toward the fee-only model, preparing for the day when compensation is linked more closely to performance rather than the number of transactions or sheer volume of assets under administration.

Once such commissions disappear, he adds, new questions will arise. “If [sellers] are going to lose 50 basis points on a trailer fee, how will they replace that?” asks Austin. The loss on a $50-million book could be $250,000 annually. There’s likely to be more pain as well. “If a flat fee is used instead, more clients are going to be asking, ‘What am I getting for this?’” The result may be more clients who walk when they conclude the much more visible fee is not justified by the results they receive.

Of course, many questions remain about the ultimate form of the CRM or any other disclosure document. “Many people still don’t have it together,” Austin says, “because there is not enough guidance [from regulators] about what it’s supposed to look like.”
@page_break@There’s also the vexing question of which regulatory bodies should be doing what.

Currently, the nitty-gritty details of the CRM are being hammered out by the Mutual Fund Dealers Association of Canada and the Investment Industry Regulatory Organization of Canada. But both Austin and Struthers suggest that more input is needed from those with the ultimate say — securities regulators.

Part of the problem, Austin observes, is that something complex must be explained in a way that most people can understand. And that can lead to oversimplification. “You can only dumb things down so much,” he says. “We will see what people produce and what the staff [at securities commissions] say.”

Although all the new rules have yet to take definite shape, it’s clear that some sellers of financial products are already looking for safer harbours — in other words, products that they perceive as being more lightly regulated. Insurance, for instance, typically has fewer restrictions in terms of commissions or other forms of compensation. But both Austin and Struthers caution against looking for regulatory relief by shifting products.

Although Struthers has noticed this trend in her practice, she says, there’s less regulatory leeway than some people may believe. The IIROC has established know-your-product rules, she notes, which govern all of its members — whether they are selling traditional mutual funds or some other product.

“I think what [sellers of financial products] perceive as an opportunity is less of an opportunity than they might think,” she says. “That is, advisors could be liable if they sell products they don’t understand. Think about the whole asset-backed securities fiasco.”

Questions then arise, of course, about the obligations of salespeople as they move among product classes. Which hat are they wearing, and when?

Nigel Campbell, a litigation partner with Blake, Cassels & Graydon LLP in Toronto, notes that the regulatory landscape has become increasingly “ragged.”

“The weird thing is that there isn’t a lot of clarity,” he says. “If you are approaching a task in an advice-giving capacity, your duties may expand. That’s as opposed to simply making a product available to someone.”

Insurance may be perceived as more likely to fall into the latter category: some industry-watchers, for instance, believe that the Canadian Life and Health Insurance Association lacks the independence of other SROs. “But [such differences are] a short-term phenomenon,” Campbell cautions, noting that new regulation is likely to flow into any gaps in fairly short order.

Navigating through the current confusion over which regulatory regime applies at which time is not likely to be easy, Campbell says. For example, seg funds are now regulated as insurance products. Should they be treated as investment products? Is it more important who is doing the selling? Does an investment advisor have a higher duty of care toward the client than an insurance advisor?

Says Campbell: “Those are the open questions that are creating confusion.”

As a result, it’s increasingly important for everyone selling and advising on financial products to maintain a running dialogue with their compliance department, Campbell says. It’s also key for compliance staff to be continually informing themselves of the duties imposed on staff.

In any case, Campbell adds, it’s probably a good idea to bring the same standard of care to selling a product, whether it’s a mutual fund or an insurance product, that would be required by the seller’s main designation.

Although civil suits against those selling financial products remain relatively uncommon — especially with the advent of less formal complaint procedures such as IIROC’s arbitration program — it’s still prudent to keep in mind that an ounce of prevention is worth a pound of cure. Thus, it remains crucial to pay attention to matters such as risk management, suitability issues and the ever-present reality that a happy client today may be an unhappy client tomorrow.

As was made clear in a case Campbell won for Toronto-based RBC Dominions Securities Inc. last year, it’s still essential to maintain excellent record-keeping: “The story that was told [by the plaintiff investor] about what happened ran contrary to some documentary evidence, and the documentary evidence was helpful [in winning the case for RBC].”

Although it may seem tedious, keeping notes on chats with managers and other ways to track client conversations can be hugely helpful when, five years later, questions are being raised by irate clients in a hearing room, Campbell points out: “It doesn’t work like magic, and sometimes there are complications. But sensible and careful correspondence is the key, not firing off the glib email.” That’s a message that can’t be repeated too often. IE