What to make of the CSA’s revised client-focused reforms

Experts weigh in on what the new CFRs mean for advisors and investors

The Canadian Securities Administrators’ revised client-focused reforms provide welcome relief for the industry on referral arrangements and clarity on conflicts, while some advisors say the reforms don’t go far enough to protect investors and keep up with regulation in other countries.


Last week, the Canadian Securities Administrators published the client-focused reforms (CFRs), which consist of amendments to National Instrument 31-103 and require advisors and firms to address material conflicts in the best interests of clients and put clients’ interests first when making suitability determinations. The amendments are supported by new know-your-product (KYP) requirements and enhancements to know-your-client (KYC), suitability, conflicts of interest and relationship disclosure.


Jason Pereira, partner and senior financial consultant at Woodgate Financial in Toronto, says the CFRs don’t go far enough and are instead evidence that the industry in Canada is falling behind its global peers.


“Look around the world and compare where we stand,” Pereira says, referring to extensive reforms in Australia and the U.K.


In Canada, “we’re not even talking about the banning of embedded compensation,” Pereira says.


Last year, Canadian regulators proposed banning deferred sales charges, not embedded compensation, but the Ontario government didn’t support the proposal, which is now on hold.


The CFRs are subject to ministerial approval before coming into force at the end of this year. When asked whether the Ontario government would support the reforms, a spokesperson for Minister of Finance Rod Phillips said in an emailed statement that the ministry is in the process of its 60-day review.


In contrast to the Canadian approach to embedded commissions, some stateside governments are taking the SEC to task for failing to implement a fiduciary duty for brokers.


With a regulatory track record that includes the CRM2 requirement to disclose trailing commissions, not total costs, and a failure to introduce a fiduciary standard, Canada’s industry regulation is “shamefully behind,” Pereira says, and doesn’t truly put clients first.


In response to a majority of comments on the proposals, the CSA added a “materiality” threshold regarding conflicts of interest, so that only material conflicts must be identified and addressed.


“The commenters argued that having to identify and address non-material conflicts would impose a significant burden on registrants without providing corresponding investor protection or benefits,” CSA says in its notice of the amendments.


Materiality adds a tangible aspect in identifying conflicts, says Christina Mackinnon, an associate at Torys in Toronto. Material conflicts potentially involve a power imbalance, informational asymmetry, or an investment decision that disadvantages a client, she says, and material conflicts could differ among firms depending on firm structure.


One material conflict cited by the CSA in its notice is receiving embedded commissions. Still, the regulators say advisors and firms can offer funds with embedded commissions if they can demonstrate that the recommendation is based on the security’s quality without influence from any third-party compensation.


Recommending products with embedded commissions is “possible but not advisable,” Mackinnon says. Advisors would have to show how the recommendation puts the client’s interest first, which might be challenging when there are other comparable products that could be recommended. “It makes the advisor’s life more difficult,” she says.


Senior advocacy group CARP (Canadian Association for Retired Persons) says it continues to advocate for the elimination of embedded commissions. “Canadians pay among the highest mutual fund fees in the world and often investors are unaware of the fees they pay on those investments,” says Marissa Lennox, chief policy officer at CARP in Toronto.


While the CFRs don’t break fresh regulatory ground, Mackinnon says they serve a purpose. The regulators are providing clarity about standards and registrant obligations, and regulatory expectations now match guidance, she says.


Investor advocate FAIR Canada says that while the reforms don’t as far as they had hoped, the changes “represent material improvements in the protection of investors.”


In an emailed statement, executive director Ermanno Pascutto commended the CSA for requiring that conflicts be addressed in clients’ best interests.


“Among other things, this will require that registrants change sales compensation incentives which lead to advice that is in the best interest of the firm rather than the client,” he said.


Dropped proposals

Several requirements floated in the CSA’s proposals have been dropped.


For referral arrangements, the CFRs originally proposed a fee and duration limit, which could have negatively affected advisors and portfolio managers working in tandem.


Jason Ayres, CEO at Croft Financial Group in Toronto, says he appreciates the regulators’ awareness of business models, which function effectively and add value in most cases.


Still, Pereira says “there’s need for correction” concerning referral arrangements, such as when advisors collect fees but don’t service the client. “That’s wrong and needs to stop,” he says.


In NI 31-103’s companion policy, the CSA provides guidance on addressing the conflict arising from referral arrangements, outlining expectations related to disclosure, supervision and assessment of referrals’ qualifications and registration if applicable. Also, CSA says it may develop and propose for comment additional reforms related to referral arrangements.


“Transparency and disclosure […] is a good start,” but a minimum standard of service is missing from the regulation, Pereira says.


Despite the lack of a codified standard, Ayres says a recent OSC audit at his firm made clear that “there were certain expectations […] with respect to conflicts of interest, fee disclosure and client understanding of roles and responsibilities within the relationship” of a referral arrangement.


He says a positive is that the CFRs’ enhanced standards for conflicts related to referral arrangements motivate firms in aggregate to revisit their documentation and legacy relationships, thereby overcoming complacency.


Further, as regulators continue to review referral arrangements, they might push forward with standards, such as a cap on referral payments, which would help harmonize the arrangements and create consistency, Mackinnon says.


Another dropped proposal — the requirement for firms to make information publicly available that a reasonable investor would consider important in deciding to become a client — was overly broad, Mackinnon says, and put firms in a difficult position in instances where they provide tailored services, for example, or negotiate charges. What investors typically want to know is found in relationship disclosure information, the rules for which are clear, she says.


Implementing the changes

The amendments introduce a new section — misleading communications — which prohibit advisors from presenting themselves in ways that might deceive clients. For example, client-facing advisors can’t use corporate officer titles (e.g., “vice-president” to denote seniority), or titles or recognition based on revenue (e.g., “President’s Club” on a LinkedIn profile).


“Clients can be too trusting when confronted with such titles, leaving investors ill-prepared to ask questions and make fully informed decisions,” Lennox says.


Firms must be onside with that amendment, as well as the many others, which could mean greater costs and time commitments. Mackinnon says considerations for firms include implementing KYP requirements, updating KYC documents and relationship disclosure information, and redrafting compliance manuals so that policies and procedures are robust, especially for conflicts of interest. In an audit, the first thing regulators will look at is whether the firm is onside with the conflict of interest amendments, she says.


Firms should also self-audit their record-keeping systems for compliance and comprehensiveness, she says. For example, suitability determinations must now be documented.


“If an advisor’s challenged on why they recommended a proprietary product, they have to have that [suitability determination] in writing,” Mackinnon says. Record-keeping will be all the more important with the CFRs’ client-first standard and with the onus on advisors to justify their recommendations, she says.



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