Dealing with conflicts of interest for registrants - disclosure is not enough

Business meeting

Securities and Corporate Finance Alert

By:

On April 27, 2017, the Investment Industry Regulatory Organization of Canada (“IIROC”) issued a rules notice and guidance note (the “Notice”) regarding dealer firm (“Dealers”) management of compensation-related conflicts. The review identified three areas of concern including: (i) reliance on disclosure without first addressing the conflict and inadequate disclosure; (ii) a lack of dealer review and oversight of compensation programs and the conflicts they create; and (iii) inadequate supervision and monitoring of fee-based accounts.

These concerns may be equally applicable to non-IIROC registered Dealers and portfolio managers. IIROC is working with the CSA to formulate new conflicts rules and guidelines as a part of the initiative referred to in “Canadian Securities Administrators Consultation Paper 33-404 - Proposals to Enhance the Obligations of Advisers, Dealers, and Representatives Toward Their Clients”.

IIROC and the CSA are of the view that further regulatory action is required to better align the interests of registrants to the interests of their clients. In connection with this initiative IIROC has recently sent a request for information to Dealers in an effort to gain a clearer understanding of how Dealers are administering their fee-based accounts. The nature of such responses may have a significant impact on both the responding Dealers as well as on rule changes going forward.

A.   What are the current rules?

IIROC Dealer Member Rule 42 (“Rule 42”) provides guidance on conflicts. Rule 42 is a principles-based rule that (together with supplemental guidance) requires a Dealer’s policy and procedures: (i) identify; (ii) avoid; and (iii) address, material conflicts of interest. Rule 42 does not identify specific conflicts that must be avoided but does require:

  1. the Dealer’s representatives address all material conflicts – whether existing or potential – in a manner that is consistent with the best interests of the client;
  2. recognition that Dealers must balance the interests of multiple clients simultaneously; and
  3. any conflicts that cannot be addressed in this manner must be avoided.

In addition to Rule 42, there are rules and guidance of general application which Dealers must consider. These include:

  1. Dealers and their representatives must observe high standards of conduct and not engage in conduct unbecoming or detrimental to the public interest;
  2. Dealer Member Rule 38.1 that requires Dealers to establish and maintain a system to supervise their activities reasonably designed to achieve compliance with all applicable laws1; and
  3. Canadian securities legislation requirements that Dealers deal fairly, honestly and in good faith with clients.

B.   Do your practices comply?

1. Is there an over reliance on disclosure?

The Notice suggests that Dealers and representatives are increasingly relying solely or primarily on disclosure as a manner of managing conflicts of interest. This alone is not sufficient to address the principles-based rule set out above. IIROC (in alignment with the CSA) is of the view that on its own, disclosure of a conflict is generally an inadequate mitigation mechanism because of its limited impact on a client’s decision making process and disclosure as a solution is now being questioned for its efficacy and possible unintended consequences. IIROC and the CSA refer to independent studies which indicate that (i) disclosure may be disregarded or ineffective, (ii) it may give rise to a phenomenon referred to as the “burden of disclosure” where clients feel pressured to act in the compensation-based interests of the advisor despite discounting advice subject to a conflict, and (iii) over-reliance on disclosure as a mitigation method may in fact lead the representative to provide more biased advice.

2. Should you be relying on disclosure?

IIROC takes the position that, prior to relying on disclosure, Dealers should first attempt to address the conflict of interest in a fair, equitable and transparent manner, consistent with the client’s best interest. Where the conflict cannot be addressed the conflict should be avoided altogether. Where there is still a conflict after these steps, disclosure is required.

3. Do you provide your clients with proper disclosure?

Disclosure must be timely and meaningful. Specifically, disclosure should be made before the product or service that is related to the conflict is sold or provided. The disclosure must be prominent, complete and in plain language and must accurately describe the conflict so as to ensure the client understands its nature. A generic disclosure simply stating that a conflict may exist is insufficient. In addition, representatives should explain the nature of the conflict and confirm that the client has actually read the disclosure.

4. Do you have proper review and monitoring of compensation programs?

No two compensation programs are the same. Dealers use different incentives and a variety of methods for calculating compensation which could result in a misalignment between the interests of representatives and the interest of their clients. IIROC noted that most Dealers reviewed and monitored certain conflicts involving related-party products but that few Dealers had conducted a detailed review of their overall compensation program and the inherent conflicts that can arise therein. Furthermore, few Dealers have implemented compliance monitoring processes to address any conflict risks identified.

5. Are your supervisors independent?

A Dealer should ensure independent supervision of all retail accounts.2 For example, a branch supervisor’s compensation may be partly based on overall branch profitability, however, Dealers should identify and review any factors which would create any undue bias towards branch profitability at the expense of the client’s best interest.

6. Do your policies and procedures consider conflicts associated with placing clients in fee-based accounts rather than commission-based accounts?

Dealers should consider whether they have the appropriate policies and procedures in place to ensure that clients are put into the most appropriate accounts. IIROC stated that their review clearly indicated a bias on the part of most Dealers towards fee-based accounts instead of commission-based accounts. They noted that a number of Dealers provide additional incentives to representatives in the form of bonuses linked to fee-based accounts and that most Dealers provide the highest possible grid payout to representatives based on fee-based revenue. The concern is that clients may be moved into fee-based accounts, despite them not being consistent with their best interests.

7. Are there additional fees charged to clients with fee-based accounts?

The Notice highlights that in several instances clients with fee-based accounts pay additional fees3, or the advisor receives additional compensation, on top of the standard fee. IIROC acknowledges that in some cases this may be the most cost-effective arrangement for a client so long as the aggregate fee charged is in the client’s best interest and the fees charged have been clearly disclosed to, and acknowledged by, the client.

C.   Key takeaways and expectations

  1. IIROC and the CSA are of the view that further regulatory action is required to better align the interests of registrants to the interests of their clients and to ensure they are dealt with fairly, honestly and in good faith. IIROC will now request a Dealer’s compensation grid as a standard item for every exam and IIROC’s Business Conduct Compliance team has implemented enhanced procedures related to compensation-based conflicts.
  2. Where a conflict has been identified, a Dealer or representative must consider whether the conflict can be addressed in a fair, equitable and transparent manner, while considering the best interest of the client. If this cannot be done, then the conflict must be avoided.
  3. Where it has been determined that a conflict of interest cannot be avoided it should be disclosed. Such disclosure should be adequately addressed within a Dealer’s materials and representatives should adequately explain and/or confirm that the client understands the nature of the conflict.
  4. Dealers should conduct a complete review of their business models, compensation programs, and monitoring/supervision processes to ensure that potential conflicts of interests can be properly identified, avoided or addressed as they arise.
  5. Dealers should have processes to consider the initial appropriateness of a fee-based account for a client and ensure they periodically review fee-based accounts for ongoing appropriateness.
  6. Dealers should review their policies and procedures related to controlling conflicts associated with “double charging”. Dealers should have a controlled process to back out products with embedded compensation before calculating account fees.

 

 


[1] Including the requirements under National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations, section 11.1 that Dealers have controls and supervision in place to manage the risks associated with their business.

[2] IIROC Dealer Member Rule 38 and 2500.

[3] Includes hybrid accounts where the client pays an overall account fee, as well as a ticket fee or commission on all trades or fee-based accounts that contain assets with embedded advisor compensation.