Improving the Client-Registrant Relationship: New Proposals from the CSA

On June 21, the Canadian Securities Administrators (CSA) published two notices on investor protection initiatives: one setting out the CSA's "intended policy decision" with respect to mutual fund embedded commissions (the Embedded Commission Proposed Amendments); and the other proposing a number of amendments to National Instrument 31-103 that are aimed at enhancing the obligations of registrants to their clients (the NI 31-103 Proposed Amendments).

What You Need To Know

The Embedded Commission Proposed Amendments proposes to prohibit both:

• deferred sales charges (DSC), including low-load options, and their associated upfront commissions; and
• the payment of trailing commissions to dealers who do not make a suitability recommendation.

The NI 31-103 Proposed Amendments seek to enhance registrant obligations, including through:

• a requirement that registrants update Know-Your-Client (KYC) forms at a minimum every 12 to 36 months, depending on the type of account or class of registrant;
• an express Know-Your-Product (KYP) requirement applicable to both registered individuals and firms;
• enhancements to registrants' suitability obligations, including an overarching requirement to put the "client's interest first" when making suitability determinations;
• a requirement that registrants resolve all conflicts of interest in the best interest of the client;
• limits on the amount and duration of referral fees; and
• requirements for enhanced disclosures relating to proprietary products.

It is important to note that these are at present only proposed amendments, which have not yet been implemented. However, the proposals come after much work and consultation by the regulators, and are a clear signal of regulatory Staff's current intentions and expectations of registrants.

• The CSA also indicates that, following extensive public comment, the Ontario Securities Commission (OSC) and the Financial and Consumer Services Commission of New Brunswick (FCSC) have decided not to impose a best interest standard on registrant advisers, as had been previously proposed.

Background/Additional Information

Both sets of amendments are part of the CSA's "harmonized response to concerns with the client-registrant relationship as it exists today" intended to "better align the interests of registrants and investors, improve investor outcomes and raise the bar for registrant conduct."

The CSA is requesting public comment on the NI 31-103 Proposed Amendments by October 31, 2018. The CSA intends to publish rule proposals for comment with respect to the Embedded Commission Proposed Amendments in September 2018.

The Embedded Commission Proposed Amendments

Background

On January 10, 2017, the CSA published for comment CSA Consultation Paper 81-408 Consultation on the Option of Discontinuing Embedded Commissions. The Consultation Paper identified issues arising from the practice of investment fund managers compensating dealers and their representatives for mutual fund sales through embedded commissions. In particular, there was concern that embedded commissions (i) resulted in conflicts of interest that misaligned the interests of registrants with investors, (ii) limited investor awareness, understanding and control of dealer compensation and (iii) did not align with the services actually provided to investors.

The Proposed Amendments

After an extensive 18-month consultation process, the CSA is proposing the following policy changes, which will be published in a rule proposal for comment in September 2018:

• Prohibition on DSCs. The CSA is proposing to prohibit DSCs, including low-load options, and their associated upfront commissions in respect of purchases of securities of prospectus-qualified mutual funds.
• Prohibition on trailing commissions. The CSA also proposes to prohibit the payment of trailing commissions to, and the solicitation and acceptance of trailing commissions by dealers who do not make a suitability recommendation in connection with the distribution of prospectus qualified mutual fund securities (i.e., discount brokers).

The NI 31-103 Proposed Amendments

Background

On October 25, 2012, the CSA released Consultation Paper 33-403 The Standard of Conduct for Advisers and Dealers: Exploring the Appropriateness of Introducing a Statutory Best Interest Duty When Advise is Provided to Retail Clients. Since then, the CSA has engaged in a consultation process with industry and investor representatives with a view to enhancing the obligations of registrants toward their clients. Among other things, a key area of consultation was the CSA's proposal of an overarching best interest standard that would serve as the principle that would govern the interpretation of all client-related obligations of a registrant.

The Amendments

As a result of the consultation process, the CSA has now confirmed that the OSC and FCSC will not be pursuing a best interest standard. However, it has proposed a number of amendments to NI 31-103 which will enhance obligations of registrants to their clients:

• Know-Your Client Updates. The CSA is proposing to codify existing guidance that registrants be required to update KYC information. The proposal contemplates updates every 12 months for managed accounts, 12 months prior to making a trade or recommendation for exempt market dealers, and every 36 months for all other accounts. Should the SROs implement similar rules (as they will be expected to do), this will be a new requirement on IIROC dealers. The CSA is also proposing to require registrants to take reasonable steps to obtain a client's confirmation of the accuracy of KYC information collected. Again, this codifies existing guidance requiring that KYCs are signed by clients at the time of account opening.
• Know-Your-Product Obligation. The CSA also proposes to impose explicit KYP obligations on registered firms and individuals (currently, the Companion Policy to NI 31-103 provides principles based guidance on the CSA's KYP expectations), which will include a requirement on dealers to understand how the securities they recommend compare with "similar securities."
• Enhanced Suitability Obligation. The proposal also includes a number of enhancements to registrants' suitability obligations, including: (i) an express requirement that registrants put their clients' interests first when making a suitability determination; (ii) requiring registrants to consider certain factors, including costs and the impact of the trade or other action on the account, in making suitability determinations; and (iii) moving away from trade-based suitability to an overall portfolio-level suitability analysis. The CSA is also proposing certain triggering events that will require a registrant to reassess suitability (including, for example, a change in the client's KYC information or a change in a security in the account). IIROC and the MFDA already require suitability reviews upon the happening of certain triggering events, but will be expected to review their existing triggers to ensure that they are consistent with the amendments ultimately adopted by the CSA.
• Conflicts of Interest. The CSA is proposing to adopt a "best interest" standard relating to conflicts of interest, meaning that when a registrant addresses a conflict of interest, it must do so in the best interests of the client. It is also proposing to: (i) require registrants to disclose all conflicts of interest to clients (not only conflicts that are material), (ii) prohibit registrants from borrowing money from a client, lending money to a client or having control over the financial affairs of the client (subject to SRO rules and to certain other exceptions); and (iii) enhance disclosure requirements relating to conflicts of interest.
• Referral Fees. The CSA is proposing to prohibit referral fees that (i) last longer than 36 months, (ii) constitute a series of payments that together exceed 25 percent of the fees or commissions collected from the client by the party who received the referral and (iii) increase the fees or commissions that would otherwise be paid by a client to a registrant.
• Disclosure Regarding Proprietary Products. The CSA proposes to require registered firms to provide disclosure to clients regarding (i) their use of proprietary products, (ii) any limitations on the products and services that they will make available and (iii) the impact each of these things can have on investment returns. The proposal also contemplates requiring registered firms to make publicly available the information that potential clients would consider important in deciding whether to become a client (through information on their websites, replies to e-mail requests or by giving out short documents).