On April 28, 2016, the Canadian Securities Administrators (CSA) released its long-awaited Consultation Paper 33-404: Proposals to Enhance the Obligations of Advisers, Dealers and Representatives Toward Their Clients.
The paper describes:
(1) specific reforms to NI 31-103 under consideration by all CSA jurisdictions designed “to better align the interests of registrants to the interests of their clients and enhance various specific obligations that registrants owe to their clients,” and
(2) a general regulatory “best interest” standard that is supported by the provincial securities regulators in Ontario and New Brunswick, opposed by the securities regulator in British Columbia, and looked upon by regulators in Quebec, Alberta, Manitoba and Nova Scotia with “strong reservations.”
Both the specific reforms and the proposed best interest standard would apply to all advisers, dealers and representatives, including members of the Investment Industry Regulatory Organization of Canada and Mutual Fund Dealers Association of Canada.
The CSA’s proposals
Consultation Paper 33-404 is the continuation of a four-year project to consider the introduction of a best interest standard for investment advisers and dealers in Canada. The end is not in sight – the paper reflects the lack of unanimity within the CSA on creating an overarching best interest standard.
Specific Targeted Reforms
The specific targeted reforms would amend NI 31-103 as it relates to obligations concerning, among other things, conflicts of interest, know your client, know your product, suitability, relationship disclosure, and proficiency.
It would require, for example, that firms and representatives respond to material conflicts of interest in a manner that prioritizes the interests of the client ahead of the interests of the firm and/or representative, and that disclosing a conflict of interest to a client be “prominent, specific and clear.”
Know-your-product obligations of representatives would require that they understand and consider the structure, product strategy, features, costs and risks of each security on their firm’s product list, how a product being recommended compares to other products on the firm’s product list, and the impact on the performance of the product of all fees, costs and charges connected to the product, the client’s account and investment strategy.
Firms would be required to identify whether they have either a proprietary or mixed/non-proprietary product list.
Mixed/non-proprietary firms would be burdened with additional regulatory obligations, including the obligation to select products that they offer in accordance with a “fair and unbiased market investigation of a reasonable universe of products that the firm is registered to advise on or trade in” and a product comparison to determine whether the products that the firm offers are “appropriately representative” of the reasonable universe of products most likely to meet the investment needs and objectives of its clients. An “optimization process” whereby the firm adjusts the range of products offered to achieve a range “that is appropriately representative of the products most likely to meet the investment needs and objectives of its clients” also would be required.
Among the consultation questions posed in relation to this proposal is whether this could result in firms offering fewer products and create incentives for firms to stop offering non-proprietary products.
Registrants would be required to undertake a comprehensive financial suitability, investment strategy suitability and product selection suitability analysis in accordance with specified criteria each time they make a recommendation concerning or accept a client instruction to buy, sell, hold or exchange a security, or make a purchase, sale, hold or exchange of a security for a managed account.
Existing provincial securities legislation would be amended to introduce a statutory fiduciary duty for registrants when managing the investment portfolio of a client through discretionary authority granted by the client.
Best Interest Standard
The proposed framework for a regulatory best interest standard, unequivocally supported by only two of the provincial securities regulators, would require that a registered dealer or adviser (and its representatives) deal fairly, honestly and in good faith with its clients and act in its clients’ best interests. The conduct expected of a registrant in that regard would be that of a prudent and unbiased firm or representative acting reasonably.
Registrants would be guided by certain articulated principles in that regard, namely, acting in the best interests of the client, avoiding or controlling conflicts of interest in a manner that prioritizes the client’s best interests, providing full, clear, meaningful and timely disclosure, interpreting law and agreements with clients “in a manner favourable to the client’s interests where reasonably conflicting interpretations arise,” and acting with care.
This would be a “regulatory conduct standard” not a restatement of a common law fiduciary duty – the intention is not to create a statutory fiduciary duty.
The Ontario and New Brunswick regulators believe the regulatory best interest standard as a governing principle would assist in interpreting the more specific requirements and guide registrants in addressing situations not covered by a specific rule.
However, the Alberta, Quebec, Manitoba and Nova Scotia regulators share “strong reservations” about the benefits of this proposal. The British Columbia Securities Commission does not support the introduction of a general best interest standard, believing it will create uncertainty for registrants and may be unworkable.
The British Columbia, Alberta, Quebec, Manitoba and Nova Scotia regulators share concerns that introducing an overarching best interest standard may exacerbate the expectations gap between clients and registrants because of the existing restricted registration categories and proprietary business models permitted in Canada.
“Clients may expect that all registrants have an unqualified duty to act in their best interests, not understanding that some conflicts would still be permitted.” For example, “It is simply not possible to require a salesperson of proprietary products only to act in a manner that is truly in an investor’s best interest.”
The new standard may also create legal uncertainty. How will courts interpret a standard that expressly requires conduct in the client’s best interest, but in some cases permits conduct that may not be in the client’s best interests so long as there is disclosure? The proposed standard may affect the interpretation of existing fiduciary standards for portfolio managers and investment fund managers. Adopting a best interest standard for other registrants that is “qualified to mean something less than a full fiduciary standard may impact the interpretation of the words ‘best interest’ as they apply elsewhere.”
The US analogue
On April 6, 2016, following extensive consultation, the US Department of Labor published its final fiduciary rule requiring those who provide investment advice to retirement plans and individual retirement accounts about the purchase, sale, holding or exchange of securities for compensation to abide by a fiduciary standard. In general, financial institutions and advisers will be prohibited from receiving compensation that creates a conflict of interest unless a “best interest contract exemption” is met.
The exemption would allow financial institutions and their advisers to charge commissions provided specific conditions are met that mitigate potential conflicts of interest. The best interest contract exemption would require the financial institution and its advisers to: (i) acknowledge their fiduciary status in a written agreement with the client; (ii) adhere to standards of impartial conduct, including giving prudent advice in the customer’s best interest, avoid misleading statements, and receive no more than reasonable compensation; (iii) adopt policies and procedures to mitigate conflicts of interest; and (iv) disclose information about conflicts of interest and the cost of their advice.
Although a best interest standard of more general application had been proposed by Securities and Exchange Commission staff in 2011, to date no new standard has been adopted.
Issues arising from the best interest standard proposal
A number of concerns have been raised surrounding the application of best interest standards in the United States and Canada.
The costs of compliance may be onerous. The Investment Industry Regulatory Organization of Canada previously announced that the CSA’s original proposal would result in increased scrutiny of compensation-related conflicts of interest. Many firms will have to make changes to their monitoring technology, account opening procedures and general operations to demonstrate compliance. In the US, AIG sold its broker-dealer arm citing increased compliance costs. There is also a concern the changes will increase the risk of client lawsuits and regulatory action.
A general best interest standard may be too broad and disadvantageous for certain consumers. It may force firms to shift away from commission-based payment structures to reduce compliance risk, notwithstanding that there are circumstances where commission payment structures may be less expensive and entirely appropriate for certain clients. Investors without significant investment assets may be the most disadvantaged by a general fiduciary rule. Firms may be reluctant to provide cheap investment advice to small retail investors as compliance costs rise, increasing the advice gap between those who can afford personal advisers and those who cannot.
Finally, there is concern that notwithstanding efforts to harmonize requirements, potentially different standards may be imposed by different securities regulators, making compliance even more of a challenge. As indicated, in the US the fiduciary rule has only been adopted for certain types of retirement investment advice. A somewhat different standard or broader application could be put in place by the SEC. In Canada, the apparent lack of unanimity among provincial securities regulators about implementing a general best interest standard creates a risk that such a standard may apply to dealers and advisers operating in one province, but not another.
Comments on the CSA proposals must be submitted by August 26, 2016.
The author wishes to thank Danny Urquhart, articling student, for his assistance in preparing this legal update