The Canadian Securities Administrators (CSA) recently issued CSA Consultation Paper 81-408 – Consultation on the Option of Discontinuing Embedded Commissions (the Paper). While the CSA has not yet made a decision on banning embedded commissions, the Paper outlines the various investor protection and market efficiency issues the CSA believes embedded commissions raise. These include creating conflicts of interest, limiting investor awareness of dealer compensation costs as well as distorting incentives for dealers.
If adopted, a ban on embedded commissions would bring about substantial changes to the investment funds industry that the CSA believes will lower fees and increase competition among fund managers. Given the potential magnitude of these changes, the CSA has launched a 150-day consultation period for public comment on the Paper. The Paper contemplates that a ban on embedded commissions, if adopted, will apply to structured notes and all “investment funds” as defined under securities law, whether sold under a prospectus or in the exempt market under a prospectus exemption.
Embedded commissions for investment funds, which include sales commissions and trailer fees, are the most prevalent method of dealer compensation in Canada. Concerns regarding the impact of embedded commissions on dealers’ incentives, however, are not new to the investment fund industry. While the Ontario Securities Commission (OSC) has voiced concerns on this issue as far back at 1995, the Paper builds on a 2012 discussion paper that identified a number of negative aspects of embedded commissions.
Investor protection and market efficiency issues
In the Paper, the CSA finds that embedded commissions raise the following three issues related to investor protection and market efficiency:
conflicts of interest for dealers are created and the interests of fund managers and dealers are misaligned with those of investors;
a limitation on the level of investor awareness and control over dealer compensation costs due to the inherent complexity of embedded commissions; and
embedded commissions are generally out of line with the services provided to investors in that investors often fail to receive ongoing advice despite dealers being paid trailer fees. Furthermore, the cost paid through commissions may outweigh the benefit it provides investors.
Based on these issues, the CSA believes that embedded commissions can incentivize dealers to recommend funds that best compensate themselves rather than funds that are best for their clients. Furthermore, embedded commissions can impair the ability of investors to assess the true impact of fees on their returns. Finally, embedded fees can incentivize fund managers to rely on paying commissions to dealers to increase sales of their products which, the CSA believes, can cause fund underperformance and higher retail prices for investment funds.
Alternatives to embedded commissions
The alternative to embedded commissions is direct pay arrangements. These could include upfront commissions, flat fees, hourly fees or fees based on assets under administration as well as other arrangements. According to the CSA, the defining features of a direct pay arrangement are that: (i) the arrangement is negotiated exclusively between the advisor and investor pursuant to an explicit agreement; and (ii) the investor must exclusively pay the dealer for the services. However, managers could facilitate direct pay arrangements through payments taken from the investor’s investment (for example, deductions from purchase amounts or periodic redemptions from the investor’s account).
Potential changes to the investment funds if embedded commissions are discontinued
A requirement that dealers use a direct pay arrangement would fundamentally change the business models of the majority of Canadian fund managers and dealers. In the Paper, the CSA identified several of these changes, including the following:
the entry of lower-cost products into the Canadian market. Based on research from other markets, the CSA predicts that new entrants could offer management expense ratios up to 40 basis points lower than the current industry average;
a reduction in the number of fund series available as well as a reduction in the complexity of fund fee structures. This would be due, in part, to the elimination of the need for different series of the same fund that pay different commissions;
increased price competition between fund managers, which would be associated with a decrease in overall fund management costs;
reallocation of money from below-average performing funds due to advisors recommending funds based solely on their performance rather than on the commissions the funds pay;
increased levels of innovation in advising investors such as advice provided online or by robo-advisors; and
reduced access to investment advice for lower-income investors for whom investment advice was previously paid for through embedded commissions.
Related regulatory initiatives
In addition to the Paper, the CSA is also moving forward with other reforms, including the point of sale disclosure and the client relationship model phase 2 projects. Despite concerns about the large number of reforms and their impact on the business operations of fund managers and dealers, the CSA believes that these reforms would be complementary to a ban on embedded commissions. However, the CSA has specifically requested comments on whether these other reforms may satisfactorily address the concerns raised by embedded commissions.
The CSA has initiated a 150-day comment period with respect to the Paper, which will close on June 9, 2017. Following this, the CSA will review the comments and results of the consultation process and will decide whether to draft a new rule for public comment. While not indicative of the CSA’s position on this issue, OSC Chair Maureen Jensen has stated that such a new rule could be issued within a year. Looking further ahead, the Paper itself suggests a transition period of 36 months following the effective date of a final rule.
The authors wish to thank Mark Bissegger, Student at Law, for his help in preparing this legal update.