Client Focused Reforms (CFR) And Retail Investor Protection

After a prolonged consultation process, on 3 October 2019, the Canadian Securities Administrators (CSA) published a revised version of the Client Focused Reforms proposed in June 2018. These reforms attempt to have clients’ interests come first in transactions with firms and individuals. “Best interests” is all about the outcome, and therefore all about eliminating influences that may detract or conflict with the achievement of that outcome. Registration categories will remain the same, as will proficiency standards for now. Critics of the CFR are concerned with the core concept of trying to implement best interests standards within current business models..

The CSA state that CFR does not address certain important matters discussed in the Consultation Paper and the Proposals, such as proficiency standards, titles and designations, embedded commissions, a statutory fiduciary duty applicable to advisors exercising discretionary authority, and reforms to the referral arrangement requirements. Given the CSA ‘s track record and government regulatory “burden” priorities, it could be some time before we see any additional client-focused reforms to address these matters, all of which are needed to support CFR success.

CFR Overview

While the CFRs don’t break fresh regulatory ground, the CSA is providing clarity about standards and registrant obligations, and regulatory expectations now match guidance without actually imposing an all-encompassing obligation for firms and individuals to act in the best interests of their clients. Instead, specific obligations are incorporated into various provisions in National Instrument NI 31-103 Registration Requirements, with most provisions codifying what regulators consider to be prevailing good practices, and a few representing new requirements. CFR rules require registrants to resolve conflicts of interest in the best interests of clients and to codify best practices regarding client disclosure, Know-Your-Client (KYC) and Know-Your-Product (KYP) obligations. Representatives will, however, continue to be permitted to have conflicts that threaten their ability to act in a client’s best interests.

Under CFR, registrants are required to;

1. address material conflicts of interest in the best interest of the client,
2. put the client’s interest first when making a suitability determination, and
3. do more to clarify for clients what they should expect from their representatives.

The CSA is relying on the “professional judgment” of firms and reps in ensuring they adhere to the broad, principles-based standard of “clients’ best interests” and regulatory guidance when faced with conflicts. The implied goal of CFR is to result in portfolios that are more diversified, lower in costs and likely to generate higher risk-adjusted returns in the long run.

These core elements are supported with the introduction of a Know-Your-Product (KYP) provision in the rule and enhancements to the existing Know-Your-Client (KYC), suitability, conflict of interest, and Relationship Disclosure Information (RDI) requirements. These provisions set out the fundamental obligations of registrants towards their clients and are essential to investor protection. They are designed to work together throughout the client-registrant relationship, as an extension for the duty of registrants to deal fairly, honestly and in good faith with their clients. However, they do not impose a fiduciary duty on registrants as a regulatory standard of conduct.

Relationship Disclosure Information

The CFR includes the new requirement for firms to disclose when they offer primarily proprietary products and whether there will be other limits on the availability of products and services. This should help clients better understand that the “best interests” advice they are receiving is constrained by products that may not be the best, cheapest or lowest risk. However, the CSA chose not to make a formal rule of the requirement in the original Proposals for a registrant to explain to clients the impact on returns as a result of any restrictions on the products or services the firm will provide to a client.

Titles And designations

CFR rules prohibit registrants from using titles or designations that could reasonably be expected to deceive or mislead existing and prospective clients. This is intended to constrain the use of titles and designations that confuse or mislead existing and prospective clients, including more vulnerable and less sophisticated investors. The restrictions on titles, especially the use of a fake corporate officer title like VP, (unless their sponsoring firm has appointed that registered individual to that corporate office pursuant to applicable corporate law), is a positive. Similar rules have been in place for years but without enforcement.

Enhanced KYC information

The CFR provides additional KYC information including;

• the client’s personal circumstances (not limited to financial circumstances),
• risk profile (guidance clarifies that this includes both the client’s risk tolerance and their risk capacity), and
• investment time horizon which should help improve portfolio construction by providing a more comprehensive set of suitability criteria.

There is a requirement for registrants to:

1. take reasonable steps to obtain clients’ confirmation of the accuracy of their KYC information,
2. keep KYC information current by updating the client’s information if the registrant become aware of a significant change,
3. specify minimum intervals when a client’s KYC information must be reviewed:

                           I.         12 months for managed accounts.

                          II.         12 months before making a trade or recommendation for exempt market dealers.

                        III.         36 months for other cases. It should be expected that the 3-year period will be truncated by responsible registrants dealing with seniors or other vulnerable investors.

CFR requires that KYC questions and client communications should be in plain language and supported with explanations of what each question or item relates to and what relevant terms and expressions mean. If reps move away from the checkbox approach to KYC and seek a deeper understanding of client needs and objectives, this would be a huge improvement.

Representatives will need to be better trained in the process for converting KYC information to personalized investment advice. Each firm should have a standardized and documented approved process for this as well as one for client risk profiling. KYC processes will need a revamp to match CFR criteria.

Cost Is Now An Explicit Suitability Factor

The CSA have made cost an express part of the suitability requirement. There is plenty of empirical evidence that puts cost as a top issue when considering purchasing a financial product or selecting an account type. It remains to be seen if this factor will lead to an increased use of low-cost products, passive investment strategies and decreased use of products with ongoing costs. The CSA has removed the guidance in the Companion Policy that stated that they expected the lowest cost security that is suitable in the circumstances to be recommended to a client unless the registrant has a reasonable basis for determining that a higher cost security will be better for the client. Unfortunately, the CSA did not seize the opportunity to include total Cost Disclosure Reporting (“CRM3”) in the CFR package, one of the most important factors in investor decision making and Rep assessment.

Conflicts of interest

CFR requires registered firms to address all existing and reasonably foreseeable material conflicts of interest including conflicts arising from compensation arrangements and incentive practices, in the client’s best interest. Firms must avoid a conflict, if that is the only reasonable response in the circumstances, that is consistent with the obligation to address conflicts in the best interest of clients. In principle, this means that firms will have to walk away from attractive business opportunities if conflicts of interest cannot be satisfactorily addressed.

The CSA have provided in the Companion Policy examples of controls to consider how to address such conflicts in the best interest of their clients, which includes maintaining internal compensation arrangements that do not differ by product or service sold to the client, or by account or client type. It should be expected, for better or worse, that fee-based accounts will accelerate under CFR.

Fee-based Accounts

“However, we maintain that placing a client in a fee-based account that holds securities with embedded commissions may be considered to be a material conflict of interest that must be addressed in the best interest of the client.” This choice of language is incongruent with several formal settlement Agreements with firms where firms that double-billed were required to compensate clients. The CSA should expressly prohibit embedded commissions in such accounts as it is clearly NOT in the client’s best interests. CFR requires registrants to recommend the account type that is best suited for the client and to monitor for continued suitability over time. “Reverse churning”, however, remains an investor concern.

New KYP Obligation:

The CFR Amendments introduce Companion Policy guidance to assist firms and individuals to meet their KYP obligations to clients when considering legacy securities and recommends that registrants should understand the basis of a security’s return and monitor securities for significant changes. The requirement that a firm must perform a comparison between the securities it makes available to clients and other similar securities in the market was removed. It is not obvious how a rep could assert s/he was acting in a client’s best interests without this market knowledge.

The CFR also removed many other of the prescriptive KYP requirements that had been set out in the Proposals, such as requirements for firms and/or individuals to;

1. conduct a rigorous KYP analysis of securities transferred into a client’s account with a registered firm (e.g., legacy securities),
2. have a general knowledge of each type of security available to clients, and how those securities compare, and
3. monitor and reassess securities offered to clients.

Suitability Determination

The current suitability requirement has been replaced with a new subsection providing that before a registrant opens an account for a client, purchases, sells, deposits, exchanges or transfers securities for a client’s account, takes any other investment action for a client, or makes a recommendation or exercises discretion to take any such action, the registrant must determine, on a reasonable basis

1. the action is suitable for the client, based on the following factors:

i.     KYC information,

ii.    the registrant’s assessment or understanding of the security,

iii.   the impact of the action on the account, including its concentration and liquidity,

iv.    the actual and potential impact of costs on the client’s returns,

v.     a reasonable range of alternatives available through the firm at the time the determination is made, and

       2.  the transaction recommendation puts the client’s interest first. As for risk assessment, CFR makes it clear that using the risk rating of a security as the only input in determining its risk suitability for a client is unacceptable.

To meet the CFR criteria to put the client’s interest first, suitability cannot be determined only on a trade by trade basis, but must be determined on the basis of the client’s overall circumstances, given the relationship between the client and the registrant, and the securities and services offered by the registrant. The new suitability provisions also include a rule replacing the current provision for client directed trades. CFR provides an exemption, if certain steps are taken by the Rep, such as obtaining an informed client consent, after presenting the client with a suitable alternative action, where the Rep receives a client instruction to take an action that does not satisfy suitability criteria.

If the suitability decision is incorrect vis-a-vis the best outcome (i.e. buy risky assets instead of paying off the credit card balance), then it is irrelevant whether the security selected is the most appropriate of its type. Without a best interest outcome statement it is impossible to assess a client’s best interests outcome.

The CSA did not carry forward Companion Policy guidance from the Proposals suggesting that a firm/rep should obtain information about a client’s other investments or holdings held elsewhere in order to inform its suitability determination. The consequence of this is that investors will need to inform reps of all their other investments if they expect an optimal review of their financial position. In addition, the Amendments have removed certain prescriptive suitability assessment factors from NI 31-103, and instead included these factors as Companion Policy guidance.

Systemic Issues

“The firm’s complaint handling policy should provide for specific procedures for reporting the complaints to superiors, in order to allow the detection of frequent and repetitive complaints made with respect to the same matter which may, on a cumulative basis, indicate a serious problem. Firms should take appropriate measures to deal with such problems as they arise”. Some consider this response to systemic issues feeble by international standards. There is also a question of proactivity that the CFR does not adequately cover. Where a firm identifies repetitive or systemic problems in its provision of, or failure to provide, a financial service, it should consider whether it ought to act with regard to the position of clients who may have suffered detriment from such problems but who have not complained and, if so, take appropriate and proportionate measures to ensure that those clients are given appropriate redress or a proper opportunity to obtain it.

Complaint Handling

There is no enhancement to client complaint handling provisions. The Ombudsman for Banking and Investments will still be restricted to making non-binding compensation recommendations. Abusive lowball settlements with clients will continue. Firm client complaint handling rules will however have to be updated to reflect the new CFR criteria.

Important Rule Removals

The CSA has removed from the rule the requirements relating to prohibitions on acting as an executor of an estate/Power of Attorney or trustee for clients leaving it to firms to address or avoid conflicts. The proposed factor from the rule that required registrants to consider the overall concentration and liquidity across all the client’s accounts at the firm has been removed. These removals could lead to investor protection issues and client complaints.

Certain Abusive Practices Should Be Extinguished

The CFR rules which explicitly require registrants to resolve material conflicts of interest in the best interest of their clients, and to put their clients’ interests first when determining suitability should, at least in principle, reduce or eliminate Deferred Sales Charges (DSC) sold mutual funds and eliminate the abusive practice whereby discount brokers receive trailing commissions for services and personalized advice not provided.

Transition Timing

The CFR Amendments relating to conflicts of interest and the associated RDI provisions take effect on December 31, 2020, and the remaining Amendments taking effect on December 31, 2021. Registrants will have to comply with the applicable Amendments after those dates. There are no grandfathering provisions.

The Bottom Line

These reforms are a step forward on balance. Firms may need to revisit, and redesign if necessary, recruitment standards, sales and compensation practices, compliance training, incentivize appropriate sales practice conduct consistent with the CFR rule package, and develop robust processes to identify and mitigate/avoid conflicts-of-interest. Robust supervision, compliance and enforcement will be mandatory for CFR to achieve the desired outcomes. Rules without timely and effective regulatory enforcement are just words on paper.

The CFR changes are based more on negotiation than evidence-based regulation. Caveat Emptor still prevails. It is not entirely clear what the practical impact of the new “client first” requirement in the suitability obligation will be. Further detailed and objective CSA guidance should be developed to ensure real change occurs. Regulators will have to monitor the transition very carefully. The CSA really needs to articulate a vision for the future of personalized financial advice in Canada.

Ken Kivenko, PEng, President , Kenmar Associates, Etobicoke, ON (416) 244-5803, kenkiv@sympatico.ca, www.canadianfundwatch.com.