Restricted Product Shelves, Proprietary Products And More

In theory, it’s great when the person you go to for advice can say, “I have just the right solution for your problem.” However, real-life salespersons (advisors) who sell from a restricted product shelf may be affected by conflicts-of-interest. A restricted product shelf has constraints on what products the advisor can recommend. If the restrictions limit the advisor to recommend only proprietary products, he/she is unable to offer the best advice.

The Canadian Securities Regulators’ definition of “proprietary product” means a security of an issuer if one or more of the following apply: (a) the issuer of the security is a connected issuer of the registered firm; (b) the issuer of the security is a related issuer of the registered firm; (c) the registered firm or an affiliate of the registered firm is the investment fund manager or portfolio manager of the issuer of the security. In most cases, proprietary funds are easy to spot. If the title of the company that provides advice is in the title of the fund in your portfolio, that’s a proprietary fund. In other cases, you’ll have to do some digging, as some providers often use subsidiaries to mask the proprietary nature of a fund.

The typical bank branch provides clients only with their in-house mutual funds. Clients do not have access to competing funds, ETFs, individual stocks, bonds or options. A number of firms offer only proprietary funds, low-cost index funds may not be available even as proprietary funds. These limitations can cause portfolio construction to be sub-optimal.

Clearly, in addition to its asset management business, the financial advisory firm stands to collect management fees and other fees associated with the proprietary product(s). The firm may be motivated to steer more assets into those products and funds where they collect twice, often unbeknownst to the client. Such sales practices can lead to skewed advice. Even a one per cent average annual portfolio underperformance over the long-term can have a major adverse impact on retirement income security.

A firm may be restricted to specialized offerings because of its registration category (mutual fund dealers and exempt market dealers, for example), or by terms and conditions placed on its registration, as well as by business decisions to limit what it offers to clients based on client base, compliance costs or other considerations. Profit maximization for the corporation is certainly one such consideration. The products or services that a firm offers to a client might also be restricted because of regulatory or business restrictions on a registered representative assigned to their account.

Credo Consulting, a respected Canadian research/consulting firm in the asset management segment, released a two-year research survey (February 2018) on financial advisors loading their clients’ investment portfolios with their affiliated companies’ financial products (“Proprietary Product Loading” or PPL). The research found that clients who work with advisors associated with firms that also have related asset management affiliates are many times more likely than other advised investors (i.e.: up to nine to twelve times more) to have that company’s products in their portfolios. Despite the heavy overweighting of proprietary products, Credo found that clients felt generally satisfied with the advice provided.

Starting in July 2021, securities regulators will require firms to disclose material conflicts-of-interest, through the Client Focused Reforms (CFR), when making a recommendation of any strategies or transactions involving securities.

However, CFR (https://www.osc.ca/sites/default/files/pdfs/irps/ni_20191003_31-103_reforms-enhance-client-registrant-relationship.pdf ) still allows for commission-based compensation and does not clearly define “best interest”. While CFR helps mitigate some forms of conflicts-of-interest, the rule doesn’t prohibit them. It also doesn’t prohibit restricted product shelves or the sale of proprietary products by salespersons. The CFR, however, regards trading in or recommending proprietary products as a material conflict-of-interest. Registered firms creating incentives to sell or recommend certain products or services over others and registered individuals receiving greater compensation from their firm for the sale or recommendation of certain products or services over others are also considered material conflict-of-interests.

Regulators have provided guidance about disclosure of conflicts-of-interest regarding restricted product shelves and the sale of proprietary products. In response to industry comments, they removed restrictions on the products offered to a client (such as only offering proprietary products) from the impacts that must be discussed with clients. The restrictions could mean that clients are not being informed about better performing or cheaper products. If the product shelf is restricted to in-house products, clients may not be able to access all available asset classes or may be unable to transfer the proprietary security to another firm.

If a client has opened an account after having been given clear disclosure that a dealer or advisor will be using proprietary products, the regulators believe it is reasonable to assume that the client has agreed to a client-advisor relationship on that basis. Firms do not have to disclose to clients their relationship with a related or connected issuer that is a mutual fund managed by an affiliate of the firm if the names of the firm and the fund are similar enough that a reasonable person would conclude they are affiliated.

Regulators do discuss the issues related to restricted product offerings in the Companion Policy guidance on Relationship Disclosure Information (RDI) under the heading Description of products and services (on page 234).

Under paragraph 14.2(2)(b.1), a registered firm must provide a general description of any limits on the selection of the products and services the firm will offer to the client, including whether the firm will primarily or exclusively provide proprietary products to the client; whether there are other restrictions on the selection of products or services.

Securities regulators have provided guidance under Examples of conflicts-of-interest disclosure in respect of proprietary product disclosure, where they’ve indicated that:

If a registrant is trading in, or recommending, proprietary products, it is an inherent conflict-of-interest. In our experience, it is almost always a material conflict that a reasonable client would expect to be informed of. The registrant should disclose if they only offer proprietary products or whether they offer a mix of proprietary products and non-proprietary products on their shelf and recommended product list.

With respect to the potential impact of this conflict and the risk it could pose to clients’ interests, if the registrant is only offering proprietary products, then the registrant should consider making the following disclosure prior to opening an account for the client:

The suitability determination conducted by the firm and its representatives will not consider the larger market of non-proprietary products or whether those non-proprietary products would be better, worse, or equal in meeting the client’s investment needs and objectives.

The firm must also disclose how they are addressing this conflict in the best interests of their clients.

When providing disclosure about proprietary products, a registered firm may also choose to maintain a list of the related or connected issuers for which it acts as a dealer or advisor. It may make the list available to clients by:

(a) posting the list on its website and keeping it updated,

(b) providing the list to the client at the time of account opening or

(c) explaining to the client at the time of account opening how to contact the firm to request a copy of the list free of charge.

The list may include examples of the types of issuers that are related or connected and the nature of the firm’s relationship with those issuers. For example, a firm could describe the nature of its relationship with an investment fund within a family of investment funds. This would mean that the firm may not have to update the list when a new fund is added to that fund family.

CFR requires that information regarding proprietary product conflicts be made available to clients before the advice or trade giving rise to the conflict so that clients have a reasonable amount of time to assess it. Registrants should, according to CFR, use their “professional judgement” for the best way and time to inform clients about these conflicts. Previous disclosure may no longer be relevant to, or remembered by, a client while disclosure of the same conflict more than once in a short time may be unnecessary and confusing.

The Ontario Taskforce on securities modernization expressed concerns related to restricted product shelves/proprietary-only shelves. According to the Taskforce Report approximately 95% of deposit-takers’ mutual fund assets under administration are comprised of proprietary mutual funds.

The report recommended increased regulatory oversight of product shelf issues, including targeted reviews and publication of guidance regarding conflicts-of- interest because of shelf composition. It also recommended that the Ontario Securities Commission (OSC) work with the self-regulating organizations to develop a regime that will clarify titles for all registrant categories and will provide additional clarity to investors with respect to proprietary channels. Finally, the Taskforce recommended that all dealers that sell proprietary products be required, by OSC rule, to document, in detail, their rationale when independent products are refused access to their product shelves and, by OSC rule, that dealers that sell proprietary products report to the OSC, on a quarterly basis, the percentage of proprietary versus independent products on their product shelves, segmented by channel and product category, and the percentage of proprietary versus independent products sold to clients in the same format.

Proprietary products may be suitable in certain cases, but the astute investor is well advised to shop around. If you do decide to retain an advisor with restricted product shelf/proprietary products, be sure you understand the pros and cons. Recognize too, that the value of an advisor–client relationship is not limited to individual securities selection. Other considerations include good asset allocation, behavioural coaching, advice on taxes and the preparation of a holistic financial plan. Conversely, if all you get is a sales pitch when you meet, you’re dealing with a salesperson, not an advisor.

One thing is clear, the current regulation of restricted product shelves and proprietary products is not congruent with the provision of truly independent investment advice.

Professional advisors believe in the division of advising and asset management businesses. It’s the only way to ensure that client portfolios are constructed in a conflict-free manner with the clients’ best interests in mind. These professionals believe it is key for clients to have unbiased, open access to the top investment products for portfolio construction, which means not being limited to a collection of proprietary products in their portfolios.

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