Advisor Conflict Of Interest And Their Influence On Recommendations

Canadians are increasingly required to take responsibility for their own retirement income security. However, many financial consumers are ill-equipped to make financial decisions and have turned to professional financial advisors for help. While advisors often provide valuable services, it can be difficult for retail investors to evaluate the advice they receive and to identify the potential for negative effects of conflicted advice because they are often unaware of applicable securities regulations and the intricacies of advisor compensation structures and their impact on skewing recommendations.

Introduction

The investment industry is rife with conflicts of interest at every point of interaction. This article is focused on the client-advisor relationship. A conflict of interest arises when a firm or advisor becomes untrustworthy because of a clash between personal (or self-serving) interests and professional duties or responsibilities. Such a conflict occurs when a firm or individual has a vested interest such as money, status, knowledge, relationships, or reputation—which puts into question whether their actions, judgement, or decision-making are unbiased and in your best interests. Conflicts of interest usually arise due to an asymmetry or imbalance, of information between the parties.

Such conflicts of interest lead firms/advisors to influence investors to use more services, increase transactions, or invest in risky investments that yield higher profits for the firm at the investor's expense.

Here are a few specific examples:

An advisor might place you in a fee-based account and use that account to recommend mutual funds with embedded commissions for advice—in effect, double-billing.
The vast majority of mutual funds contain an embedded sales commission, which can incent an advisor to recommend the mutual fund over lower-cost, better alternative investments.
The advisor may receive an above-average sales commission rate for selling you an Initial Public Offering (IPO-new stock issue) even if it is not in your best interests; IPO sales commissions are very attractive.
An advisor might recommend an unduly risky portfolio asset mix because equity mutual funds pay higher commissions than bond funds.
Your Know Your Client (KYC) information might be recorded inaccurately so that the advisor can recommend more expensive, complex products that are not suitable for you.
An advisor may recommend excessive trading or encourage buying on margin/taking out an investment loan to increase commissions.

The Regulatory Framework

On June 30, 2021, the Canadian Securities Administrators (CSA) introduced Conflicts of Interest (COI) rules and, in particular, firm COI obligations. All aspects relating to COI are considered important by the CSA because conflicts and how they are managed are key components of investor protection.

Firms are expected to make reasonable efforts to identify the COIs that they and their representatives encounter. Firms are expected to be able to provide evidence that the actions taken to handle conflicts are in the best interest of their clients and for conflicts deemed to be material, that all mandated disclosureshave been provided to clients. The CSA has made it clear that

disclosure alone will not be sufficient to satisfy the firm's obligations when it comes to addressing material conflicts. Firms must, in addition, establish controls, policies and procedures to mitigate and manage conflict risk exposures that may arise from a material conflict or avoid the conflict altogether.

Firms are required to train advisors to identify and report conflicts internally. They must be made aware of their obligations in relation to conflicts, the so-called best interest standard, what constitutes a material conflict, and the firm's expectations.

The CSA has suggested certain material conflicts of interest that require extensive documentation to be maintained. These include but are not limited to:

(a) Compensation/ incentive plans arrangements,

(b) Sales practices,

(d) Restricted product shelves and

(e) Referral arrangements.

Consent or disclosure without other action on the part of the firm/advisor will not be sufficient to address a material conflict in the best interest of a client.

If a client has opened an account after having been given clear disclosure that a firm or advisor will be using proprietary products, the CSA believe it is reasonable to assume that the client has agreed to an advice relationship on that basis. The firm or advisor must, however, also take other steps to address the conflict before it can proceed.

Firms who only trade in or recommend proprietary products are recommended to perform a competitive comparison between the proprietary products they make available to clients and other similar securities in the market under CSA Conflict-of-interest regulations. There is no regulatory requirement for firms to explain or disclose the possible consequences of using proprietary products. The CSA view that limited menu product offerings are evidence of a material conflict is in some tension with the Client Focused Reforms (CFR), which expressly permits restricted product shelves.

In August 2023, the CSA and the Canadian Investment Regulatory Organization (CIRO) released a report on the industry progress of COI implementation. Deficiencies noted in the review include:

Failure to identify one or more material conflicts of interest (34 per cent of registrants),
43 per cent of firms provided incomplete disclosures, and
66 per cent of firms had inadequate written policies and procedures.
A whopping 83 per cent of firms failed to provide adequate training to advisors and other staff.

There's clearly a lot of work to be done.

Common Advisor Conflicts Of Interest

Examples of compensation conflicts include:

Revenue or other benefits (financial or non-financial) to advisors from their firm or its affiliated companies, such as compensation or other rewards associated with sales quotas, bonuses, sales contests.
Differential commissions based on the product sold, new client accounts opened, assets under management growth and indirectly, trailing commissions paid to firms from mutual fund companies for selling their funds.

Other compensation, revenues or other benefits (financial and non-financial) could include gifts, meals, travel, concerts, etc., obtained in connection with the advisor's attendance at third-party sponsored "training" and conferences. Compiling a complete list of conflict of interests can be a very challenging task.

Of course, there are also disincentives for an advisor not meeting management targets, which could include reduced chances of promotion, no salary increase, reduced access to "hot" IPO issues, relocation and even termination.

A strong compliance culture is not normally associated with the investment industry. The main driver of advisor mis-selling is driven by the firm's management via compensation/ reward practices and sales pressure tactics. Advisors are tied to a proprietary product shelf by management and cannot recommend better alternatives even if they want to. This is not to say that some advisors don't do some unethical things like executing unauthorized trades, adulterating documents/signatures or even outright fraud/ theft.

Investment Advisor Red flags

Advisors under the influence of COI typically raise these red flags:
Uses “Check the box” KYC process; no real discussion of your personal situation.
Promoting products, not tailoring advice to your needs.
Ignoring your objectives, risk profile and time horizons.
Lack of transparency of fees and risks.
Overcomplicated investment strategies.
Frequent buying and selling of securities.
Makes “too good to be true” promises on returns, risk.
Lacks professional credentials.
Avoids answering questions in terms you can understand.
Sells products on the side not offered by the firm.
Becomes an executor for a client's Will.
Borrows money from a client.

Impact of conflicted advice

The impact of conflicted advice can be life-altering. Some of the possible consequences include:
Need to remain in the workforce longer than anticipated.
Reduced lifestyle and standard of living.
Need to come out of retirement to cover expenses.
Loss of home.
Plan to assist adult children and grandchildren impaired.
Deterioration of marital relationship.
Adverse impact on physical health, increased medical expenses.
Adverse impact on mental health—depression.
Isolation due to shame associated with financial loss.

In extreme cases of financial loss, the harmed investor might commit suicide.

Investor Self-defence Tactics

Check the registration status of your advisor to ensure a good fit with your needs (info.securities-administrators.ca/nrsmobile/nrssearch.aspx )
Check the disciplinary record of your advisor on the CSA website.
Do not be taken in by the title used by your advisor. Check out professional credentials and experience.
Ensure you have been informed of all conflicts of interest affecting your relationship with your firm/ advisor.
Know how your advisor earns his compensation.
Check your KYC profile to ensure it is accurate and up-to-date.
Never sign a form with blank entries, and retain a copy for your files.
Ask your advisor to send you final copies of any submitted documents.
Ensure your advisor focuses on your needs as much as the investments.
Ask questions of your advisor when a recommendation is made.
Before purchasing, ask about the ongoing product fees vs. alternative investments.
Check trade confirmation slips to ensure you have approved the trades.
Read your account statement and question any unusual transactions or fees.
Peruse the annual report of fees and performance to see if you are getting value for money.
Be on your guard if your advisor suggests frequent trading. By account churning, the advisor collects a lot of commissions but is likely not acting in your best interests.
Challenge the need for, risks of and costs of complex investment strategies and/or products.
Avoid buying a security that is not going to be processed by your firm.
Make any and all payments directly to the firm, never to the advisor.
Avoid naming your advisor as a POA or executor/ beneficiary of your Will.
Avoid "free lunch" and "educational" seminars—they are usually just a sales pitch.
Avoid lending money to your advisor.
Recognize that borrowing to invest magnifies risks as well as returns.
Be aware that you have free access to an independent third-party complaint service if you are dissatisfied with how the Firm has handled your complaint (www.obsi.ca).
Don't hesitate to get a second opinion on any advisor recommendation that appears out of line with your financial objectives and risk profile.
Consider a fee-only advisor (no transactions).

Conclusion

Disclosures of these conflicts, while certainly better than nothing, do not remove them or their harmful effects. Often such disclosures are simply "glossed over" as "this is just another form that the regulators say we must present."

Most financial advisors are not fiduciaries, so Caveat Emptor is not inappropriate. It may very well be that the CSA's Client-Focused Reforms will ultimately take hold, and the investment industry culture may change. Until that time, remember that no one cares more about your money than you do. Control your own financial destiny, or someone else will.

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