Sunday, July 28, 2019

Case study: Excessive leveraged trading in IPO’s in fee based account generated huge trading commissions while supervisor watched


Kevin Frederick Price (Settlement) – Toronto, Ontario



Over a two-year period, Price recommended to a client that she use significant margin, which was unsuitable. Price also earned significant compensation by engaging in a short-term trading strategy for the client. This short-term trading was not within the bounds of good practice.



The client was retired [born in 1948] with limited investment knowledge and just under $1 million in assets. She opened four accounts with Price, all of which were fee-based and required the client to pay a percentage fee based on the market value of the securities held. The client required regular income from her portfolio for living expenses. Since inception, Price purchased securities on margin, which increased the income generated but also increased the risk, which eventually exceeded her risk tolerance.



Price recommended a significant number of trades in new securities. Over a two-year period, he purchased $4.1 million of new issues, representing approximately 71 percent of all securities bought. These purchases were also part of a short-term trading strategy that, overall, was not profitable for the client. However, the new issue purchases generated additional commissions, which were paid by the issuers, for the firm and Price. Over the same period, he earned approximately $40,000 from the new issues, in addition to the account fees paid directly by the client. The underlying new issues were not unsuitable and consistent with her investment objectives.



The client lost approximately $369,000 in her accounts.



Price paid an internal discipline fine of $21,000 to his employer, completed the Conduct and Practices Examination, and was subject to strict supervision for six months. He also contributed $55,000 towards compensating the client for her losses. Price agreed to pay a fine of $15,000 and costs of $5,000



Source: https://www.iiroc.ca/news/Documents/IIROC2017EnforcementReport_en 

2017 IIROC Enforcement report.



Questions: Does anyone believe Supervision was robust, that the fine was fair and proportionate and that general deterrence has been achieved?  The really good news? Mr. Price is now registered as a Dealing representative in Ontario, BC and Alberta with Mackie Research with no terms or conditions on his registration.This case demonstrates the value of checking IIROC registration (?}.😉 It might be wiser for clients to assess their trade confirmations, account statements and performance reports. Note the elegance of the IPO strategy is that the commissions won’t show up in the fee based account statement. We urge IIROC to provide rules and guidance re fee based accounts/ reverse churning and sanction deficient supervisors, branch managers, compliance staff and firms with uncharacteristic vigour. 





IIROC Settlement Agreement https://www.newswire.ca/news-releases/enforcement-notice---decision---iiroc-fines-toronto-investment-advisor-kevin-frederick-price-667877493.html


 



Saturday, July 27, 2019

Reverse Churning | IIROC is watching ( we hope)


According to the 2018 PriceMetirx report, revenues from fee accounts grew by 17% in 2018 over 2017, while revenues from transactional accounts declined by 5% year over year. Revenue growth was further propelled by the fact that fee assets are more productive than transactional assets. Average revenue yield (revenue over assets) for fee accounts was 0.91% in 2018 compared to 0.37% for transactional accounts. The (asset-weighted) average client age stands at 67.6 years. For the household segment (those with $1 million to $1.5 million in assets), the top 10% of clients (based on rate paid) pay 1.40%, while the bottom 10% pay 0.73%, or half as much as the top 10%. For those households, fee account pricing dropped 2 bps (from average 1.08% in 2017 to 1.06% in 2018), compared to a drop of 5 bps the previous year.



The PriceMetrix report further shows that 52% of advisor-client relationships included a fee-based account in 2018, up from 31 % in 2015. Investment dealers value fee-based accounts because they are much more predictable and reliable as a revenue generator than charging clients sales commissions. In a fee-based account, clients pay roughly 1 % to 2 % or more of their total invested assets (including cash, GIC’s and bonds)  per annum depending on account size.



When you consider these statistics, it is abundantly clear that conflicts-of-interest will come into play and seniors / retirees will be prime targets. Fee-based accounts are very lucrative arrangements for salespersons (aka “advisors”). There is a very real danger that reverse churning will rear its ugly head particularly under the low suitability standard for advice giving. 



Given the rapid rise of fee- based accounts, regulators should take action to address reverse churning.  First, firms should be required to ensure that there is an adequate supervision system in place to guarantee that accounts are handled properly.  IIROC should make it clear that it will hold firms accountable if there is no system in place for supervision.  Second, salespersons should take care to monitor their client’s accounts.  Advisory service going beyond the provision of statements, such as fulsome conversations confirming the client’s goals and objectives (and appropriate documentation of such conversations), is both prudent and necessary.  Finally, decisions to hold or stand pat in any account, and decisions to move from commission-based accounts to fee-based accounts, should be documented carefully with an eye towards avoiding claims that the move was reverse churning.



We expect and hope that IIROC is particularly concerned with : (1) accounts in which securities are purchased and portfolios are designed in commission paying brokerage accounts and then transferred to a fee-based account in which the same trades could have been initiated without paying commissions; (2) accounts that consist primarily of cash or bonds that are transferred to fee-based wrap accounts in which the fees are higher but the investments do not  materially change; and (3) accounts that are fee-based accounts in which few if any transactions are made.


Additional concerns include including embedded commission funds in these accounts (double billing) as well as defining how IPO’s are to be treated.



IIROC should not depend on general principles to regulate the choice of proper account type. Rules and guidance are required to give dealers the IIROC perspective on reverse churning. The controversial IIROC principle that conflicts -of-interest are to be resolved in the best interests of clients is too vague for operational application.



Kenmar look forward to regulatory actions to protect retail investors from the latest threat to their retirement income security.




 


Wednesday, July 3, 2019

Why are financial advisors reluctant to speak freely about the industry?


We’ve always wondered why so many IIROC regulated professionals have remained silent on how to improve the industry. It is extremely rare to read an article or a Comment letter to a Consultation that points out what needs to be done to fix the wealth management industry .After reading John DeGoey’s latest book, STANDUP to the financial services industry , we now know why. From his book we quote:
 
Speaking personally, I have never once agreed with the interpretation of IIROC Rule 29.7 (1) that allows compliance departments to vet legitimate STANDUP advisors' ideas regarding how the industry might be improved, as a form of corporate censorship disguised as maintaining a level of decorum. That interpretation is also a direct contravention of section 2 of the Canadian Charter of Rights and Freedoms, where "freedom of thought, belief, opinion and expression" are expressly enshrined as basic rights that all Canadian citizens enjoy.
 
According to compliance departments, if one were to point out that things are not being done in the best possible manner, that would be seen as "contrary to the interests of the industry." In My Life and Work, Henry Ford recalled that he'd once said, "Any customer can have a car painted any colour that he wants so long as it is black." Securities firms in Canada effectively say, "You can say whatever you want about the industry as long as it is not critical-even [especially?] if it is demonstrably true."


So now you know why. Advisors (“Registered Representative’s”) are constrained on what they can say just like investors who settle a complaint with a dealer. (John’s Book is available at Amazon.ca)

Friday, May 3, 2019

Misinformed Consent


There are some phrases that are used in all manner of contexts that are widely understood with a wry smile, but seldom contemplated with the serious effort leading to some sort of metaphysical mega-truth. One of my favourites is: “It ain’t what you don’t know that gets you into trouble, it’s what you know for sure that just ain’t so.” That little observation about the human condition has been mis-attributed to several humourists, including Mark Twain. The truth is that no one knows for sure who said it first. That’s especially ironic because there are lots of people out there who purport to know very well who said it, thereby demonstrating just how universal and applicable the phrase is.


There’s a second quip that I like almost as much. Given that it is more serious, I suspect fewer people have heard it. It is this: “No reasonable person would consent to being given bad advice.” In the world of personal finance, so much of what is covered by industry regulation revolves around the notion of informed consent. The problem here is that investor acquiescence is seen as a proxy for proper disclosure and conduct.

Now, let’s combine the two concepts to see where that takes us. How should we react to a situation where there are people who give advice based on concepts that they believe to be true, but are, in fact, not true? What happens when good intentions give way to bad advice? If I give you advice based on misinformation and you accept and act on that advice, does that constitute  “informed consent”?


I am a lifelong proponent of informed consent, but I also believe that there should be a recognition of a necessary premise. That premise is that the options under consideration should be presented fairly and accurately. I consulted Wikipedia for a readily-accessible definition and here’s what I found: permission granted in the knowledge of the possible consequences, typically that which is given by a patient to a doctor for treatment with full knowledge of the possible risks and benefits. The write-up after the definition goes on to say that: an informed consent can be said to have been given based upon a clear appreciation and understanding of the facts, implications, and consequences of an action.

People who know me would also know that I have long yearned for financial advisors to be thought of (and held to the same standards) as doctors, dentists, lawyers and accountants. Given the definition, there are a few questions that might follow:

·      (a)If people don’t really understand their options, can informed consent ever truly be provided?

·    (b) If the people providing options don’t properly understand the salient details of what they are recommending (i.e., if they are unwittingly giving bad advice), does the acceptance of that advice constitute “informed consent”? Wouldn’t the term “misinformed consent” be more appropriate?


Stated differently, is informed consent even possible if the options being forwarded for consideration are incomplete, inappropriate or downright incorrect? Sure, you might consent. You might have been ‘informed’ about your options from someone who has good intentions (i.e., who is not trying to mislead you). However, if the person making the recommendations is misinformed and is making the recommendations based on misguided beliefs, we have a moral dilemma. If the intentions are good, but the advice is nonetheless bad, how do we characterize the acceptance and implementation of that advice? Would your opinion change if the person giving the unwittingly bad advice refused to change the advice once the error in her ways was pointed out to her?



In May, I released my book STANDUP to the Financial Services Industry. What you’ve read so far constitutes a summary of the problem it explores. In late 2016, an academic paper entitled The Misguided Beliefs of Financial Advisors was released that showed beyond any reasonable doubt that advisors believe certain things that are untrue. The question most people will ask themselves is: “How could this be?” The question most people should be asking themselves, however, is: “What should I do about it?” Irrespective of why advisors believe things that they shouldn’t, the most pressing challenge is to find specific, actionable ways to overcome the associated risks.


You should be terrified. Imagine if you went into a doctor’s office and told him you were a pack-a-day cigarette smoker and he just kept on talking as though you had told him you were an Ottawa Senators fan. If the information was interpreted as being essentially irrelevant (despite being highly unfortunate), you’d be well within your rights to be concerned. We’re now at the point where it is pretty much impossible to imagine a doctor (or anyone else, for that matter) being oblivious to the harmful impact of cigarette smoke. The same cannot be said regarding the investing public, or even financial advisors, regarding mutual funds these days. It seems many advisors do not have a clear appreciation and understanding of the facts, implications and consequences of their recommendations. Specifically, the paper showed that advisors, while well-intended, frequently chase past performance, pay insufficient attention to product cost and are prone to recommend concentrated positions.


Regulators have been told about this problem repeatedly and have done absolutely nothing about it. Far too many advisors believe things that simply are not true, yet no one seems inclined to do anything to disabuse them of their unsubstantiated viewpoints. By way of illustration, I’d like to draw on passages from the transcript for the roundtable discussion associated with comments on paper 81-401 regarding mutual fund fees held on Friday, June 7, 2013 at the Ontario Securities Commission office. I was delighted to be asked to serve as one of the presenters that day.


One of the other presenters for the panel I was on was Peter Intraligi, the CEO of Invesco. Mr. Intraligi spoke in favour of maintaining embedded compensation structures. In fact, his comments included the passage: “While we acknowledge that compensation can play a minor role in the advice channel, the fact is the main driver of flows is a fund’s performance and its ability to preserve capital.” This still strikes me as an acknowledgement that recommendations are made based on past performance, even though there have been about a dozen studies that have shown conclusively that past performance does not persist and should not be relied upon when choosing investment products. Indeed, every prospectus under the sun has carried a disclaimer to that effect for the past quarter century.


Mr. Intraligi went on to say that: “Since the market downturn in 2008, new money flows shifted sharply towards funds with 4- and 5-star Morningstar ratings, which represent less than 20 percent of all funds in Canada. Yet, this limited number of funds accounts for 100 percent of the industry’s net flows each of the past five years. Clearly, assets migrate to products with a demonstrated long-term track record of exceptional performance, as they should.” I was gobsmacked. Beside the fact that he did nothing to explain what he meant by “long-term” (I’ve seen mutual fund rating books referencing the term and applying it to timeframes as short as three years), the presumptuousness was astonishing. If someone said choosing investment products based on the reading of their tea leaves was acting “as they should”, surely regulators would have questioned the speaker. Nonetheless, there is no evidence that past performance is any more reliable than tea leaves regarding product selection. No one questioned him.


When my turn came, I referenced one of the giants in modern finance, Nobel laureate and professor Bill Sharpe of Stanford University. I used a quote from Mr. Sharpe, who said that: “Extensive, undeniable data show that identifying in advance any one particular investment manager who will, after costs, taxes and fees, achieve the Holy Grail of beating the market is highly improbable.”

The problem is simple: many (most?) advisors believe things that are simply not true. Meanwhile, we have corporate leaders making submissions to regulators by telling bald-faced lies and positioning them as matters of fact without being challenged by the regulators. The problem is that no one (including the regulators themselves, it seems) recognizes that they’re lying in the first place. As a result, the misinformation persists indefinitely, and no amount of traditional regulatory reform will get us any closer to a sensible world where advisors make recommendations based on evidence instead of wives’ tales. The abstract to the misguided beliefs paper concluded with the ominous warning that: “policies aimed at resolving conflicts of interest between advisors and clients do not address this problem.”


The solution, I believe, does not come from improved disclosure or the elimination of embedded compensation or better investor education. None of those things will cause advisors to think differently. Because of that, none of those things will cause advisors to make more appropriate product recommendations to their clients. For nearly a generation, I’ve been trying to get advisors to recognize their own biases and to make recommendations based on evidence. The crickets are chirping louder than ever. If regulators cannot compel advisors to think and act differently and no amount of logic can persuade advisors to think and act differently, it may very well be up to investors to lead the revolution.


My experience is that advisors have been defiant in the face of evidence that refutes so many of their presumptive value propositions and product recommendations. These same advisors unapologetically make recommendations that have little or no basis in fact while simultaneously insisting that they are looking out for their clients’ best interests.


STANDUP to the Financial Services Industry arms investors with facts. It explains what advisors believe and how they think, but more importantly, it also offers dozens of specific questions to help readers determine just how blinkered their advisor might be, along with the sourced material “answers” from some of the world’s leading financial economists and research houses that emphatically refute the answers that many advisors are likely to give. Those resources (research papers, real time performance data, etc.) are also available on my website: www.standup.today .

This is NOT a conflict-o- interest problem. This is a situation where advisors believe things that are not reliable and make recommendations to unsuspecting investors based on those unreliable (read: misguided) beliefs. In other words, this is a behaviour problem. To date, advisors have stubbornly resisted evidence because they seem to prefer happy lies over inconvenient truths. The sincerest apology is changed behaviour. If your advisor is unwittingly giving you bad advice yet will not acknowledge as much even after you demonstrate that to be the case, then it’s time to switch advisors.


John J. De Goey, CIM, CFP, FELLOW OF FPSCTM is a registrant with Wellington-Altus Private Wealth Inc. (WAPW). WAPW is a member of the Canadian Investor Protection Fund (CIPF) and the Investment Industry Regulatory Organization of Canada (IIROC). 



The opinions expressed herein are those of the author alone and do not necessarily reflect those of WAPW, CIPF or IIROC. Investors should seek professional financial advice regarding the appropriateness of investing in any investment strategy or security and no financial decisions should be made solely on the basis of the information and opinions contained herein. The information and opinions contained herein are subject to change without notice.



This article appeared in the May, 2019 Canadian MoneySaver


Wednesday, February 27, 2019

CSA- please make complaint handling tolerable for retail investors


Eliminating Step 3 (internal Ombudsman) in the investment dealer complaint process - the rationale and request for action



This past year has not been kind to retail investors. The CSA, defying both evidence and reason, has decided to retain embedded commissions and abandon an overarching Best interest standard. Even the welcome CSA proposal to ban the DSC option has been derailed by the Ontario government’s unilateral intervention. At the same time, the CSA has allowed risky alternative mutual funds to be sold to retail investors.



As of Nov. 1 , 2018 less than 30% of bank assets will be with OBSI -the recent departure by the Bank of Nova Scotia sent a clear message: The banks do not support an independent dispute resolution provider. As a result, retail investors are even more vulnerable to industry mis-selling and unfair complaint handling.



Bank-owned and insurance company owned dealers usually have a three step process. The first step is with the branch, the second step is at the dealer's Care center (or equivalent) with escalation to their internal "ombudsman “if the client remains unsatisfied as step 3. A 4th step would be to OBSI if the client still remain unsatisfied. Four steps can wear already stressed clients down to the point they lose their resolve to achieve a fair result. This should not be the outcome of a contemporary complaint resolution system in the wealth management industry.



The CSA has not yet acted on Kenmar recommendations or those of PIAC and FAIR Canada to fix obvious flaws in the complaint handling system. In Oct. 2017, PIAC and FAIR Canada sent a letter to the CSA

https://faircanada.ca/submissions/letter-obsi-joint-regulators-committee-re-use-internal-ombudsman-registered-firms-responding-investment-complaints/ identifying numerous complaint handling issues .The letter strongly recommended  that OBSI’s Terms of Reference and the internal complaint handling rules (be they policies or rules) of IIROC and the MFDA be amended to conform with NI 31-103. OBSI’s Terms of Reference and the SRO complaint handling rules should be revised to require firms to provide a substantive response to a complaint within 90 days, whether they use a second review process (an “internal ombudsman”) or not. The letter stated that “Within the 90 days, firms may choose to provide a second level of review. However, they should not be permitted to take more than 90 days to do so.”.



The lack of CSA action on these recommendations has left complainants exposed to diversion. Investors are being channeled to “internal ombudsman” while critical OBSI-related time periods and civil action limitation periods continue to run to the prejudice of investor complainants. The use of “internal ombudsman” services is detrimental and prejudicial to investor complainants and is contrary to sections 13.16 (3) and (4) of NI 31-103.



It is emotionally and physically draining for a retail investor to file a complaint. It is also highly intimidating for most people. To have a complaint dismissed even once, let alone multiple times is a very debilitating experience. Many people give up as they feel they have no chance of prevailing against the big bank-owned dealers. Other consumers opt to not file complaints about their dealers because they are intimidated by the complaints process, do not understand their rights or how to navigate the process itself, are afraid of the possible negative consequences of complaining about their dealer and do not possess the written or oral skills to effectively advocate for themselves. This process can also impact physical, emotional health and family relationships. For many, sustaining undue losses is life-altering. One major reason that the current system isn’t working for investors is the banks insertion of an internal “ombudsman”.



An unsatisfactory response at the first step results in escalating the complaint further - this necessitates a complainant to redraft a cover letter and resubmit the complaint with supporting records as if nothing had occurred prior to this step having taken place. An appeal to the internal ombudsman also requires the signing of a Consent Agreement which may prejudice future proceedings. Among other items, the Agreement contains a confidentiality clause and in at least one case, gives the right of the ombudsman to access all of the complainant’s accounts with the bank.



Complainants can legitimately conclude that the dealers’ complaints process is designed to wear them out. Does this repeating of steps, as mandated by the process and placed on the shoulders of the complainants, contribute in any way to a fair and reasonable complaint resolution process? Does the internal ombudsman add value or risk? The CSA surely knows the answer. In 2011, the UK FCA eliminated the internal “ombudsman “step in order to streamline the complaints process. The CSA should do the same.



Securities regulators have tried to improve the process by requiring that dealers provide a substantive response within 90 days of filing a complaint. Prior to that, dealers would drag out complaints to the point where complaints just threw in the towel. This was followed up by a CSA/IIROC/MFDA Staff Notice in Dec., 2017 http://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20171207_31-351_ombudsman-banking-services-investments.htm  attempting to deal with several system failures.


That has not been effective as banks continue to deceive complainants. For example, the TD Bank website states “If you require further assistance after the decision of the TD Ombudsman, the following independent services may provide you with information and a further review of your complaint. These agencies may contact TD to facilitate their investigation and work toward a resolution”. The independent service referred to is the OBSI option.
https://www.td.com/to-our-customers/resolving-your-problems/comments.jsp



Section 13.16 of NI31-103 specifies that a firm must make available the services of OBSI at the earlier of when the firm informs the client of its decision with regard to the complaint or 90 days after receiving the complaint. Companion Policy 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations concerning compliance with the requirements under section 13.16, provides that a registered firm should not make an alternative independent dispute resolution or mediation service available to a client at the same time as it makes OBSI available.



But Section 13.16 of NI 31-103 does not prohibit the use of an internal “ombudsman”. As a result, for investment dealers, the 90-day timeline, which is supposed to apply to all internal complaint-handling processes, doesn’t include the use of an affiliate’s internal ombudsman. These dealers are able to divert hundreds of complaints each year from OBSI to their own “ombudsman” without fear of sanctions.



Bank-owned dealers have cleverly subverted CSA intentions by offering the optional (sometimes not) third step choice- their own internal “ombudsman”. Complainants sidetracked there are entering a no man’s land with an entity that is neither an ombudsman nor independent of the dealer, nor under CSA/IIROC/MFDA jurisdiction. Trusting and gullible complainants, to their detriment, assume that this entity is a real ombudsman and voluntarily agree to subject themselves to this entity instead of the regulated, independent ombudsman service-OBSI. It should be noted that proposed Federal Bill C-86 would not permit these internal ombudsman to assert they are independent or use the misleading nomenclature “ombudsman”. This is a clear recognition by lawmakers that these internal “ombudsman” are merely an artifice to mislead clients and add a completely unnecessary step in resolving complaints.



How can an investigator from the bank’s ombudsman’s office be impartial given that he/she is an employee of the bank, may have existing relationships with parties being complained about and is ultimately accountable to the legal team of the bank? The use of the descriptor “Ombudsman” is not being made in good faith by the banks as the banks know that the ombudsman’s true purpose is to protect the bank at the expense of the consumer (in some countries such misrepresentation is illegal). In contrast to its true purpose, the bank internal ombudsman is marketed to the consumer as that of a fair, impartial and independent investigator. Most clients do not realize they are in an adversarial relationship. The inclusion of an internal ombudsman in the dispute resolution process is solely for the benefit of the dealer/banks and most definitely not in the complainant’s best interests.



Kenmar have therefore concluded that, while some dealers may use the three-step complaint process appropriately, it is inherently prone to misuse and abuse, in particular because it gives investment dealers an incentive to reject complaints at the first two steps on the basis that only a relatively small number of complainants will persevere and the dealer then has a third chance to rectify any shortcomings or, more likely, again provide an unsatisfactory offer.



Unlike OBSI, internal Ombudsman are not transparent - their loss-calculation methodology is not publicly disclosed. Kenmar argue that any interaction with the internal ombudsman helps the Dealer as part of its risk reduction and defence-building processes. Complainants are not cognizant of the fact that any information provided can later be used by the Dealer to defend itself if an external complaint process is commenced. In other words, complainants are in harm’s way.



The reason OBSI was purposefully created was to deal fairly and expeditiously with cases where clients are not satisfied with the dealer's substantive response letter delivered within 90 calendar days.  There is no need for a third step involving a non-independent, unregulated internal "ombudsman". It unduly increases the complaint cycle time beyond 90 days, eats into precious statute of limitation time , exposes complainants to conflict-of-interests and legal risks and adds to complainant stress and disillusionment.



We have found that if a complainant is rejected 3 times, it is highly unlikely he/she will proceed further. This may explain the relatively small number of investor complaints that reach OBSI. Therefore, we recommend that the CSA abolish the three-step process. The new rules would mean that the firm’s step 2 response would be its definitive ‘Final response’.



Complainants would then be given a crystal clear message that they can escalate their complaint to OBSI (where the limitation time clock is stopped), must do so within 180 calendar days or pursue litigation/IIROC arbitration. We believe that this will lead to investment dealers focusing their attention on providing robust responses to complaints at the first two points of contact. This should lead to fairer, higher quality complaint decisions. It would put an end to consumers having to restate their complaints twice or more, something that stops many people taking their cases further. This would also reduce the complexity of the process for retail investors therefore reducing the abandonment rate of valid complaints.



Kenmar believe this is a major socio-economic issue, aggravated by an increase in complaints by seniors/ vulnerable investors, a rapidly growing demographic.



A fair and effective independent dispute resolution service is important for investor protection in Canada and is vital to the integrity and confidence of the capital markets OBSI is the last line of defence in a Caveat Emptor investing environment. Accordingly, we are of the firm conviction that an elimination of step 3 (internal ombudsman) is in the Public interest. Kenmar urge the CSA to act given the overwhelming evidence of investor harm we have provided.




Ken Kivenko, President

Kenmar Associates



Reference

Monday, February 11, 2019

Root Cause Analysis: Increasing the utility of IIROC Hearing Panels

IIROC investigates and initiates disciplinary proceedings to determine whether there has been a breach of IIROC Rules , securities legislation, or other requirements relating to trading or advising in respect of securities, commodities contracts or derivatives. Enforcement staff review the findings of the investigation and recommend an appropriate course of action.

If the evidence establishes a contravention of IIROC requirements, Enforcement staff may initiate a disciplinary proceeding in order to resolve the matter before an IIROC Hearing panel. The Rules require that the Hearing Panel be made up of one public chair (generally a retired judge or lawyer) and two industry members (either active or retired).Hearing Panels decide the case based only on the evidence that is put before them. This limitation is a barrier to corrective action as we discuss in this document.

The stated purpose of IIROC disciplinary proceedings is to maintain high standards of conduct in the securities industry and to protect market integrity. Sanction Guidelines are intended to promote consistency, fairness and transparency by providing a framework to guide the exercise of discretion in determining sanctions which meet the general sanctioning objectives. IIROC Sanction Guidelines assist Hearing panels in determining whether to accept settlement agreements.

The Hearing Panel is responsible for the hearing process, determining whether any misconduct occurred and if so, whether any sanctions should be imposed on the Respondent. At the conclusion of a hearing, the Hearing Panel issues written reasons for its decisions concerning misconduct and sanctions.

The declared purpose of sanctions in a regulatory proceeding is to protect the public interest by restraining future conduct that may harm the capital markets. In order to achieve this, sanctions should be significant enough to prevent and discourage future misconduct by the respondent (specific deterrence), and to deter others from engaging in similar misconduct (general deterrence). We note that investor compensation is not on the Panel radar- something that needs to be addressed because client restitution is in the public interest. 

Deterrence is a key component of any effective enforcement strategy. Deterrence is credible when would-be wrongdoers perceive that the risks of engaging in misconduct outweigh the rewards and when non-compliant attitudes and behaviors are discouraged. Deterrence occurs when persons who are contemplating engaging in misconduct are dissuaded from doing so because they have an expectation of detection and that detection will be rigorously investigated, vigorously prosecuted and punished with robust and proportionate sanctions.

Misconduct is defined as unacceptable or improper behavior by a dealer and/ or Dealing Rep. However, not all rule breaches are a result of deliberate registrant misconduct. We could include negligence / errors of omission, inadvertent error, ineffective disclosure processes and honest misunderstandings. Other more likely  potential causes include but are not limited to poorly framed rules, deficient prospectuses, outdated policies and procedures, weak business / IT control systems, unqualified staff, deficient KYC process, inadequate staff training, lax supervisory processes , an ineffective compliance function and poor complaint handling.

Consider poor client complaint handling- it is a recurring issue. If client complaints were handled more effectively, much investor grief could be avoided. It is our firm conviction that IIROC rule 2500B is a root cause. The rule lacks depth, favors dealers, allows diversions to internal “ombudsman” and is open loop as regards systemic issues. See More issues with IIROC complaint handling Rules http://www.canadianfundwatch.com/2018/04/mre-issues-with-iiroc-client-complaint.html  and Fairness and balance in the complaint process where interests of the dealer and registered representative must be considered!    http://blog.moneymanagedproperly.com/

Leveraged ETF’s are another example .LETF’s may be mis-sold to a buy-and-hold investor because the Rep did not understand the mechanics of LETF’s.  The reason for the mis-selling could be that he/ she did not fully understand the product because the dealer did not ensure Reps were adequately trained to recommend such complex products.  The root cause of the breach then is a deficient dealer training program for Reps coupled with lax dealer supervision. Another example might be weak risk profiling tools provided by the dealer. Any Rep using such tools might conclude with an improper client risk profile which could in turn result in unsuitable recommendations. In such a case, the root cause of the rule contravention is dealer management which had provided Reps with inadequate tools of the trade.

A root cause is defined as a factor that caused a non-conformance/ Rule breach and should be permanently eliminated through process improvement. Root cause analysis (RCA) is a collective term that describes a wide range of approaches, tools, and techniques used to uncover causes of problems. The highest-level cause of a problem is called the root cause. Root cause analysis is part of a more general problem solving process and an integral part of continuous improvement.Because of this, root cause analysis is one of the core building blocks in an organization’s continuous improvement efforts.

Root Cause Analysis (RCA)


Many rule breaches have their root cause in dealer compensation models. Compensation drives Rep behaviour which leads to misconduct if the design is defective and dealer monitoring is sporadic .For instance: supervisors obtaining commission over-rides on staff supervised, branch managers compensated solely based on branch profitability, commission grids biased towards proprietary products and conflicts-of-interest associated with recommending a fee -based account. Unless Hearing Panels dig deep, such systemic issues may not be identified or dealt with. In fact, we now know via the IIROC compensation survey that such investor-unfriendly practices have been alive and well for years. They were there in full sight but not dealt with by Hearing Panels.

Hearing Panels are structured to decide cases where there had been a breach of IIROC rules /securities laws -misconduct. A critical role to be sure, but breaches can also provide invaluable information about how the regulatory control system is functioning (or not).

While it is necessary to sanction Dealers /individuals for breaches, it is also necessary to drill down further. Is the Rep proficient in dealing with de-accumulating accounts? Is the compensation and reward system designed to incent individuals to cross the line? Are sales quotas unrealistic and/or inappropriate? Have Reps been provided the tools they need to do their job? Are supervisory control systems robust? Are dealing representative recruitment criteria matched up with the ethical and conduct standards to comply with securities regulations /laws and the provision of trustworthy personalized financial advice? Are controls and information systems designed to promptly detect system breaches? It is only by addressing root causes that we can improve the system , reduce breaches and improve the fairness of decisions.

It is well known that discount brokers have been improperly collecting trailer commissions for services and personalized advice that was not and could not be provided. Yet until this was recently challenged via several Class Actions, the dealers did nothing to stop the investor abuse. In a very real sense this was organized theft. Discounters could have easily set parameters to exclude the purchase of funds that have a fee for personalized advice or services just like the parameter to reject a stock or fund purchase if there is not enough cash in the account to pay for the purchase. Over all these years, were there not hearings where this could have been dealt with before hundreds of millions of investor retirement savings were transferred to dealers? This abuse is clearly a management responsibility- tone at the top.

Since we believe that management is responsible for 80-90 % of problems, Hearing Panels should be checking to identify root causes rather than just deal with symptoms of episodic misconduct. In that way the overall system can be corrected and failure mechanisms eliminated. This is called continuous improvement and it is missing from the current Hearing process design.

Too many Panel hearings fail to establish corrective actions based on Root Cause analysis. Kenmar have observed that dealers with sound supervisory practices for suitability generally identified risks, developed policies, and implemented controls tailored to the specific features of the products they offered and their client base. These controls help identify any bad practices by Dealing Reps long before they become big problems. These controls include, for example, restricting or prohibiting recommendations of products for certain investors ( e.g. seniors) , as well as establishing systems- based controls (or “hard blocks”) for recommendations of certain products to retail investors to ensure that representatives adhered to those restrictions or prohibitions. Technology and specialized software ( e.g. security risk-rating ) can greatly assist supervision and compliance. These are the kind of corrective actions we’d like to see considered on every case.

Some dealers also implement methods to verify the source of funds for leveraged transactions. In addition, certain dealers require representatives, including principals with supervisory responsibilities, to receive training on specific complex or high-risk products before the representatives recommend them so the representatives fully understood the products’ risks and performance characteristics, as well as the types of investors for whom the product might not be suitable. Control System issues should always be part of Panel decision making as they are often the best form of lasting corrective action.

We’ve also observed some Dealers facing challenges with their supervisory control systems and other operational issues relating to quantitative suitability. For example, as concluded by PlanPlus Research (http://www.osc.gov.on.ca/documents/en/Investors/iap_20151112_risk-profiling-report.pdf }, most risk profiling processes in use today are unfit for use. Deficient risk profiling processes were never explicitly flagged by Panels as a systemic root cause – the belief was that it was always the individual that was responsible.  “Misconduct” and unsuitable recommendations will continue until core KYC processes are corrected. See SIPA report  Improving the KYC process
https://www.sipa.ca/library/SIPAsubmissions/500%20SIPA%20REPORT%20-%20KYC%20Process%20Needs%20Overhaul%20-%20201607.pdf

The scandal involving double billing is a prime example of a breakdown in control systems. The inability to correctly assign fees and promptly detect the mischarging was a systemic issue within firms and across the industry. It is clear from the no –contest Settlement agreements that the wealth management industry needs to beef up the quality assurance of its systems and controls. This requires ongoing system audits, periodic system testing and review of client complaints/ feedback. Process owners need to be held accountable. Root cause analysis was not employed by securities regulators. Hearing Panels should have enumerated a corrective action plan in addition to fines and other sanctions. Merely consenting to fix the systems for fee calculation robustness does not explain the poor initial design and failure to uncover fundamental system flaws, in some cases, for over a decade. CRM2 reporting was instrumental in bringing the internal control issue to light.

When a Dealer or Rep has “actual or de facto control” over a client’s account, there must be a reasonable basis that a series of recommended securities transactions are not excessive and unsuitable in light of the client’s investment profile. DSC mutual fund manipulations and fund churning are a classic example that should not be permitted to happen. Some progressive dealers have developed parameters for trading volume and cost to identify and prevent excessive trading/fund churning as well as restrictions on frequency or patterns of clustered or single product exchanges. In some cases, clients whose accounts breached the firm’s thresholds should receive telephone calls from principals or detailed activity letters setting forth the frequency and cost of trading over specific periods. These are the kind of learnings and action plans we’d like to see integral to Panel Decisions.

The best dealers have an organized, validated risk profiling process. System triggers should kick in when certain KYC criteria are incongruent or suspicious. Too many dealers do not have controls in place to validate changes in risk profile. All too often we see risk tolerance increased simply to justify what has been sold to clients. Better supervisory controls should be applied to risk profile changes increasing the client’s risk tolerance. Our review of numerous Panel cases suggests that Seniors/ retirees should not be put through the same KYC processes as clients of other age groups and the frequency of KYC updates /type of KYC information gathered should vary with age.

We would like to see IIROC formally build corrective action into its Panel Decision objectives. IIROC should summarize these observations for industry action and/or a change in Rules.

The bottom line

IIROC has worked on improving the efficiency of enforcement /Hearing Panels and the collection of fines , primarily from individuals. This may improve investor protection at the margin. A true corrective action program would yield much more substantive, lasting effects and thereby less need for Hearings and fine collection. As professor Peter Drucker has said “  Doing the right thing is more important than  doing things right”. When tactics and strategy balance, regulation is enhanced.

Obviously, individuals should be sanctioned for misrepresentation, unauthorized trading, Off book sales, signature forgery / document adulteration and fraudulent acts. But even in these cases, the Dealer should be jointly held accountable for the actions of its representatives. It is therefore our view that the Hearings process should be reviewed and updated to reflect prevailing thinking on securities regulation, dealer accountability and enhanced investor protection expectations.

We’ve found that currently dealers and Dealing Reps are not doing enough to uphold the suitability standard for their clients, .They must be able to demonstrate why their recommendations are a good fit for the client’s unique needs/goals, risk profile, personal and financial circumstances – in other words, to practise KYP ,KYC and responsible supervision. One solution might be a recommendation that Investment Policy Statements be employed as industry standard practice. That is the kind of deliverable we’d expect if Panel decisions were analyzed with a corrective action perspective rather than on case by case basis limited to sanctions. As currently structured , such a recommendation from a Panel is unlikely .

Each Panel decision should, as a Best practice, look not only at sanctions/deterrence but also at underlying management control and supervisory systems. Every breach of the rules is an opportunity for improvement. An ounce of prevention is worth a pound of cure.

The Panels can be given a form of score sheet or checklist that could be used to help Panel members test for common weaknesses; the information from these can be entered and analyzed for even broader value.  FAIR Canada and others have called for considerably stronger analytics and publicly accessible, relational, searchable databases that will better focus regulatory action. 2019 is the year to get this initiative under way.

Ken Kivenko

Saturday, January 5, 2019

Canadians and Investment complaints


Canadians are provided investment advice under the lowly suitability standard by people that are operating with numerous conflicts-of-interest . As a result, the likelihood of being sold unsuitable investments, overcharged or sold expensive products is not insignificant. In addition, there is the usual assortment of wrongdoing including account churning, undue leveraging, , unauthorized trading, reverse churning and fraud. This means that the likelihood of having a complaint against your dealer is to be expected. There are many issues related to filing a complaint including not knowing your rights, a complex process and dealers who view a complaint in an adversarial manner rather than an opportunity to create client satisfaction and process improvements. This article details the challenges and offers some constructive changes for reform.

The illusion of independent supervision




“It's best that the king's food taster reporst to the king rather than the chef” – Machiavelli , the Prince


For years we’ve been complaining about lax supervision of Dealing Reps (aka “advisors”, salespersons). It has been a mystery how so much wrong-doing was effected in plain sight of supervisors and branch managers for extended periods of time.  A number of White Hat Reps have gotten the courage to clue us in. Here is what they tell us:


·         Branch managers may obtain over-rides of sales commissions received by those they supervise. 

·         Branch managers may receive a bonus  based solely on the revenue/profitability of the branch

·         Some Branch managers also double as Reps so in effect they are part time managers. Some Branch managers have actually purchased the client “book “from those they are supposed to supervise.

·         Branch managers may be rewarded based on the number of new Reps brought on and on AUM growth  

·         Branch managers are tolerant of signature forgery, document adulteration and pre-signed blank forms

·         Titles such as VP can be awarded solely on the basis of sales production 

·         Dealers provide greater incentives for fee-based accounts  


We’ve also been told that at some firms when a Rep under a manager quits or is fired ,the Branch manager hand picks the largest accounts for himself and passes on the small ones to other registered Reps.

The conflicts -of-interest here are enormous so it should come as no surprise that supervisory controls are lax. In effect, we have conflicted Reps overseen by conflicted supervisors (gatekeepers).
Branch Manager duties typically include the review and approval of new client application forms (NCAF’s) and client account updates, as well as the review of daily and monthly trading summary reports. They are there to ensure that Reps under their supervision do not engage in improper or unlawful behaviour e.g. suitability, discretionary trading,  leveraging, excessive trading (churning) violations or fraud.

In a 2017 Guidance NOTE http://www.iiroc.ca/Documents/2017/5365cb5b-e384-477f-8fc0-8c2b9450424a_en.pdf  IIROC noted that in most Dealers .reviewed, they saw supervisors compensated partly (to varying degrees) on revenue generated by registrants subject to the supervisor’s oversight.

IIROC Dealer Member Rule 2500 III.A.3 requires that:

“A Dealer Member should ensure independent supervision of all retail accounts.”  IIROC  adds "While this rule is more frequently cited to ensure a producing supervisor does not have supervisory oversight over his or her own accounts, the spirit of the rule speaks to the need for genuinely independent supervision. It is understandable that the compensation of a supervisor who is also a branch manager is based partly on the overall profitability of his or her branch. However, the Dealer should consider other factors in determining supervisor compensation that would offset any undue bias towards branch profitability at the expense of client best interest.”.

IIROC finds it acceptable that Branch Managers can be partly compensated based on branch profits and can also be dealing Reps, supposedly supervised by someone else. More importantly, IIROC  believes that the non--independence can be negated by other, albeit unspecified, factors. IIROC’s guidance is pretty vague and leaves it entirely up to dealers to resolve the conflict-of-interest- the very dealers who have created the conflict-of-interests. Apparently independent doesn’t really mean independent in the commonly understood use of the word. There really is a good reason why external auditors report to the Board and not management- independence.

For example, without a rule regarding fee -based accounts, we do not see how, except in the most abusive cases, IIROC can give operational meaning to its guidance on independent supervision. IIROC have not created criteria that would enable them to robustly enforce certain issues e.g. wrong account type.

We think these conflicts must and can be avoided. There are numerous ways to measure how well a manager is supervising staff. Dealers should be required to prove to regulators that managers’ performance is evaluated based on many factors so that branch profitability isn’t a factor. This can be done by investment dealers just as it is done in retail, manufacturing, etc. companies.

Here are some ideas for rewarding Branch managers/ supervisors:

·         The manager/branch office supervisor should be evaluated on her/his performance in implementing corporate standards of behaviour. This assumes, of course, that the firm expects employees to behave as well trained professionals compliant with regulatory requirements.

·         Measuring the number of client complaints at the branch 

·         How well the manager is supervising his staff’s compliance with the regulations. There should be a review of supervisor’s performance from the firm’s compliance department certifying how many regulatory violations the supervisor’s advisers have had.  So a branch manager’s performance includes how well he is managing staff from a regulatory perspective. If dealers are required to explicitly approve a supervisor’s performance, this will raise the bar, putting Compliance staff on the line... Example: if a Branch manager has many staff faking client signatures or if he allows big producers to get away with discretionary trades... compliance department will be aware of this.

·       His/her Reps are fully compliant and up to date with professional training and CE. Supervisor gets rewarded if Reps are seeking more product knowledge  training, more professional upgrading, improving their professionalism 

We appreciate that the conversion from a sales culture to a client focus will be challenging but the journey must begin.IIROC as a Public interest regulator must address these fundamental conflicts-of-interest in the supervision of Reps.

Wednesday, December 12, 2018

Checklist for the DSC mutual fund investor




Thanks to D. McFadden 



For mutual fund investors, deferred sales charges (also known as “back-end fees”) can cause a lot of headaches when investors come to realize that their investments are essentially locked-in by deferred sales charge (DSC). The DSC is a fee that gets charged to a client (5-6% in year 1, declining to 0% in years 6-7) if they sell a mutual fund without transferring it to another mutual fund from the same company. There is no penalty fee if you switch funds within the same fund family but the dealer may charge a switch fee varying between 0-2%.

Investor advocates have warned investors for years about the DSC sold mutual fund. Securities regulators are proposing to ban them outright. If your fund salesperson attempts to sell you a DSC fund we suggest you ask Questions like:

1. Why are the MER’s of DSC funds identical to front load funds? Answer should be: The MER’s are identical because the fund companies have decided not to create a separate DSC series; this means that other fund investors are unknowingly subsidizing DSC unitholders.
2. What happens if I need access to cash during the redemption period due to a family or other emergency? Answer should be: A penalty must be paid per redemption schedule. No exceptions. 
3. Does the redemption penalty apply to original cost or current price of fund units? Answer should be: It varies by firm. Best to check with the firm. 

4. What happens if I take distributions in cash? Answer should be: If distributions are paid in cash they go toward the 10% of units that can be redeemed each year without attracting a redemption charge. 
5. Does the penalty still apply if I die? Answer should be: The penalty must be paid by the estate if the fund is redeemed. 
6. Can I redeem some units for free? Answer should be: Yes, 10% are free redemption units each year but privilege is not cumulative. Use it or lose it. 

7. Do I have to reinvest distributions? Answer should be: No, reinvestment is at option of unitholder.
8. What happens to my DSC units after the redemption period has expired? Answer should be: They remain as DSC units but with no redemption schedule ( at least one firm auto converts to Front load with lower MER). 
9. What commissions do you receive on this sale? Answer should be: The dealer and salesperson share a 5% upfront payment+ trailer commissions (typically 0.50% p.a.) for as long as you own the fund. 

10. Is there a cost to switch funds? How much? Answer should be: Yes. Cost can be up to 2%. Switch fees can be negotiated.
11. Is the redemption penalty tax deductible? Answer should be: Yes, in open account as it reduces returns; No in registered accounts where capital losses cannot offset gains.
12. Does it make sense to buy a money market fund on a DSC basis? Answer should be : No, since a money market fund is a temporary parking spot for cash, liquidity is key. 

13. What if the fund is merged with another fund I don’t like? Answer should be: A redemption from the merged fund will still involve an early redemption penalty fee. 
14. Can the MER be increased during the hold period? Answer should be: Yes, it could happen .
15. Why are regulators proposing to ban the DSC? Answer should be: There is a massive mis-alignment of investor-representative interests. 

16. Are reinvested distributions subject to a new redemption schedule? Answer should be: No . 
17. Do you sell other lower cost products? Answer should be: YES – Index funds, ETF’s among others. 
18. Are there other versions of the fund with shorter hold periods? Answer should be: Yes, no- load, front load (typically 0%) with no constraint on holding period and low-load funds are available with shorter redemption periods. Check with your fund salesperson. 

NOTE: In a number of well documented cases , unethical advisors will recommend redeeming a mutual fund as soon as the redemption schedule expires and buy a new fund, starting the dreaded redemption schedule all over again. A lack of liquidity is exactly the opposite of what investors need.

If after you receive honest answers, and you still want to buy a DSC fund, we wish you the very best of luck. DSC sold funds have been abused by salespersons. For example, when the redemption period expires, the salesperson will recommend selling the DSC fund and purchasing a new fund, thereby starting the redemption schedule all over again. In some cases, DSC funds have also been sold to clients with time horizons less than the redemption schedule. DSC investors, especially seniors, need to be wary of numerous shenanigans. Professional advisors do not recommend DSC series funds as they are not in your best interests. Be ALERT.