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. 

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.

Wednesday, November 28, 2018

Simple Do’s and Don’ts for Investors by advisor Bruce Loeppky




I am in contact with some investor advocates and am shocked that things are still happening that I hoped would disappear or at the very least be very infrequent events by this point in time. Investors are still being ripped off by rogue financial advisors; clients are still buying DSC mutual funds and still borrowing to invest when they shouldn’t. These are three of the most common problems plaguing the financial services sector.



1. Rogue ‘Financial Advisors’

There are a number of things you can do (or look for) to ensure that you never get put in the position of losing your nest egg to an unscrupulous ‘financial advisor’;


Don’t EVER sign a cheque to your ‘financial advisor’. Always to the firm or fund company. That way you will have the company’s protection if things go sideways. If you sign a cheque to your ‘financial advisor ‘he will deposit it into his own bank and it won’t go through the companies normal processing so they will be unaware of its existence. If it goes through their system they have a record of it and can probably rectify the situation. Is he living an extravagant lifestyle? That can be a sign. Sometimes where people get too successful. they feel they are untouchable.



2. To DSC or NOT DSC?

Why are people still buying DSC mutual funds when they essentially lock you into a fund company for 6-7 years, unless you pay the penalties for early redemption? Don’t invest with a Front End (FE/or ISC) Option that takes away 1-5% of your investment before the starting line either. ONLY invest FE 0% to give you full flexibility.



There is NO advantage to purchasing mutual fund with the DSC option. It limits your flexibility and costs you money if you redeem early or move to another fund company.



If your Financial Advisor forces you to decide between DSC and FE 3-5% for example, look for somebody else or go to the bank until you find somebody that offers that option. Banks and credit unions always offer FE 0%.



The DSC option should go the way of the dinosaurs in my opinion. The ONLY time I would OK its use is if you are working with a newly licenced advisor and he needs to use it to stay in business while he build his practice. The option does provide more immediate income to the financial advisor.



3. Borrowing to Invest (Leveraging)

This is the most over used strategy in the industry and I saw it abused many times while at investors Group where the use of it was promoted frequently as a method of earning more money and growing your book of assets faster, but at whose expense?

Only examine this strategy IF; you have a good/steady job, you maximize your RRSP’s every year, your home is paid off or you have a very low small mortgage, high income(s) and you have no debt. I have seen too many people come to me who borrowed $100,000 only to have it sitting at $65000 after a correction and are upset about the method in which the leverage was sold to them.



Most people can deal with a loss IF one of your potential scenarios showed a 30%-40% loss one year. The problem is that most projections show a steady 7% growth rate and the numbers all look very rosy and unrealistic.NO markets or investments rise as a steady 7% year after year. Every 10 years you will see a major correction and illustrations should reflect that reality.



Trust your Gut



If your gut is telling you something, listen to it.If the numbers sound too good to be true they likely are. If you have had investments work well (or not) for many years and somebody (often a new financial advisor but not always) advises a drastic change, check with your accountant or another financial planner/advisor to get a second opinion. Don’t put everything in the same investment. Stay diversified with different bonds, and both Canadian and foreign equities. Don’t rush into anything.



Don’t move forward if you feel pressured or must make a quick decision. I read recently about a gentleman who owned a business and had about 2 million invested and made a change (Exempt Market product I think) and within’ 3 months lost everything and was forced to sell his cottage to stay afloat. He was coasting along wanting for nothing after a successful career and ONE mistake changed his position dramatically and it will never go back to where it was.



All it takes is ONE big error and you’re in trouble. Make sure you (or your parents/grandparents) don’t make it.Nobody needs that stress, especially when you’re retired.

NOTE: The views expressed here represent the views of Mr. Loeppky and do not necessarily coincide with our position. We thought it important to allow advisors to let their voice be heard.






Tuesday, October 16, 2018

DSC sold fund doomed in IIROC channel - if IIROC rules followed and enforced



Information asymmetries and investors’ assumption that those providing them personalized advice must act in their best interest means unsophisticated investors too often rely heavily on their Reps, which leaves retail investors vulnerable to exploitation. Numerous surveys confirm this unchallenged reliance on Rep recommendations. But rules and regulations exist to prevent mis-selling. As long as they are enforced by IIROC dealers, most retail investors should be safe.

DSC funds pay 5% upfront commission to the dealer .Five per cent is a big chunk of change for a fund company to pay up front. In order to make the money back, the fund company needs clients in the fund for 6-7 years. It is difficult to see how responsible IIROC dealer supervisors or compliance staff would ever consider this bondage to be in the best interests of the client. Reps should not recommend DSC funds if clients plan to invest for only a short time, if they have little money and can't afford to lose any of it, or if they have a low tolerance for market/price volatility. A well-documented compliant KYC process should help keep such clients away from DSC sold mutual funds.

Existing IIROC rules require a Dealing representative to resolve conflicts -of -interest in the best interests of clients ( Rule 42). Other rules require Reps to only make recommendations which are suitable for clients based on KYC. Mutual funds with embedded commissions create a conflict-of-interests with DSC sold funds dramatically amplifying that conflict with the outsized 5% upfront payment. So a Rep faced with deciding to sell a DSC vs. FEL (0%*) fund would have to recommend FEL to address the conflicts between compensation schemes. In addition, it can be argued that the liquidity of the FEL series vs. the locked in nature of DSC funds is itself a conflict-of- interest since decreased liquidity is not in the best interests of clients.
* an IIROC dealer could subvert this by not offering 0% front load funds

Also, even under a lowly suitability regime product cost enters into the picture. In the case of say, Fidelity funds, the MER of the FEL series of funds is less than the identical DSC series so the FEL should win again IF Reps are truly resolving conflicts in the best interests of clients. While clients can switch into money market funds at no cost (except for 0-2% switch fees), because DSC funds allow switches within the same family without triggering redemption fees, the DSC redemption schedule still remains. Any attempt to redeem for cash will result in a penalty. Directly recommending a DSC money market fund would have to be considered abusive selling as a m/m fund is intended to act as a temporary parking spot for cash and should not therefore be bound with illiquidity chains.

Furthermore, it is imprudent for Reps acting in a client’s best interests to recommend actively-managed mutual fund unless the reasonably expected return from such fund will cover the extra costs and risks typically associated with such funds. This is key, as most actively-managed funds simply are not cost-efficient if analyzed properly. If the potential closet indexing factor is considered by analyzing a fund's incremental costs in terms of Ross Miller's Active Expense Metric (see Reference), the number of cost-efficient actively-managed mutual funds is very low.

Before processing any order, Reps. must disclose the charges the client will incur for the purchase, sell, switch or transfer, or a reasonable estimate if the actual amount is not known at the time of the disclosure. We expect that such disclosure may be inadequate unless the Rep. informs the client of the FEL series or other alternatives. If the disclosure is balanced and fair, we would however expect a rational investor to reject the DSC series.

The accurate collection of the client’s time horizon is an essential component of the KYC process and it is imperative that Reps/supervisors consider this information when assessing suitability .If time horizon is less than 7 years or client is older than say 65 then it may not be suitable to lock a client into a fund for up to 7 years. Regardless of age, there is no logical justification for exposing a client to early redemption penalties when equal or better alternatives are readily available.


Additionally, Reps should consider the suitability of DSC purchases for accounts in a de-accumulation stage e.g. the suitability of DSC purchases in RRIF accounts. In most cases, suitability will be almost impossible to justify when FEL is an available alternative.

Further ,when product and account cost becomes a formal suitability factor when/if proposed client-focussed reforms see the light of day, the Rep would have to look at a spectrum of products that are suitable including index funds , ETF’s and actively- managed ETF’s. Given empirical research on actively - managed funds that shows chronic underperformance vs. Benchmarks, indexing would most likely be the optimum solution, especially for investors with modest account sizes. Any other Rep recommendation would be subject to scrutiny from compliance and likely eligible for a client complaint.

Of course, if the Rep has not met disclosure obligations, that too would be a basis for a complaint. It is inconceivable that any informed investor faced between being locked in and not, would ever choose to be locked in. An informed investor would likely also object to the 5% advance payment for advice if the alternative was pay as you go. Rep recommendations should not be limited as to whether the redemption schedule was disclosed to the client but rather a consideration as to the suitability of the recommendation to purchase the DSC fund. For example, investors who do not have an adequate emergency fund should not be sold a DSC fund.

So there you have it, with so many hurdles, there is no future for the DSC actively-managed mutual fund in the IIROC distribution channel. One BIG assumption –IIROC Dealer Reps care about their clients financial wellbeing AND supervision and compliance interpret and enforce the rules as intended.

Some argue that it is impossible for an SRO (junior regulator) to say that DSC is wholly unsuitable for everyone when it is allowed by the CSA. IIROC can (and does) certainly say that DSC is not suitable for certain clients by interpreting their suitability rules but they are not able to ban it entirely (as it is allowed by the CSA). According to one source ,just over 30% of DSC sold fund assets are with IIROC dealers. There is no doubt, an outright ban on this toxic product is in the Public interest. Caveat Emptor.

Kenmar Associates 

References:

Ross Miller's Active Expense Metric and its implications
If the Fund fails the metric test, passive would have to be considered. The DSC issue would automatically be resolved since low cost Index Mutual funds could not pay the 5% upfront commission. If index fund MER’s were increased, then ETF’s would have a field day.
http://landryinvest.ca/documents/articles/measuring_true_cost.pdf  

Vanguard CEO: High-Cost Active Management is Dead - Video | Investopedia

Ellis, Charles D., “The End of Active Investing,” Financial Times, Jan. 20, 2017


Ontario right to oppose mutual-fund trailer bans, says Primerica Canada CEO:WP
"...Calling the proposed ban “draconian,” he warned that its approval would leave many investors of modest means — “those without a large amount to invest who rely on commissioned advice without an upfront fee” — unable to receive advice from an advisor. “When this sort of drastic market intervention is proposed, it is appropriate for the minister of finance to step in, to look at the concerns and weigh the policy options to ensure a balanced policy outcome.”.."
https://m.wealthprofessional.ca/news/mutual-funds/ontario-right-to-oppose-mutualfund-trailer-bans-says-primerica-canada-ceo-249396.aspx?utm_source=GA&utm_medium=20181017&utm_campaign=WPCW-Newsletter-Opener&utm_content=&tu=. Investor advocates argue that clients without a large amount to invest can readily access robos , credit unions and banks without pre- paying for conflicted advice and without being locked in for 7 years in an actively -managed mutual fund. Such clients would also avoid all the dirty tricks that can ( and have been) be played with DSC sold funds. Such a product is clearly not in the best interests of families struggling to save for retirement. Professional advisors are unlikely to recommend DSC sold funds but fund salespersons might. The biggest beneficiary of DSC funds is the salesperson. Caveat Emptor . NOTE: If for some reason you change firms, you will have pre-paid the lion's share of the advice fee ,so your new Rep may want to alter your holdings so that he / she receives compensation related to his / her efforts. That portfolio adjustment can be expensive.


Deferred sales charges: Stealth wealth killers - The Globe and Mail

Investor Protection Takes A Step Backward - High Rock Capital Management
Article shows how the DSC Mutual fund abuses Canadian families saving for retirement.
http://highrockcapital.ca/scotts-blog/investor-protection-takes-a-step-backward


IIROC fines Branch Manager for deficient supervision of DSC funds
In this case, the Rep often sold mutual funds with deferred sales charges (DSC) and then repurchased similar funds, requiring clients to pay redemption fees and it reset the early redemption schedule on the newly purchased mutual funds. ($125,402 in redemption fees ere triggered)  The Rep also unnecessarily charged switch fees for the trades, which some clients said they weren’t told about. Clients were charged $367,459 in switch fees. 

Toothless investor Protection
https://boomerandecho.com/weekend-reading-toothless-investor-protection-edition/




Thursday, October 4, 2018

For your financial health, Avoid DSC mutual funds






One of our major concerns is the impact of the Deferred Sales Charge (DSC) mutual fund on clients, especially vulnerable seniors.

A  Dec. 2015 report from the regulator of mutual fund dealers identified several problematic practices, including: clients over age 70 that were sold DSC funds ( aka back-end load); clients who were sold funds with DSC redemption schedules that were longer than their investment time horizon; and evidence of poor disclosure of the redemption fees at certain firms. The report stated “Overall, there was a lack of consistency across [dealers] on how to supervise transactions involving seniors who purchased DSC funds.”.

A DSC sold fund pays a 5% sales upfront commission to a dealer/advisor when a purchase is made. This structure creates many conflicts-of-interest that can skew the recommendations from advisors to the detriment of elderly clients. DSC sold funds carry significant penalties if they aren’t held for 6 years. Ready access to investments is important for retirees living on fixed income in case of an emergency.The DSC fund also glues clients to their salesperson even if service is mediocre. Mutual fund salespersons are not required to act in the client’s best interests.

We’ve seen cases where seniors are exploited by salespersons that keep them locked into underperforming funds for long periods of time. The underperformance directly reduces their retirement income security and limits their choice of funds.

When a fund company unilaterally decides to shut down a fund, unitholders must either switch to another fund in the same family and possibly incur an up to 2% switch fee or redeem with a penalty and crystallize unplanned capital losses or gains. It’s like being between a rock and a hard place.

We’ve even seen cases where retirees were sold Canadian money market Funds intended for short term parking of cash sold on a DSC basis. That is beyond exploitive.

And then there’s fund churning that causes a lot of early redemption penalty fees to be incurred. The penalties are bad enough but in a RRIF they cannot even be offset against income. Any early redemption penalty fee paid is money lost in the RRIF (or RSP) forever.

Finally, even when an investor passes away, the DSC still applies, leaving beneficiaries a big headache - it is like a cancer that won’t go away.

An attempt by Securities regulators to ban the sale of such toxic funds is being vigorously opposed by some members of the mutual fund industry. Investor advocates want to protect investors by limiting access to the DSC option because it pays an outsized upfront commission to the dealer/ salesperson than other sales options, and a lower continuing commission for service to the client. Paying for advice well in advance of the provision of services is not smart especially if the advisor leaves the firm or retires.

Accordingly, there is not one consumer or investor advocacy group in Canada that supports the retention of the DSC sold mutual fund.

Here's what you can do:

      ·         Just don’t let your advisor sell you this toxic product 

·         Ask your advisor about the  Annual 10% DSC Free option if you already own such a fund 

·         Ask your dealer to waive switch fees and early redemption fees and switch  you into a lower cost product  that meets your needs

·         Ask your dealer to stop reinvesting distributions in your existing DSC funds

·         Buy a fund from a reputable fund company that has discontinued selling mutual funds on a DSC basis – these include Investors Group, Dynamic Funds and BMO Investments Inc. among several others

·         Shun fund firms and salespersons that promote the sale of DSC mutual funds

·         Tell all your friends , colleagues  and family to avoid being sold a DSC fund

For more information visit http://www.canadianfundwatch.com/search?q=dsc+  
The DSC Sold Fund Under the Microscope

If you want a real world education on advisor exploitation of seniors, read this
Classic Case of elder abuse and DSC sold Funds .It’s a MUST READ for every
senior and retiree http://www.iiroc.ca/Documents/2012/3cb46f19-f9fc-4fbe-8e88-584c5337f054_en.pdf

One way to avoid all this complexity and expense is to consider using a robo-advisor.

Sunday, September 9, 2018

Effective and Fair OM Exemption complaint investigations


Effective and Fair OM Exemption complaint investigations

Based on discussions with unsophisticated retail clients that have been adversely impacted by the regulatory exemptions regarding exempt securities a nasty picture arises. Most do not appreciate the rules of engagement, the unique risks of this market and especially the lack of liquidity.  Any distribution of securities in Canada must either be qualified by a prospectus or be exempt from the prospectus requirement.

The Offering Memorandum (OM) exemption allows issuers to raise funds from investors who are either not sufficiently wealthy or not in a sufficiently close relationship with the issuer to qualify for certain other exemptions. It is found in section 2.9 of National Instrument 45-106 Prospectus Exemptions. Certain conditions of the OM exemption apply across all provinces and territories, while certain other conditions vary depending on the jurisdiction in which securities are distributed. The common conditions include a requirement that the OM contain financial statements of the issuer, and that investors acknowledge in writing that the investment is risky. The variable conditions include, in certain provinces and territories, an annual investment limit of $10,000 (all figures in CA$) per investor unless the investor satisfies certain criteria, including having a specified level of income or assets. Complaint investigators must become familiar with the varying provincial rules and how they are interpreted by regulators.  

OM investors are required to complete and sign a form highlighting the key risks associated with investing in securities acquired under the OM Exemption. Individual investors are also be required to complete two schedules to the offering memorandum which ask investors to confirm their status (as an eligible investor, non-eligible investor, accredited investor or an investor who would qualify to purchase securities under the family, friends and business associates exemption) and that the investor is within the investment limits, where applicable. The OM exemption is loaded with bear traps for unsophisticated retail investors.

Marketing materials used by issuers in distributions under the OM Exemption must be incorporated by reference into the offering memorandum and filed with the securities regulatory authority. As a result, the marketing materials are subject to the same liability for a misrepresentation as the disclosure provided in the offering memorandum itself. Misleading OM marketing materials have been a source of angst for retail investors but should come into play when investigating complaints.

The companies and Exempt Market Dealers (EMD) that sell exempt securities want to see investors do well. But companies are also interested in maximizing the amount of capital they can raise and dealers want to boost their commissions – so there are conflicts-of-interest and incentives for both groups to encourage investors to buy exempt securities.

Problems/ complaints often arise because EMD Reps have not informed themselves as thoroughly as they should have about the investor's ’ situation ( KYC), the features and risks of the exempt investments they have recommended (KYP) and how those two Assessments should be applied to the client’s situation. For instance , someone with low to medium risk tolerance and capacity , low financial literacy and a large mortgage or credit card balance shouldn't be sold securities under the OM exemption even if they technically are eligible and are willing to sign the risk disclosure document. It is vitally important also for complaint investigators to recognize that (a) disclosure is NOT the same as transparency and (b) the well known downsides and limitations of disclosure.

In May 2017, the Alberta Securities Commission (ASC) concluded in a report that while many exempt market dealers adhered to the KYC, KYP and suitability rules, numerous others had significant compliance deficiencies in the collection and documentation of KYC information, inadequate Know your Product analysis , marketing materials that contained unsubstantiated or exaggerated claims and inadequate identification and response to conflicts-of-interest. Furthermore, a large number of instances were uncovered where brokers' clients possessed unsuitable investments such as: low-risk investors holding high-risk securities; income investors holding growth securities; short-term investors holding long-term securities; and investors with portfolios over-concentrated in exempt securities.
http://www.albertasecurities.com/Regulatory%20Instruments/5331553%20_%20EMD_Project_Staff_Notice%2033-705.pdf

Unsuitable investments are bad enough but we have found that OM client complainants are also treated poorly. Attempts are made to blame the investor by citing he/she signed all the forms on risk and understood other complex matters related to investing in exempt securities. Complaint investigators need to go beyond the signed documents given the known vulnerabilities of retail investors.

In the EMD sector, OBSI closed 18 cases in 2017 with just one complaint (5 %) being upheld. This contrasts sharply with compensation recommendations for investment complaints generally- OBSI upheld 39% of investment complaints in 2017 (and 23% of banking complaints).

Our concern is that complaint investigators are not using proper complaint assessment principles to deal fairly with unique OM exemption complainants and complaints.

We suggest the following Checklist be adopted by OM complaint investigators to ensure complainants are treated fairly.
.
                                                                                                                            
EMD complaint investigation checklist

·         Basic Principle : KYP, Suitability determination is the sole responsibility of the Exempt Market Dealer – suitability and eligibility are NOT the same thing. Eligibility should be validated before suitability assessment  
·         Has the dealer exhibited due diligence in evaluating the exempt security?
·         Is there objective evidence that eligibility was verified? Income tax returns/ payroll stubs should be checked if client appears uncertain on responses  
·         Are marketing materials misleading or different than the OM materials?
·         Did the Dealer rely solely on self- certification of eligibility? Many retail investors do not understand the relevant terminology or have low financial literacy
·         Employment stability checked as appropriate by Dealer?
·         Was product risk adequately disclosed in terms the investor can understand?
·         Was time horizon properly defined? Liquidity , redemption fees
·         Has the lack of liquidity of exempt securities been considered in suitability determination re KYC?
·         Is the client a vulnerable investor? Low financial literacy, senior, poor literacy, weak numeracy , language issues
·         Does client have experience with OM exemption?
·         Are client life objectives documented? IPS ? financial plan?
·         Is Dealer NAAF/ KYC form adequate given the nature of the risks? Debt obligations, cash income needs, number of dependents , age , tax rate
·         How was the client’s financial knowledge determined? If determined to be Low or Fair, extra Dealer controls are  required especially as regards eligibility information provided and understanding of risks
·         Was risk tolerance determined by a Dealer approved test and process? Is objective evidence available?
·         Did the Dealer depend solely on client self -assessment of risk?
·         Was client risk capacity determined? e.g. a retiree , an investor with  a large mortgage /young family, unemployed
·         Did the Dealer rely solely on client completed risk acknowledgement form?
·         Was “informed consent” obtained?
·         Are Rep Notes available for review?  
·         Has the Dealer documented the suitability assessment?
·         What is Rep background? Registration, disciplinary history , designations, qualifications  
·         Any there any regulatory/ legal actions against Dealer, Issuer or product?
·         Is marketing and sales literature misleading? Deceptive?
·         Was Suitability assessed per transaction or on portfolio basis? Should be on individual security and on portfolio ( concentration of assets) basis.

We believe that complaint investigators should use such a checklist in order to ensure a fair assessment of an OM complaint. We appreciate however that every case will be fact-specific considering all of the evidence.

References


Jeffrey MacIntosh, "Enforcement Issues Associated with Prospectus Exemptions in Canada,"  August, 2017. “…By comparison, equity financing in the public market averaged approximately $16.5-billion a year in each of 2010 and 2011 – comprising $3-billion in initial public offerings, $1.5-billion in private-venture funding and $12-billion in secondary offerings (based on Prof. Jog's estimates).Indeed, the exempt market "dwarfs the public market," says Prof. MacIntosh. Given the enormous size of the exempt-securities market, the amount of harm inflicted on investors could be considerable if extensive non-compliance exists, he adds…”


Guidelines for obtaining meaningful consent - Office of the Privacy Commissioner of Canada
The Office of the Privacy Commissioner will begin to apply these guidelines on January 1, 2019. The release of these guidelines is part of the Office’s work to improve the current consent model under the Personal Information Protection and Electronic Documents Act (PIPEDA). For further details, please refer to the consultation on consent under the PIPEDA.
https://www.priv.gc.ca/en/privacy-topics/collecting-personal-information/consent/gl_omc_201805/. There are many issues re informed consent in the investment business especially given the asymmetry in knowledge and the clever (cunning) writing of consent agreements by industry participants. 

Ending abusive clauses in consumer contracts Report 2011 http://uniondesconsommateurs.ca/docu/protec_conso/EndAbusiveClauses.pdf