Tuesday, December 23, 2014
The Kenmar Associates team has prepared a User Guide for Fund Facts that should allow you to obtain the most value from this disclosure document.
The attached Guide is written in plain language and broken down by sections in Fund Facts for ease of use.While current regulations require pre-sale delivery of Fund facts only in May 2016, many firms will start providing it now. In any event, you can ask your dealer for it now- it’s your money. Get the Kenmar Guide here.
This checklist is intended to help identify diligent supervisory practices used to detect Off Book and Outside Business Activities by "advisors".We sincerely hope it will help in the successful prosecution of investment dealers who say “ I had no idea” by identifying prudent practices that should be in place to prevent investor abuse. For seniors and retirees this abuse can be life-altering.There is no room for wilful blindness in today's advice giving industry.
Tuesday, December 16, 2014
Comments unbecoming of a “wealth management industry”
Despite fierce industry opposition ,a determined group of regulators has finally made the delivery of Fund Facts mandatory BEFORE the investor is required to make an investment decision. Imagine that!The industry should be embarassed and ashamed at its anti-investor stance over these many years.
One has only to review the comments that were made during the prolonged consultation on the pre-sale delivery of Fund Facts to realize just how big the gap is between sales and advice at the most senior levels of the mutual fund industry ( referring to itself as being in the wealth management industry) . The most basic act of advice is for a professional advisor to explain the product and why it is being recommended for inclusion in a portfolio. For investor advocates, this is so fundamental to advice giving that it is a no-brainer. Yet as you gaze upon some of the comments regulators had to wrestle with, you quickly realize the source of the many problems in the fund industry and the fierce opposition to a Best interests standard is ... top management. Given the intense industry stonewalling ,it is no wonder it took over 10 years to bring in this most fundamental reform related to being in the investment advice business ( The comments actual apply more to an industry in the sales and marketing business ).
Take a look at the rationale used to delay , bypass or kill pre-trade disclosure of Fund Facts:
A few commenters said that, given the substantial anticipated costs and the lack of a detailed cost-benefit analysis, they are unable to agree with the CSA's perspective on the benefits and costs of implementing pre-sale delivery of the Fund Facts.
A commenter noted the "specific" costs of implementing the pre-sale delivery of Fund Facts are:the administrative, production and delivery costs of sending the Fund Facts separately, instead of with the trade confirmation;the operational costs of creating and running a process to ensure for timely pre-trade delivery of Fund Facts and the costs of sufficiently documenting investor receipt of Fun Facts
It was suggested that a trial program be conducted among a sample of dealer representatives to see if the costs associated with pre-sale delivery of the Fund Facts can be justified in terms of its utility for investors.
Some commenters said that moving from post-sale to pre-sale delivery of Fund Facts is a significant change that shifts the delivery obligation from a dealer back office operation to the front line sales force. Therefore, the pre-sale delivery requirement will affect independent dealer representatives and small firms in a disproportionate manner.
Furthermore, a number of independent mutual fund companies are dependent on third party distributors, who seldom have face-to-face meetings with investors and often rely on telephone conversations or other means of communication.
Several commenters expressed the view that pre-sale delivery of Fund facts would slow down the sales process.
Some commenters that it is important to make a distinction between investors who rely on a dealer representative's recommendation and those who rely on their own research and judgment. We were told pre-sale delivery of the Fund Facts will only delay an investor from executing an investment decision they have already made.
Some commenters said that the requirements to qualify for the pre-sale delivery exception are unduly narrow and are likely to frustrate some investors, especially experienced and knowledgeable investors who do not want orders delayed pending delivery of the Fund Facts. These investors should be allowed to expressly waive pre-sale delivery of the Fund Facts in favour of post-sale delivery.
The pre-sale requirement will be less onerous for bank-owned distributors, who meet with investors at a local branch, facilitating in-person pre-sale delivery of Fund Facts.
Some commenters also noted that pre-sale delivery will impact a dealer representative's product shelf because it will be more difficult for smaller and independent dealers to distribute a wide selection of mutual funds. To ensure pre-sale delivery of the Fund Facts and to complete transactions on a timely basis, dealer representatives may be forced to narrow their "product shelf." Over time, this may affect the level of competitiveness of the mutual funds industry.
One commenter noted that an unsatisfactory transition period would pose serious human resource challenges, leading to delays, as well as customer experience and compliance concerns.
Industry commenters were generally unanimous in recommending a switch-over date that avoids the months of November through April since resources at that time of year would be heavily engaged with RRSP season [ sales ] activity, year-end trading and financial reporting. Therefore, an early summer change-over period would be preferable since it would be the least disruptive from an operational standpoint.
For telephone sales, one commenter told us that pre-sale delivery of the Fund Facts has the potential to create a negative investor experience. In such circumstances, it was suggested that dealers should be permitted to inform the clients that they can receive the Fund Facts within two days of the purchase rather than the onus being in on the investor to initiate the request
One commenter also suggested that dealer representatives be permitted to ask their clients for annual instructions or standing instructions in a manner analogous to the continuous disclosure process in National Instrument 81-106 --Investment Fund Continuous Disclosure. Alternatively, the opt out could be in the form of a declaration (e.g., a clause in the account agreement subject to annual renewal in writing) or an acknowledgement upon the purchase of a mutual fund that the investor will be responsible for getting the most recent copy for the Fund Facts prior to any new trade instructions to the dealer representative.
One commenter noted that the verbal disclosure would take approximately six minutes without taking into account additional time that might be needed to answer any questions the investor may have. This would be even more so when an investor purchases several funds at the same time. Moreover, in the case of investor-initiated trades, especially by seasoned investors, this mandatory verbal disclosure will amount to an annoyance and delay and fee-only dealer representatives will have to charge the investor.
One commenter also expressed concern that the limited number of third party service providers to facilitate implementation could place industry members at financial risk as they will negotiate contracts with a "virtual monopoly", which may result in a "concentration risk in outsourcing".
One commenter noted that the pre-sale delivery of the Fund Facts is proceeding without assurances that investors will realize costs savings. Operational savings from the cessation of prospectus distribution to investors may lead to material profits for fund companies, while the dealer representatives pay for the bulk of pre-sale delivery costs.
Some commenters lauded the removal of the previously proposed requirement to bring the Fund Facts to "the attention" of the purchaser, which was viewed as an unclear requirement that could have potentially added unnecessary costs and confusion for dealer representatives and investors.
We could go on ,but the evidence is clear. A sales mindset and culture is in place trying to masquerade as a professional wealth management/ advisory business. Until this changes, investors will be at risk .That is precisly why investor advocates are demanding increased “advisor” ( the misleading title used by the industry to portray dealer representatives) proficiency and a fiduciary standard. It's now up to regulators to bring in needed reforms or investors to implement Caveat Emptor and ignore all the industry hype about the value of advice.
Let us all hope that 2015 will see some leaders emerge and transform the industry to a trusted one – one that is sorely needed by most retail investors.
Friday, December 12, 2014
December , 2014
Supervision on vacation , compliance out of sight
The Hearing Panel’s decision dated November 21, 2014, is available at: http://docs.iiroc.ca/DisplayDocument.aspx?DocumentID=E3CCCA84688043EBB50218E0C0801C75&Language=en .
Specifically, the Hearing Panel found that Mr. Matthews committed the following violations:
a) Between approximately January 2009 and May 2012, Mr. Matthews failed to use due diligence to ensure that recommendations were suitable for four clients, based on factors including the client’s financial situation, investment knowledge, investment objectives and risk tolerance, contrary to IIROC Dealer Member Rule 1300.1(q);
b) Between approximately June 2010 and May 2012, Mr. Matthews engaged in discretionary trading with respect to the accounts of one client, without being authorized and approved as having discretionary authority, contrary to Dealer Member Rule 1300.4;IIROC Notice 14-0289 Enforcement Notice/News Release – In the Matter of Grant Patrick Matthews – Discipline decision - Liability
c) In December 2008, Mr. Matthews engaged in discretionary trading with respect to the accounts of one client, without being authorized and approved as having discretionary authority, contrary to Dealer Member Rule 1300.4; and
d) Between January 2009 and March 2011, Mr. Matthews engaged in improper practices by excessively trading in (churning) the accounts of three clients, for the sole purpose of generating additional commissions, contrary to Dealer Member Rules
These are fine regulator-speak words but let's take a closer look at what really happened to one of the clients in more detail , client EF. Source : http://www.iiroc.ca/Documents/2014/5e35ee7b-0a06-4618-a4f3-b90971a9ef33_en.pdf
Know your Client (KYC): Client - EF is a 69 year old retired widow. She has a high school education, and was a homemaker for much of her working life. She also worked at one time as a franchisee operator of a lottery booth. Her late husband, RF, worked as a custodian at a local high school before he retired. Prior to that, he managed a gas stationer generally left the household financial affairs and investment decisions to her husband.11. A March 2004 New Client Account Form (“NCAF”) for EF’s RRSP account stated that EF earned $40,000 per year from the lottery booth, and RF earned $32,000 per year as a custodian. Their stated liquid assets were $100,000, and their fixed assets were listed as $300,000. The stated [ emphasis ours] investment objectives [ emphasis ours] were 50% long term growth, 50% short term speculative, [ are these are clear and proper objectives for a retiree?] and her stated risk tolerance parameters were 50% medium and 50% high. At the time, EF was 60 years old and her investment knowledge was listed as “fair” [ whatever that means but we can be confident she didn't understand the leveraged ETF's mechanics] . Her husband died in May 2010. Following her husband’s death, in June 2010, EF, met with Matthews to sign estate documentation and discuss his future handling of her accounts. She was then 67 years old. Do you think this is a well defined set of “objectives” for a person in this financial situation? Do you think this is robust KYC or a setup for a fee grab?
She completed an NCAF to open her TFSA account, which stated that she was retired,
with a modest income of $32,000 per year. The investment objectives were 25% income/50%
long term growth/25% short term speculative, and the risk tolerance parameters were
changed to 33% low/33% medium/33% high [ whatever that means]. The stated assets remained the same, as did the description of her investment knowledge as “fair”. Given the available information, her risk capacity , the ability to absorb losses, was low . Losses in a TFSA cannot be offset against capital gains. The word “ fair” is meaningless and it appears to be a slick way to justify the risky trading strategy in her TFSA account by portraying her as more knowledgeable than she really is..
Following her husband’s death, EF completed an NCAF for the TFSA, but not for her other accounts. There are no account updates between June, 2010, and EF’s transfer of her accounts to another firm in May, 2012 [ for us, this suggests a compliance systems problem] IIROC notes that for the period of June 2010 onward, the stated investment objectives and risk tolerance parameters were too aggressive for EF, who was then a retired and recently widowed senior, with limited assets and income. IIROC says Matthews failed to learn and remain informed of the essential facts relative to EF as the stated investment objectives and risk tolerance parameters in her accounts were inconsistent with her true financial situation, investment knowledge, investment objectives and risk tolerance. In our view that is being disingenuous. We say Mathews deliberately set it up so he would have a paper trail to show his actions were consistent with a knowingly defective KYC document. He didn't fail, he succeeded at deception.We also ask, where the heck was the supervisor or Branch manager to prevent this obvious information travesty? And why does the IIROC investigation report play word games?
Suitability :EF's investing knowledge was very limited so naturally IIROC has concluded EF relied upon and followed Matthews’ recommendations for the investments in her accounts. “This was particularly evident during the time period of June 2010 onward, following her husband’s death” IIROC notes. Did the Branch manager not notice the change in pattern? In general, the nature of the trading in the RRSP account [ her retirement fund] was focused on frequent trades in medium to high risk securities. The medium risk securities were primarily resource issuers trading on the TSX, and the high risk securities were primarily commodity-based leveraged exchanged traded funds (“LETF”) , a complex speculative product that works on the basis of daily returns. There were no low risk holdings according to IIROC yet the dealer's systems did not detect this wholly unsuitable portfolio construction.. From May 2010 to April 2012, the average hold period for all securities was approximately 5 months. The average hold period was just 38 days for positions in which gains or losses were actually realized. In addition, although there were some purchases made in the accounts of dividend-paying securities, in many cases the securities were not held long enough to be eligible to actually receive the dividends. By now, you'd think someone at the dealer would have woken up to the fact this poor retiree was being gamed. No such luck.
Between Jan. 2009 and Oct. 2010, there were an incredible 66 LETF transactions, which resulted in losses of $14,999 (including $7,805 in commissions). The majority of the LETF positions were held for short time periods, on average 2.74 days. However, there were 5 LETF trades which were held for a much longer period, an average of 178 days, and resulted in losses of $17,485. Between June 2010 and May 2012, the total value of EF’s accounts declined from $115,478 to $106,159, reflecting a loss of 8%. This included the payment of commissions of $13,378. During the same time period, the S&P TSX Composite Index increased by 5.29% for a differential of 13.5 %. During this time period, the performance of her holdings was very volatile in comparison to the overall market performance. The total value of her accounts ranged between approximately $160,000 to $100,000. Such volatility is a sure sign that account risk was high The dealer Reps recommendations were not suitable for this client in light of her age, employment status, investment knowledge , experience and true circumstances but inexplicably they continued for a considerable time without dealer intervention except to cash brokerage commission cheques.
Discretionary Trading : The nasty “advisor” behaviour doesn't stop with unsuitable investments. . During the period from June 2010 (after her husband’s death) to May 2012, Matthews made 113 trades ( about 1 trade per week!) in EF’s retirement and savings accouterments tells us that EF says that she instructed Matthews to “take care of her”, and that she “left everything up to him”. She wanted him to continue the type of trading activity that he had carried out with RF, as she had limited investment knowledge. Gimme a break . During the material time, Mr. Matthews executed many trades in EF’s accounts without confirming the details of the trades with EF prior to their execution. The hapless widow's retirement account savings were not designated as discretionary by Leede but they happened anyways. Leede’s supervision and systems failed to pick up on this in your face financial assault.
What do we learn form this case ?
Clearly , Risk tolerance does not match the trading patterns. It should have been 100% speculative risk. Anything else is a compliance breach. Investment knowledge is “fair”. An attentive supervisor should not ever set up a speculative account for an investor with “fair” investment knowledge. And of course Objectives did not match risk . Despite the obvious, this exploitation carried on in plain view for a prolonged period of time.
The first lesson learned is therefore quite clear. The most basic systems and processes were not in place at Leede . Nearly everything that could be wrong , was wrong. The real culprit here is Leede Financial . We do know the abusive practices by this individual impacted 4 other investors possibly many more at that Branch. IIROC tell us it is standard practice for IIROC Investigation teams to consider the issue of supervision whenever they are conducting an investigation of a dealer Rep, and to investigate where there are indications of a failure to supervise. However, given the confidential nature of their investigations, they cannot confirm whether or not they have or had an active investigation ongoing, unless and until any such matter proceeds to disciplinary action, in which case it then becomes public record when a Notice of hearing is issued. They assert that it is general practice to prosecute cases involving a failure to supervise by way of a separate Notice of Hearing before a separate Hearing panel.
Here's some 2013 IIROC Enforcement statistics for 2013 that we think speak for themselves.:
There were 1690 complaints of which 280 originated from the public
There were 203 complaints involving unsuitable investments and 88 involving unauthorized trading
There were just 63 prosecutions of individuals by IIROC of which 19 involved suitability ,1 involved discretionary trading and just 4 involved supervision
There were only 12 prosecutions of dealers of which a mere 5 involved supervision ( this is for the entire year for all of Canada)
Fines imposed on individuals amounted to $4,382,500; only 10.5% of the penalties assessed against individual registrants were collected.
Fines imposed on dealers amounted to $2,220,000 ,about half that imposed on individuals; 98.1% of the penalties assessed against dealers were collected
What do these numbers suggest to you?
In the Mathews case we say that management was asleep or willfully blind at such horrific and highly visible and prolonged financial assault. This cannot and should not ever happen in the wealth management industry especially to multiple victims over such a extended period of time. The advocacy community, including a number of former and current Reps, is of the firm conviction that SRO's are spending too much time on disciplining Reps ( and not collecting fines) and not going after the root cause : Deficient supervision / compliance systems and a broken KYC system. The great Quality Control expert Edward Deming coined the rule: 85-97% of problems are the responsibility of management. We are convinced this is correct .This is why for every Rep prosecution we expect at least one corresponding supervisory prosecution and with much higher penalties and sanctions. A few strong high profile examples would change dealer behaviour real fast.
We argue that suspected supervisory breakdowns should have at least as high investigation priority than Rep prosecutions and should carry larger fines. This is further supported by the fact that Reps are usually fired but Branch managers often remain on to be negligent again in the future.
Hopefully, 2015 will see a lot more timely prosecutions of dealers for breakdowns in supervision , compliance and KYC deficiencies/adulteration.
The other BIG lesson . CAVEAT EMPTOR ! You are not dealing with “advisors” that are required to act in your Best interests.
Kenmar SRO surveillance Team
Monday, December 8, 2014
ALERT : Improper use of fee-based accounts December, 2014
We have received a flood of queries and complaints regarding advisors' actively promoting fee- based accounts rather than commission –based accounts. It looks like an epidemic that we hope regulators pro-actively address. Some of the increased conversion activity may be due to proposed regulatory iniatives to prohibit embedded sales commissions/trailers in products.Ironically, unless there is robust supervision , regulatory oversight and self-protection, you may end up paying more as a result.
Commission- and fee-based accounts each involve different advantages and disadvantages for clients, and these basic advantages and disadvantages should be clearly understood before signing up for an account type.
In a commission-based account, you are charged a commission each time a trade is executed. For you, the advantage of this arrangement is that the service(s) received in exchange for the commission paid is concrete and specific-a given trade, which is typically based on a specific recommendation by the dealer representative. Moreover, when the client’s account is inactive-either because no recommendation has been made or because the advisor has recommended a long-term hold on a security-the client incurs no trading commission . Most canadians are Buy-and -Hold so fee-based accounts may not make sense for the majority.
In several cases ,client investments were converted into expensive proprietary products ( incurring early redemption fees on their mutual funds along the way ) and then their accounts moved into fee-based accounts where they were gouged on the fixed rate by paying thousands per year more than what they would have paid had they simply held the Baskets and Private Pools in ordinary non fee-based accounts. In another case , a retiree who made just two trades paid account fees which amounted to more than 10 % of her annual account income of $11,000. The unsavoury practice of placing a client who trades infrequently in a fee-based, rather than a commission-based, account is known as “reverse churning”. In one extreme case, a 89-year old widower was charged $31,000 for just 4 trades over 2 years!
In contrast, fee-based accounts charge a set percentage of account value or, in rarer cases, a flat fee, for an ongoing service, regardless of the number of trades that occur in the account over the specified period. In principle ,the advantages that fee-based accounts potentially include:
(1)fostering a greater alignment of interests between the dealer Rep and the client, under the assumption that, if the Rep's compensation is based on a percentage of the value of the assets in the client’s account, it is in the best interest of both the client and the advisor to maximize the value of those assets;
(2)reducing the likelihood of certain harmful sales practices, such as churning or making recommendations unduly influenced by compensation, since such practices will not increase the dealer Rep’s compensation, but may expose them to liability and regulatory risk;
(3)increased transparency of the cost of services and advice provided to the client insofar as fee-based charges make it less opaque to clients that they are compensating their Representive for services, including those that do not necessarily result in trades (e.g. a recommendation to continue holding a security or maintain assets in cash ). In a commission-based account, clients may be led to assume that these services ( if provided ) are provided for free, even though they may be embedded into the product fee structure; and
(4) enhanced predictability of fees/charges ( for dealer and client) but not necessarily lower fees for clients.
Unfortunately, principles and dealer Rep fee revenue goals too often collide.
The type of complaints we are receiving center on pressure to convert to a fee-based account without proper rationale. Those who transact most may be better off in a fee- based account, and those who transact little may be better off in a commission- based account. A number of complaints also surround the question of whether cash,/GIC's should be exempt from the fee.Read and understand the terms of the account agreement before signing.
The fee- based account is really a volume transaction discount, strategically priced at a level that ensures both dealer Rep and dealer earn a good return from their clients who decide to proceed with this option. Such a recurring revenue model is perfect for dealers. While one of its stated potential advantages is that it removes the temptation to churn an account, there is plenty of room to take advantage of the investor: clients who transact little and therefore have a minimal commission trail can be plunked into a fee- based account and thereby increase dealer Rep and firm revenue at the expense of clients. We have also seen IPO's appearing in retail accounts where embedded sales commissions are not only attractive to dealers but actually, in the case of closed-end funds, harmful to investors.
If you are encouraged to unnecessarily leverage your investments, the apparent advantage of lower dealer /Rep transaction fees is negated by increased fees on higher account asset balances and more investment risk for you. Using margin is an increasing danger to be on the alert for as fee-based accounts multiply.
Another common complaint is from clients, especially the elderly, with a basic bond portfolio who are being charged a fee between 1% and 2.25%, a rate that is higher than the interest rate on a majority of the bonds in the client’s portfolio. While this action is not outright illegal, it is highly unethical. A bond is meant to be an income-producing vehicle used to pay a certain interest return for a designated period of time. At bond maturity, the client receives his money.However, when the portfolio is static, meaning the Rep researched the bonds, sold them to you for a good reason, and earned a commission initially, there is no reason to charge an annual fee . To charge an annual fee for managing a portfolio of bonds, when all that the client needs are his mailed interest cheques, amounts to financial abuse.
Several complaints concern investors who hold both a commission and a fee-based account . In those cases,, the Rep charged the client a commission on the purchase of a security and subsequently charged an additional fee by transferring that security into a fee-based account.
Given the attractiveness of fee-based accounts for dealers/Reps, such an account might reduce the probability of say, Rep recommendations that involve a low-cost ETF portfolio requiring only once a year rebalancing. You need to be alert – in fact, ask why ETF's are not utilized in your commission -based account before even considering conversion to a fee-based account.
Investment dealers love a steady revenue stream and a lot of the products and services they provide are designed to deliver this. One example is the unduly popular wrap account, where a mutual fund company takes a few of its proprietary funds and wraps them together in a single portfolio-in-a-box product. Wraps are brilliantly promoted, but not nearly as good as building a portfolio by selecting the best, economical funds from a variety of companies instead of just one. In effect, a wrap does all the security selections and asset allocation freeing up the Rep to hunt for new clients.
Fee-based accounts make some sense for clients who trade actively and rely on the guidance of a professional advisor who might provide a wide range of services that might include estate and tax planning as well as investment recommendations. The important questions to ask are: “Are these services actually provided?” and “Does frequent trading actually lead to better returns?”. There is significant research evidence that it does not. “Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell..” - Warren Buffett
The best-suited clients for fee-based accounts are ones who are active investors and have a solid knowledge of what they’re doing. Unsophisticated investors more intent on collecting income than portfolio growth are the least suited to account conversion.
A large number of complaints involve A class mutual funds in a fee-based account. Effectively the dealer/Rep is receiving the trailer commission on top of the account fee ( double-dipping) .In November, TD Bank subsidiaries were required to repay overcharged mutual fund clients The
subsidiaries were required to pay about $13.5 million to some current and former clients to compensate them for more than a decade of excess mutual fund fees as part of a settlement deal approved by the Ontario Securities Commission (OSC). The OSC was told that failures in the firms’ internal controls and supervisory systems lead to fee calculation errors in some accounts. In other instances, clients were not advised that they qualified for mutual funds with lower MERs, or management expense ratios.Apparently no one figured this out over a period of 10 years. Lesson : Check your account to ensure you're not getting hosed.For a fee-based account ,you should be sold F class funds which have the trailer commissions stripped out of the MER.
In the December edition of the OSC's Investment Funds Practitioner, the regulator indicates that it is problematic for an investment fund series that is intended for fee-based accounts to include embedded trailer commissions. "This type of dual compensation structure is inconsistent with a critical attribute of the fee-based series, namely the negotiation of the dealer's compensation, which is intended to provide investors with heightened transparency of the cost of the dealer's services and a clear expectation of the services to be rendered in exchange for the negotiated fee," it says.
Bottom line : Costs count. In short, fee-based accounts may not be the best fit for certain clients if annual fees end up costing more than the trading commissions that would have accrued in accounts that show little to no activity.Think twice about opening a fee-based account then think again every time you see a charge. Experienced investors who manage their own portfolios can cut their costs dramatically. A portfolio of index exchange-traded funds (or index mutual funds) should cost no more than 0.4 % annually, including commissions to buy and sell.If you buy stocks and bonds directly via a discount broker you can save even more. .CAVEAT EMPTOR