Friday, August 30, 2019

Investor Protection, Fund Facts, trailer commissions and the CSA

Kenmar have been constructively critical of the Canadian Securities Administrators (CSA) for a number of years. In June 2018, the CSA decided, after years of consultation and research, not to prohibit embedded trailing commissions. Despite strong investor arguments, the CSA have resisted all attempts to move from the lowly suitability standard towards a Best interests standard. As regards Fund Facts mutual fund risk rating, investors strongly opposed the CSA proposed methodology but it nevertheless prevailed leaving today’s fund investors with misleading ratings. More recently, OSC research shows that CRM2 fee reporting is deficient in precisely those areas where investor advocacy groups had offered suggestions that were sidelined. 

And in August, 2019 the CSA concluded that more monitoring is required before it decides on a binding mandate for OBSI- a mandate supported by investors, two successive reports by independent reviewers and the OBSI Board itself. Investor reaction to that response exhibited disappointment, even anger.

This posts deals with another aspect of the CSA - an allegation of misleading Fund Facts disclosure.

Gary Stenzler, who is lead plaintiff in a Class action involving mutual fund trailer commissions, provides this perspective:

The CSA – Out to harm the public?

The CSA, in its official capacity as the umbrella organization speaking on behalf of all of Canada’s provincial securities regulators, has periodically drafted language and made recommendations to the contents of Fund Facts disclosures.  Two examples of the above recommendations are as follows:

1.   In December of 2010 the CSA published amendments to National Instrument 81-101 to create the Fund Facts documents.  The CSA stated that trailing commission disclosures made in those documents include the statement, “it is for the services and advice your investment firm provides to you”; and

2.   In June of 2013 the CSA published “Stage 2: Notice of Amendments to National Instrument 81-101 Mutual Fund Prospectus Disclosure and Companion Documents.”  Within this document the CSA made the following recommendation regarding the language to be used in trailing commission disclosures:  “It is for the services and advice that your representative and their firm provide to you.”

The CSA’s recommendation regarding trailing commission disclosure language (as set out in 2. above) has been incorporated verbatim for years in Fund Facts documents representing thousands of unique mutual funds.  The problem is that the CSA’s recommended language, when used by investment fund managers, constitutes prospectus misrepresentation pursuant to provincial securities laws – or more simply put, the Fund Facts documents that follow the CSA’s recommendations contain a deception (a lie).

There is no evidence that trailing commissions (which total over $6 billion annually) deducted from the investments of Canadians are required to be used by dealers to provide unique “services and advice” to those same Canadians or that other applications of the trailing commissions, such as a sales commission for distribution, are not also applicable  . In fact, dealers are legally free to use trailing commission proceeds for any purposes that they choose – including purposes that provide no benefits to mutual fund unitholders.  The $6 billion annually that are taken from the pockets of Canadians by mutual fund trustees under the guise of “services and advice” is nothing more than a slush fund to be divvied up Canada’s wealthiest and most powerful financial institutions – and they have to do little to nothing in order to get their share. 

There is no evidence that the CSA, in making its recommendations, performed any due diligence into how dealers actually use trailing commission proceeds.  Why did the CSA tie legal representations of trailing commissions to a specific purpose (services and advice provided to unitholders) when it had no independent knowledge of the truth of the matter?  There are only two reasonable answers to this question – gross incompetence (possible) or, more likely, the CSA offered to use its powerful regulatory position to provide “cover” to investment fund managers who had been making this same lie to the public (linking trailing commissions to services and advice dealers provide unitholders) in the Simplified prospectuses they had been disseminating for decades.

It is clear that the CSA knew, or ought to have known, that its recommended language for Fund Facts disclosures was misleading and incomplete. Conflicting statements made by mutual fund industry stakeholders coupled with the fact that Discount brokers overtly collect advice fees despite providing no advice serves to illuminate the falsehoods inherent in the CSA’s recommended Fund Facts language. The fact that the CSA’s members choose to not utilize their enforcement tools to rectify the matter only serves as further evidence of the CSA’s ongoing neglect of investor protections.

Gary Stenzler

Kenmar Addendum : If one looks at it from the trustees responsibilities- they make a representation ( one recommended by the CSA) in Fund Facts but are they sufficiently prescriptive as to how dealers should actually use trailing commission proceeds? We don’t know but expect the Class Action will put the spotlight on the issue. Kenmar acknowledge that some trailing commission proceeds result in some services being provided; however, it is not evident to us that the trustees do anything specific to cause this to happen or take affirmative action if it does not happen.According to the Cumming empirical research report and other research , the salesperson recommendations that are made are not always in the best interests of clients, so do they qualify as personalized advice or are they just salesmanship? [ i.e. there is strong evidence that embedded commissions skew the recommendations made]  

For years , mutual fund individuals were registered as "salespersons" but in 2009 the CSA registration label was changed to “dealing representative” without a corresponding change in role/duties , thereby adding to investor confusion . In parallel , the fund industry continued using the made up title “ advisor” for the individuals selling and distributing mutual funds , with CSA acquiescence. Investor advocates argue that any “advice” provided was incidental to the true nature of the trailing commission paid i.e. distribution. The fact that the CSA did not address the title and designations issue is directly responsible for the misunderstanding in the minds of consumer investors. 

Even while Fund Facts was being made a mandatory disclosure document, the CSA knew that Discount brokers were being paid trailing commissions for undefined “services “ and for “advice” that it knew such dealers could not and did not provide. No regulatory action has ever been taken for this payment which only makes sense if the trailing commissions are for distribution ,not advice. This disconnect with Fund Facts is at the core of the Class Action.

The DSC sold mutual fund is seen as being particularly egregious because it provides strong incentives for salespersons (hefty upfront commissions and ongoing trailer commissions) to sell mutual funds that can lock clients into underperforming products for years and has led to harmful fund churning. That these commissions and trailing commissions were key elements of distributing (as opposed to providing advice) mutual funds was well known in the late 1980's. Yet the CSA Fund Facts document never actually requires dealers to characterize these commissions as a compensatory reward for selling mutual funds. Fund Facts does however provide a convoluted clue that the trailing commission isn’t just about providing service and personalized advice viz “
The fees and expenses - including any commissions - can vary among series of a fund and among funds. Higher commissions can influence representatives to recommend one investment over another. Ask about other funds and investments that may be suitable for you at a lower cost.”

We conclude this blog with the results of a recenly released OSC investor Advisory Panel Report A Measure of Advice: How much of it do investors with small and medium-sized portfolios receive?  

It concluded that (1) 60% of mass-market investors and 75% of investors with small portfolios reported that their advisor communicated with them in the past year only “once or twice” or did not communicate at all;(2) Nearly half (49%) of mass-market investors said their advisor spent less than an hour, in total, communicating with them during the past year or didn’t communicate at all. Two-thirds (68%) of small investors and 44% of mass-affluent investors said the same thing; (3) Only a small minority reported they’d received advice about budgeting, debt management, tax and estate planning, or planning for the future needs of a family member; (4) 43% of advised investors did not agree that their advisor had provided them with educational advice about financial concepts and (5) 31% were unable to say their advisor had ever spoken to them about planning for financial goals such as retirement, education or buying a home . In our opinion, these statistics hardly support the strong Fund Facts claim of personalized advice being provided to owners of mutual funds.

It should be noted that while section 3.2 of National Instrument NI 81-105 Mutual Fund Sales Practices permits a fund organization to pay a “trailing commission” to a participating dealer, the Instrument currently does not define precisely what comprises such payment. It is therefore unclear why the CSA chose to be so precise in their recommended Fund Facts language.

While we would hesitate to say that the CSA was part of a regulator-industry complex, it is fair to say that (a) the CSA has failed the retail investor; (b) the CSA has not listened to retail investors and (c) the influence of industry has not been matched by investor influence on CSA decisions. There is now a great opportunity for the CSA to be proactive with some solid investor protection reforms and a heightened determination to listen to the voice of the retail investor.We would strongly recommend that the CSA review Fund Facts for improvement opportunities including changing the " services and advice" language and breaking out trailing commissions as an isolable cost for greater client visibility.  


Information contained herein is obtained from sources believed to be reliable, but the accuracy is not guaranteed. The material does not constitute a recommendation to buy, hold or sell. The purpose of this Document and others in the series is to educate investors by bringing together personal finance information from a variety of sources. It is not intended to provide legal, investment, accounting or tax advice and should not be relied upon in that regard. If legal or investment advice or other professional assistance is needed, the services of a competent professional should be obtained.  

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