OSC & firms fo­cus on over­charg­ing

More than 250,000 clients have over­paid on fees

Investment Executive - - FRONT PAGE - BY JAMES L ANGTON

a se­ries of set­tle­ments be­tween reg­u­la­tors and firms af­fil­i­ated with all of the Big Five banks re­veals that hun­dreds of thou­sands of clients col­lec­tively were over­charged tens of mil­lions of dol­lars. Iron­i­cally, fi­nan­cial ad­vi­sors at one of the firms were among the first to un­cover the is­sue, touch­ing off re­views through­out the in­vest­ment in­dus­try, which are on­go­ing.

The rev­e­la­tion of sys­tem­atic over­charg­ing among some of the in­dus­try’s big­gest firms has all come to light through the On­tario Se­cu­ri­ties Com­mis­sion’s (OSC) rel­a­tively new “no con­test” set­tle­ment pro­ce­dure, which al­lows firms to re­solve en­force­ment cases with­out ad­mit­ting li­a­bil­ity.

In late June, Toronto-based Royal Bank of Canada was the last of the Big Five banks to set­tle such a case. Then, Toron­to­based in­surance gi­ant Man­ulife Fi­nan­cial Corp. reached a sim­i­lar

set­tle­ment with the OSC in July.

Fur­ther­more, Jeff Ke­hoe, di­rec­tor of en­force­ment with the OSC, in­di­cates that the reg­u­la­tor still is work­ing on sev­eral cases of sim­i­lar over­charg­ing is­sues.

Al­though the spe­cific de­tails of the var­i­ous cases that the OSC has set­tled dif­fer, there are some shared fea­tures. Es­sen­tially, firms were in­clud­ing prod­ucts that con­tained em­bed­ded com­pen­sa­tion within fee-based ac­counts, ef­fec­tively charg­ing clients twice.

In ad­di­tion, some firms that of­fer the same prod­uct at dif­fer­ent prices — i.e., mu­tual funds that charge lower fees for clients with larger amounts in­vested — weren’t nec­es­sar­ily putting all of their qual­i­fy­ing clients into the cheaper ver­sion of the prod­uct, thereby charg­ing clients more than they should have been charged.

So far, the cases with the Big Five banks’ af­fil­i­ates and Man­ulife in­di­cate that more than 250,000 clients com­bined have been af­fected by th­ese forms of over­charg­ing. The set­tle­ments with the OSC have re­sulted in more than $190 mil­lion be­ing re­turned to in­vestors col­lec­tively, plus an­other $8.2 mil­lion in vol­un­tary pay- ments and costs to the reg­u­la­tor.

Al­though the OSC in­di­cates that there may still more cases to come, the full scope of client over­charg­ing in the Cana­dian in­vest­ment in­dus­try may never be known.

In­deed, over­charg­ing may not be clearly against the rules. Each of the reg­u­la­tory set­tle­ments to date have iden­ti­fied the con­duct be­ing ad­dressed in the en­force­ment ac­tion to be de­fi­cien­cies in the firms’ in­ter­nal con­trols that failed to de­tect the over­charg­ing — not the over­charg­ing per se.

Ar­guably, over­charg­ing clients could be deemed a vi­o­la­tion un­der se­cu­ri­ties law if the prac­tice was found to be un­fair, im­proper or fraud­u­lent. The type of over­charg­ing that’s cov­ered in th­ese no-con­test set­tle­ments to date does not amount to fraud­u­lent or im­proper con­duct, Ke­hoe says, given that it was pri­mar­ily the re­sult of in­ad­e­quate sys­tems rather than de­lib­er­ately dis­hon­est con­duct. How­ever, the over­charg­ing could be con­sid­ered un­fair to the clients in­volved, which would fall un­der the reg­u­la­tor’s “pub­lic in­ter­est” man­date.

There is no prece­dent for over­charg­ing be­ing treated as a vi­o­la­tion of se­cu­ri­ties rules in Canada. In fact, a re­port that the In­vest­ment In­dus­try Reg­u­la­tory Or­ga­ni­za­tion of Canada (IIROC) pub­lished ear­lier this year, which de­tails the re­sults of a re­view of com­pen­sa­tion-re­lated con­flicts at in­vest­ment deal­ers, in­di­cates that some firms al­low as­sets that in­clude em­bed­ded com­pen­sa­tion to be uti­lized in fee-based ac­counts and sim­ply ad­dress the con­flict through dis­clo­sure.

Most in­vest­ment deal­ers try to ex­clude th­ese as­sets from the ac­count fee cal­cu­la­tion, the IIROC re­port notes. Yet, the re­port con­tin­ues: “Find­ings from nu­mer­ous busi­ness con­duct ex­ams pro­vide ev­i­dence that th­ese pro­cesses are gen­er­ally man­ual and, as a re­sult, are er­ror-prone.”

This type of er­ro­neous over­charg­ing may be tricky to de­tect and is un­likely to gen­er­ate full-scale en­force­ment ac­tion. In the OSC’s set­tle­ments with the bank-owned firms, the over­charg­ing was limited to a hand­ful of clients and a few thou­sand dol­lars, in some in­stances. In oth­ers, it af­fected thou­sands of clients over many years, re­sult­ing in mil­lions of dol­lars of ex­cess fees be­ing paid.

Some of the bank-owned firms be­gan dis­cov­er­ing that they were over­charg­ing clients — and had been for more than 10 years, in cer­tain cases — as the firms be­gan im­ple­ment­ing pro­cesses to com­ply with the sec­ond phase of the client re­la­tion­ship model (CRM2) re­port­ing re­quire­ments, says El­iz­a­beth King, deputy di­rec­tor of the OSC’s com­pli­ance and reg­is­trant reg­u­la­tion branch.

The in­tro­duc­tion of CRM2 prompted firms to be­gin ex­am­in­ing what their re­quired dis­clo­sure would look like un­der those rules, and that’s when they dis­cov­ered the over­charg­ing, she says.

How­ever, sharp-eyed ad­vi­sors also played a part in un­cov­er­ing the is­sue, al­though they may have been con­cerned about pos­si­ble un­der­charg­ing in­stead.

Ac­cord­ing to the first of the no­con­test set­tle­ments, reached with a trio of Toronto-Do­min­ion Bankowned firms in 2014, a di­vi­sion now known as TD Wealth Pri­vate In­vest­ment Ad­vice found, “as a re­sult of in­quiries made by its in­vest­ment ad­vi­sors,” that cer­tain clients were un­der­charged be­cause prod­ucts were be­ing in­cor­rectly ex­cluded from their fee-based ac­count cal­cu­la­tions. At that point, the firm also re­al­ized that other clients were be­ing over­charged.

Th­ese in­stances of in­cor­rect charg­ing arose at the big banks in par­tic­u­lar, King sug­gests, as they ac­quired in­vest­ment firms, thus adding to the com­plex­ity of their op­er­a­tions and nu­mer­ous legacy sys­tems had to be in­te­grated. At the same time, fee-based ac­counts were be­com­ing pop­u­lar.

The wide­spread use of em­bed­ded com­pen­sa­tion within var­i­ous in­vest­ment prod­ucts, along with the in­creas­ing use of fee­based ac­counts, adds an­other layer of com­plex­ity that ul­ti­mately al­lowed the over­charg­ing to con­tinue at the banks over a pro­longed pe­riod of time.

An­other com­mon fea­ture of the over­charg­ing cases that have been set­tled by the big firms is that they all in­volve pro­pri­etary prod­ucts; none of the al­le­ga­tions of over­charg­ing in­clude third­party prod­ucts.

Mak­ing the case that firms are un­equiv­o­cally in a po­si­tion to pre­vent over­charg­ing that in­volves pro­pri­etary prod­ucts is eas­ier as the firms act as both the man­u­fac­turer and the dis­trib­u­tor and have all the nec­es­sary in­for­ma­tion to iden­tify — and pre­vent — any over­charg­ing, King points out.

Still, there could be clients who are be­ing over­charged ei­ther be­cause their port­fo­lios in­clude a higher-fee ver­sion of a third-party mu­tual fund or be­cause a third­party mu­tual fund that uti­lizes em­bed­ded com­pen­sa­tion is be­ing in­cluded im­prop­erly in fee­based ac­counts.

IIROC’s re­port on com­pen­sa­tion-re­lated con­flicts in­di­cates that the self-reg­u­la­tory or­ga­ni­za­tion (SRO) will be pay­ing close at­ten­tion to th­ese sit­u­a­tions dur­ing fu­ture com­pli­ance re­views.

Paul Howard, di­rec­tor of com­mu­ni­ca­tions and pub­lic af­fairs at IIROC, re­ports that the reg­u­la­tor wrote to deal­ers in April ask­ing them to con­duct in­ter­nal re­views of their fee-based ac­count pro­grams to en­sure that they have poli­cies and pro­ce­dures in place to de­tect and ad­dress th­ese con­flicts and, more im­por­tant, that those poli­cies are be­ing fol­lowed. “That work is on­go­ing at the firms,” he says.

IIROC also will be look­ing for th­ese con­flicts in fee-based ac­counts dur­ing its com­pli­ance ex­ams, Howard says: “[We can’t yet] pro­vide an in­dus­try­wide as­sess­ment of the re­sults, but the com­pli­ance re­view find­ings on com­pen­sa­tion-re­lated con­flicts will feed into IIROC’s nor­mal over­sight pro­cesses so that any is­sues are flagged and ad­dressed ap­pro­pri­ately by the firm and IIROC.”

IIROC’s re­port warns that if firms don’t self-re­port pos­si­ble over­charg­ing — and it’s later un­cov­ered in a com­pli­ance exam — they are likely to be dis­ci­plined.

The Mu­tual Fund Deal­ers As­so­ci­a­tion of Canada (MFDA) also is look­ing for th­ese over­charg­ing is­sues dur­ing its rou­tine com­pli­ance work with mu­tual fund deal­ers, says Karen McGuin­ness, se­nior vice pres­i­dent mem­ber reg­u­la­tion, com­pli­ance, with that SRO: “Dur­ing our ex­ams, we have been look­ing at fee-based pro­grams and the pre­mium/in­vestor se­ries is­sues [of mu­tual funds] with pro­pri­etary firms.”

The MFDA car­ried out a com­pli­ance sweep tar­get­ing fee-based pro­grams in 2012 and has con­tin­ued to re­view th­ese pro­grams, McGuin­ness adds: “We have seen a rise i n new fee[-based] pro­grams in the past cou­ple of years, so [po­ten­tial over­charg­ing] is an area of in­creased fo­cus for us.”

Al­though the SROs have yet to bring forth any en­force­ment cases of their own in­volv­ing over­charg­ing, the OSC states it has a few of th­ese cases in the pipe­line. How­ever, th­ese cases may be re­solved via “no ac­tion” let­ters (NALs) rather than dis­ci­plinary ac­tiv­ity.

“Now that we have our strong reg­u­la­tory mes­sage out,” Ke­hoe says, the OSC is con­sid­er­ing re­solv­ing cer­tain other cases with NALs in cases in which the over­charg­ing oc­curred on a much smaller scale and the firms in ques­tion self-re­ported the is­sue, have com­pen­sated af­fected in­vestors and fixed the sys­tems is­sues that al­lowed the over­charg­ing to oc­cur.

“Gone are the days when you can have a ‘one size fits all’ ap­proach,” says Ke­hoe. Now, reg­u­la­tors are able to use “the right tool for the na­ture of the harm, and that’s lead­ing to re­sults that we haven’t seen in the past.”

Over­all, in­clud­ing the set­tle­ments in­volv­ing over­charg­ing, the no-con­test set­tle­ment pro­gram has been used to re­solve nine cases, re­sult­ing in $340 mil­lion be­ing re­turned to in­vestors col­lec­tively. The pro­gram also has gen­er­ated in­creased in­dus­try at­ten­tion on com­pli­ance, Ke­hoe says: “I’m buoyed by that; it’s a clear ex­am­ple of the suc­cess of the pro­gram. We’re get­ting the change in be­hav­iour.”

For firms that only now are dis­cov­er­ing over­charg­ing within their op­er­a­tions, Ke­hoe says, they still can get credit for co-op­er­a­tion if they come for­ward, then fo­cus on re­me­di­a­tion.

How­ever, if a firm ig­nores th­ese is­sues and they come to light a few years down the road, he warns, “my ex­pec­ta­tion is that we would ham­mer that firm from an en­force­ment per­spec­tive.”

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