MAK­ING A MOVE ON FEES

New law­suit and SRO pro­pos­als could af­fect the CSA’s de­ci­sion

Investment Executive - - CONTENTS - BY JAMES L ANGTON

A new law­suit and pro­pos­als from SROs in­di­cate how im­por­tant the is­sue of fees has be­come.

AS THE QUES­TION OF WHETHER the Cana­dian Se­cu­ri­ties Ad­min­is­tra­tors (CSA) will ban em­bed­ded com­pen­sa­tion con­tin­ues to hang over the in­vest­ment in­dus­try, the pol­icy land­scape is shift­ing. Ev­ery­thing from the spec­tre of class-ac­tion law­suits to the prospect of a third phase of the client re­la­tion­ship model (CRM3) is on the hori­zon.

Af­ter yet an­other year of de­bate and con­sul­ta­tion, the CSA was ex­pected to reach a de­ci­sion on em­bed­ded com­pen­sa­tion by the end of March, which marks its fis­cal yearend. How­ever, that date has come and gone without clar­ity on the is­sue. Now, there are in­di­ca­tions that a de­ci­sion from the CSA isn’t likely to come un­til late spring or sum­mer.

In the mean­time, both the in­vest­ment in­dus­try’s self-reg­u­la­tory or­ga­ni­za­tions (SROs) and in­vestors are tak­ing ac­tion that could af­fect the CSA’s ul­ti­mate de­ci­sion.

To be­gin with, a class-ac­tion law­suit has been pro­posed that seeks a court rul­ing on the

fair­ness of cer­tain em­bed­ded com­pen­sa­tion struc­tures.

In early April, a pro­posed $200-mil­lion class-ac­tion law­suit was launched against TD As­set Man­age­ment Inc. (TDAM) on be­half of in­vestors who bought TDAM mu­tual funds that pay trail­ers for ad­vice ob­tained through var­i­ous dis­count bro­ker­ages.

The law­suit ar­gues that ex­ces­sive fees were col­lected from unithold­ers of TDAM mu­tual funds in or­der to pay trailer fees to dis­count bro­ker­ages for on­go­ing ser­vice and ad­vice — even though se­cu­ri­ties rules ex­plic­itly pre­vent these dis­count bro­ker­ages from pro­vid­ing ad­vice to in­vestors. The law­suit ar­gues that TDAM breached its du­ties to in­vestors by col­lect­ing fees to pay dis­count bro­ker­ages for ser­vices they can­not pro­vide.

“As dis­count bro­kers do not and can­not pro­vide in­vest­ment ad­vice to in­vestors,” the state­ment of claim states, “the pay­ment of trail­ing com­mis­sions to dis­count bro­kers on ac­count of ad­vice is im­proper, un­rea­son­able and un­jus­ti­fied.”

Fur­ther­more, the state­ment of claim ar­gues that charg­ing fees to pay those com­mis­sions to dis­count bro­ker­ages is “wast­ing” the funds’ as­sets. This, in turn, is caus­ing harm to in­vestors.

The al­le­ga­tions made in the law­suit have not been proven and the class ac­tion has not been cer­ti­fied. TDAM de­clined to com­ment on the case, cit­ing the fact that the is­sue now is be­fore the court.

Whether there’s a valid le­gal claim is not yet clear, but the is­sue of mu­tual f unds pay­ing trailer fees to dis­count bro­ker­ages has been on reg­u­la­tors’ and in­vestor ad­vo­cates’ col­lec­tive radar for some time. In fact, on the same day the pro­posed class-ac­tion was launched, the In­vest­ment In­dus­try Reg­u­la­tory Or­ga­ni­za­tion of Canada (IIROC) is­sued fresh guid­ance on sev­eral is­sues in­volv­ing dis­count bro­ker­ages, in­clud­ing the pay­ment of trailer com­mis­sions.

IIROC’s guid­ance states that the prac­tice of mu­tual funds pay­ing on­go­ing trail­ers to dis­count bro­ker­age firms is a con­flict of in­ter­est. To ad­dress this con­flict, the SRO’s guid­ance states, firms are ex­pected to make “Se­ries D” mu­tual funds avail­able — fund ver­sions de­signed specif­i­cally for dis­count bro­ker­ages.

Se­ries D mu­tual f unds typ­i­cally pay much lower trailer fees to ac­count for the fact that in­vestors aren’t re­ceiv­ing on­go­ing ad­vice from their in­vest­ment deal­ers. In cases in which Se­ries D ver­sions of mu­tual funds are not avail­able, IIROC’s guid­ance states, deal­ers should be pre­pared to is­sue re­bates to in­vestors on the por­tion of the trailer com­mis­sion that’s os­ten­si­bly be­ing paid for ad­vice.

Al­though how much of the typ­i­cal trailer is be­ing paid for ad­vice, and how much is i ntended to fi­nance “other ser­vices,” is not clear, CSA re­search in­di­cates that Se­ries D funds typ­i­cally pay trailer fees of 25 ba­sis points (bps) on an eq­uity fund rather than the 100 bps that’s com­monly paid on the full-ser­vice ver­sion of the same funds. This im­plies that about 75 bps is al­lot­ted to com­pen­sa­tion for ad­vice — and that tens of mil­lions of dol­lars a year col­lec­tively are be­ing paid for ad­vice that isn’t de­liv­ered.

In the wake of both the IIROC guid­ance and the pro­posed clas­s­ac­tion law­suit, in­vestor ad­vo­cates, who have long com­plained about the fair­ness of funds pay­ing trail­ers to dis­count bro­ker­ages, are hope­ful that the CSA fi­nally will take de­fin­i­tive ac­tion.

“We be­lieve the pro­posed [TDAM] class ac­tion and the new guid­ance from IIROC re­gard­ing the pay­ment of trailer fees to dis­count bro­kers high­light an ex­ist­ing broad prac­tice, which demon­strates baldly how em­bed­ded fees can be ap­plied de­cep­tively and harm re­tail in­vestors,” says Frank Allen, ex­ec­u­tive di­rec­tor of the Cana­dian Foun­da­tion for Ad­vance­ment of In­vestor Rights (a.k.a. FAIR Canada) in Toronto. “Even [do-it-your­self ] in­vestors, who are nei­ther seek­ing nor re­ceiv­ing any ad­vice, pay for it through Se­ries A mu­tual funds.”

In­deed, de­spite the avail­abil­ity of Se­ries D funds, the vast ma­jor­ity of mu­tual fund as­sets un­der man­age­ment (AUM) held through dis­count bro­ker­ages is in mu­tual funds that pay full trailer fees.

In fact, as of Dec. 31, 2015, there was about $30 bil­lion in mu­tual funds held through dis­count bro­ker­ages — an es­ti­mated 83% of which was held in mu­tual funds that pay full trail­ing com­mis­sions to the dis­count bro­ker­ages, ac­cord­ing to the CSA’s 2017 pa­per on em­bed­ded com­mis­sions.

Only about $4.6 bil­lion of mu­tual fund AUM held through dis­count bro­ker­ages was held in Se­ries D funds, which in­di­cates that many in­vestors ei­ther aren’t aware of the avail­abil­ity of Se­ries D funds or don’t have ad­e­quate ac­cess to them.

If 75 bps in an­nual trail­ers is be­ing paid for ad­vice on the re­main­ing $25 bil­lion in AUM, those in­vestors could be pay­ing $187.5 mil­lion a year col­lec­tively in fees for ad­vice they don’t re­ceive. Of course, this amount is only a rough cal­cu­la­tion and doesn’t ac­count for the as­set mix of these funds or fac­tor in the strong growth i n mu­tual fund AUM over the past few years.

In­vestor ad­vo­cates want the CSA to step up and take ac­tion to re­solve this long­stand­ing is­sue.

“The CSA’s pol­icy re­sponse on em­bed­ded com­mis­sions can, and must, fully ad­dress these per­ni­cious types of ar­range­ments, which can silently de­prive Cana­dian re­tail in­vestors of a sig­nif­i­cant por­tion of their in­vested funds over time,” Allen says.

The CSA’s lat­est con­sul­ta­tion pa­per on em­bed­ded com­mis­sions ac­knowl­edges that con­cern. The pa­per cites the dis­count bro­ker­age com­pen­sa­tion is­sue as one ex­am­ple of the harm em­bed­ded com­pen­sa­tion causes.

Specif­i­cally, the CSA pa­per points to the is­sue of dis­count bro­ker­ages re­ceiv­ing trail­ers for ad­vice as ev­i­dence that em­bed­ded com­pen­sa­tion “mis­aligns” what in­vestors pay with what they re­ceive from the in­vest­ment in­dus­try. Fur­ther­more, the CSA pa­per sug­gests that lack of un­der­stand­ing of fees among in­vestors also is prob­a­bly a fac­tor that re­sults in in­vestors col­lec­tively pay­ing mil­lions of dol­lars each year for ad­vice they don’t re­ceive.

Tr a d i t i o n a l l y, reg­u­la­tors have tried to ad­dress this poor un­der­stand­ing of the costs of in­vest­ing with height­ened dis­clo­sure, the most re­cent ex­am­ple be­ing the sec­ond phase of the client re­la­tion­ship model (CRM2). The re­quire­ments of that model, which have been fully im­ple­mented, are de­signed to pro­vide in­vestors with much bet­ter in­for­ma­tion about what they’re pay­ing in or­der to in­vest. Yet, some or­ga­ni­za­tions now view CRM2 as in­ad­e­quate.

N o t a b l y, the Mu­tual Fund Deal­ers As­so­ci­a­tion of Canada (MFDA) is­sued a pa­per i n mid-April that pro­poses ex­pand­ing what’s cov­ered i n the cost dis­clo­sure in­vestors re­ceive un­der CRM2. The MFDA’s pro­posal, of­ten re­ferred to as CRM3 within the in­dus­try, seeks to en­hance the CRM2 dis­clo­sure re­quire­ments to cap­ture in­vestors’ costs more fully.

CRM2 re­quire­ments fo­cus on the costs paid to deal­ers, but don’t in­clude some of the other costs that in­vestors may in­cur, such as cer­tain ad­min­is­tra­tive ex­penses, re­demp­tion fees and short-term trad­ing fees. The MFDA’s pa­per sug­gests that ex­pand­ing the CRM2 re­quire­ments to pro­vide in­vestors with dis­clo­sure of these other costs would give in­vestors a truer pic­ture of the full costs of in­vest­ing and al­low for bet­ter in­vest­ing de­ci­sions.

Al­though the in­dus­try ini­tially fought against the CRM2 re­quire­ments, it has been more wel­com­ing to­ward CRM3 — par­tic­u­larly if it dis­cour­ages the CSA from ban­ning em­bed­ded com­pen­sa­tion struc­tures.

Al­though there was ini­tial op­po­si­tion to CRM2, the re­cep­tion to CRM3 has been favourable

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