OSC sets sights on new tar­gets

The reg­u­la­tor is look­ing at pro­hib­ited com­mis­sions struc­tures

Investment Executive - - FRONT PAGE - BY JAMES L ANGTON

the first no-con­test set­tle­ment be­tween an in­vest­ment in­dus­try firm and se­cu­ri­ties reg­u­la­tors, reached in Canada in 2014, be­gan a suc­ces­sion of cases in which firms were ac­cused of sys­tem­at­i­cally over­charg­ing re­tail in­vestors. Now, reg­u­la­tors are set­ting their sights on the in­vest­ment in­dus­try’s in­cen­tive prac­tices as the next tar­get for se­rial en­force­ment ac­tion.

In mid-June, the On­tario Se­cu­ri­ties Com­mis­sion (OSC) an­nounced a set­tle­ment with Toronto-based mu­tual fund dealer Royal Mu­tual Funds Inc. (RMF) in which the firm agreed to pay a $1.1-mil­lion penalty af­ter ad­mit­ting to vi­o­lat­ing se­cu­ri­ties rules. RMF paid fi­nan­cial ad­vi­sors af­fil­i­ated with the com­pany higher com­mis­sions for sell­ing RMF’s in-house port­fo­lio mu­tual funds rather than its stand-alone mu­tual funds or third-party mu­tual funds.

Ac­cord­ing to the set­tle­ment,

RMF paid ad­vi­sors af­fil­i­ated with the firm an ad­di­tional 10 ba­sis points (bps) for sell­ing RBC Port­fo­lio Se­ries funds be­tween 2011 and 2016. That ar­range­ment vi­o­lated the mu­tual fund sales prac­tice rules, which are de­signed to pre­vent firms from pro­vid­ing their ad­vi­sors with in­cen­tives to favour in-house mu­tual funds vs third-party coun­ter­parts.

Al­though the RMF case is the lat­est in a string of re­cent en­force­ment ac­tions tar­get­ing vi­o­la­tions of the sales prac­tices rules, the case is the first to re­veal firms uti­liz­ing pro­hib­ited com­mis­sions struc­tures. Un­til now, the cases the OSC has brought forth al­leg­ing sales rule vi­o­la­tions in­volved firms over­step­ping re­stric­tions on the “win­ing and din­ing” of ad­vi­sors and over­spend­ing on the trin­kets that in­vest­ment fund firms give to in­gra­ti­ate them­selves with deal­ers.

The RMF case was un­cov­ered as part of a joint re­view of in­dus­try com­pen­sa­tion prac­tices by the OSC and the Mu­tual Fund Deal­ers As­so­ci­a­tion of Canada (MFDA). It also is the first to tar­get po­ten­tially trou­ble­some com­mis­sion struc­tures.

Ear­lier this year, the MFDA brought an en­force­ment case of its own against Toronto-based Sun Life Fi­nan­cial In­vest­ment Ser­vices (Canada) Inc., which in­cluded al­le­ga­tions that the firm vi­o­lated the sales rule by op­er­at­ing cer­tain in­cen­tive pro­grams that re­lied solely on sales of Sun Life’s in-house funds. How­ever, the OSC’s case against RMF is the first to tar­get in­vest­ment in­dus­try com­mis­sions struc­tures specif­i­cally — and un­likely to be the last.

Karen McGuin­ness, se­nior vice pres­i­dent, mem­ber reg­u­la­tion, com­pli­ance, at the MFDA, con­firms there are other en­force­ment cases in the reg­u­la­tors’ pipeline stem­ming from the joint MFDA/ OSC re­view of in­dus­try in­cen­tive pro­grams that un­earthed RMF’s sit­u­a­tion. She notes that fu­ture cases could come from either the MFDA’s en­force­ment de­part­ment or from the OSC.

Whether these types of salesin­cen­tive vi­o­la­tions are as per­va­sive as over­charg­ing clients has proven to be is not clear. But cases re­gard­ing in­cen­tives prob­a­bly won’t be as costly for the in­dus­try as the cases re­gard­ing over­charg­ing clients were.

Whereas reg­u­la­tory ac­tions in­volv­ing over­charg­ing clients re­sulted in hun­dreds of mil­lions of dol­lars be­ing re­turned to in­vestors, the OSC doesn’t al­lege that in­vestors suf­fered any harm as a re­sult of the dis­torted com­mis­sions struc­ture in the case against RMF.

But just be­cause reg­u­la­tors don’t al­lege harm in an en­force­ment case doesn’t mean there wasn’t any harm in­flicted. Rather, there may have been harm that was too dif­fi­cult to prove or un­rea­son­ably hard to quan­tify.

In the RMF case, the reg­u­la­tors found that the ex­tra 10 bps paid to ad­vi­sors for sell­ing in-house port­fo­lio funds amounted to $24.5 mil­lion in ad­di­tional com­mis­sions for ad­vi­sors dur­ing those five years — about $5,500 per ad­vi­sor per year. This im­plies that the firm sold ap­prox­i­mately $24.5 bil­lion in port­fo­lio funds dur­ing that time.

Al­though reg­u­la­tors don’t al­lege that the bil­lions of dol­lars that these funds at­tracted did any dam­age to in­vestors, in­vestor ad­vo­cates ques­tion that part of the set­tle­ment.

“We re­main skep­ti­cal that al­most $25 mil­lion in ad­di­tional pay­ments were made with­out af­fect­ing the ad­vice pro­vided to clients who ex­pect their best in­ter­est to come first, not their rep­re­sen­ta­tives’ el­i­gi­bil­ity for en­hanced com­pen­sa­tion pay­ments,” says Frank Allen, ex­ec­u­tive di­rec­tor of Toronto-based ad­vo­cacy group the Cana­dian Foun­da­tion for the Ad­vance­ment of In­vestor Rights (a.k.a. FAIR Canada).

In the­ory, if clients paid higher man­age­ment fees for the units in the port­fo­lio funds that were bought than if units in com­pa­ra­ble stand-alone funds were bought, or if the funds in which those clients in­vested suf­fered weaker per­for­mance, then those clients may have suf­fered as a re­sult of the dif­fer­en­tial com­mis­sions struc­ture.

To as­sess the ex­tent to which in­vestors may have paid ex­cess fees or suf­fered lag­ging per­for­mance, reg­u­la­tors would have to de­ter­mine which funds in­vestors could have bought in­stead of the port­fo­lio funds. In ad­di­tion, the reg­u­la­tors also would have to prove that the ad­di­tional (in­cen­tive) com­mis­sions for ad­vi­sors were the rea­son clients ended up in­vest­ing in in-house port­fo­lio funds.

In com­par­i­son, the dam­age to in­vestors is much more straight­for­ward to iden­tify and to quan­tify in the over­charg­ing cases, which have pro­duced — and still are pro­duc­ing — a se­ries of no-con­test set­tle­ments. In those cases, clients ob­vi­ously were harmed when they held the higher-cost ver­sion of a given mu­tual fund de­spite qual­i­fy­ing for a cheaper edi­tion of ex­actly the same prod­uct.

The lat­est no-con­test set­tle­ment in these over­charg­ing cases came in early June, when the OSC reached a set­tle­ment with a pair of deal­ers op­er­at­ing un­der Mis­sis­sauga, Ont.-based In­vest­ment Plan­ning Coun­sel Inc.’ s (IPC) um­brella. In this case, the OSC al­leged that the IPC deal­ers over­charged clients by fail­ing to place these clients in the low­er­cost ver­sions of spe­cific funds and by plac­ing clients with fee­based ac­counts into as­sets that also carry em­bed­ded fees.

Hav­ing al­ready con­cluded sim­i­lar cases with af­fil­i­ates of all the ma­jor banks, the case against the IPC deal­ers re­sulted in a $460,000 penalty as­sessed on those deal­ers in ad­di­tion to the $11 mil­lion they’re pay­ing back to the clients who were over­charged.

The OSC re­ports that it has con­cluded 11 no-con­test set­tle­ments, re­sult­ing in a com­bined to­tal of $368 mil­lion be­ing re­turned to in­vestors. As the dis­cov­ery of the sys­tem­atic over­charg­ing of re­tail in­vestors by the Cana­dian in­vest­ment in­dus­try con­tin­ues to play out, reg­u­la­tors are un­cov­er­ing other in­dus­try prac­tices that may put clients at a dis­ad­van­tage. For in­vestor ad­vo­cates, this points to a fun­da­men­tal vul­ner­a­bil­ity of in­vestors.

“While OSC staff did not al­lege any harm [was done] to clients who were sold in­vest­ments in the pre­ferred pro­pri­etary mu­tual funds,” Allen says, “FAIR Canada be­lieves [the RMF] case high­lights the se­ri­ous con­cerns that con­flicted com­mis­sion and in­cen­tive ar­range­ments present for re­tail mu­tual fund in­vestors in Canada.”

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