SALES RULE

Vi­o­la­tions of the rule in­volve cer­tain in­cen­tives pro­grams

Investment Executive - - CONTENTS - BY JAMES L ANGTON

The MFDA is ramp­ing up en­force­ment of the mu­tual fund sales prac­tices rule due to in­creased con­cerns re­gard­ing con­flicts of in­ter­est.

al­though the mu­tual fund sales prac­tices rule has been on the books for al­most 20 years, en­force­ment ac­tions tar­get­ing vi­o­la­tions of the rule are be­gin­ning to emerge only now as reg­u­la­tors be­come in­creas­ingly con­cerned about con­flicts of in­ter­est.

The rule, which was adopted in May 1998, was one of the reg­u­la­tors’ early ef­forts to stamp out con­flicts of in­ter­est in the fund in­dus­try that could in­flu­ence fi­nan­cial ad­vi­sors’ ad­vice at the ex­pense of their clients’ best in­ter­ests. Yet, there has been lit­tle en­force­ment ac­tiv­ity in­volv­ing al­leged vi­o­la­tions of the rule’s re­quire­ments. That’s be­gin­ning to change. No­tably, the Mu­tual Fund Deal­ers As­so­ci­a­tion of Canada (MFDA) set­tled a case with Wa­ter­loo, Ont.-based Sun Life Fi­nan­cial In­vest­ment Ser­vices (Canada) Inc. in De­cem­ber 2017 that cited vi­o­la­tions of the sales prac­tices rule. That case re­sulted in a $1.7-mil­lion fine for Sun Life.

There are ad­di­tional en­force­ment ac­tions on the hori­zon.

How­ever, sev­eral months are likely to elapse be­fore these other cases are brought to a hear­ing, says Shaun De­vlin, se­nior vice pres­i­dent, mem­ber reg­u­la­tion, en­force­ment, with the MFDA.

De­tails of these other cases re­main un­der wraps un­til the en­force­ment ac­tions are made pub­lic. How­ever, Karen McGuin­ness, the MFDA’s se­nior vice pres­i­dent of mem­ber reg­u­la­tion, com­pli­ance, re­ports that the is­sues the self-reg­u­la­tory or­ga­ni­za­tion’s com­pli­ance depart­ment has re­ferred to en­force­ment in­volve al­leged vi­o­la­tions of the sales prac­tices rule. These cases stem from in­te­grated deal­ers op­er­at­ing com­pen­sa­tion or in­cen­tives pro­grams that favour in-house mu­tual funds over the third-party mu­tual f unds the firms also of­fer.

This is the type of fun­da­men­tal con­flict the sales rule was de­signed to elim­i­nate by guard­ing against in­cen­tives struc­tures and other in­dus­try prac­tices that could dam­age ad­vi­sors’ ob­jec­tiv­ity and harm clients’ in­ter­ests.

In par­tic­u­lar, the rule was crafted to tackle some of the more trou­bling prac­tices that were preva­lent at the time, such as mu­tual fund sales con­tests, lav­ish in­dus­try con­fer­ences in ex­otic lo­cales and com­pen­sa­tion struc­tures that ex­plic­itly re­ward the sales of cer­tain funds over oth­ers. All of these prac­tices could skew the ad­vice clients re­ceive, based on in­cen­tives of­fered to ad­vi­sors.

The MFDA’s case against Sun Life high­lights a cou­ple of ways in which the cen­tral ob­jec­tive of the sales rule can be vi­o­lated — both through firmwide in­cen­tives and in the ac­tiv­i­ties of spe­cific branches that re­ward ad­vi­sors for sell­ing pro­pri­etary funds rather than third-party prod­ucts.

In the Sun Life case, the MFDA found that the firm op­er­ated a cou­ple of long-stand­ing in­cen­tives pro­grams that fac­tored in only sales of pro­pri­etary funds — namely, funds from af­fil­i­ates Sun Life Global In­vest­ments (Canada) Inc. (SLGI) and CI In­vest­ments Inc. (CI). Ac­cord­ing to the set­tle­ment, those pro­grams were estab­lished in 1989 — be­fore the sales prac­tices rule took ef­fect. Yet, Sun Life failed to re-eval­u­ate these pro­grams to en­sure that they com­plied with the MFDA’s rule.

In­stead, these pro­grams “in­ad­ver­tently cre­ated in­cen­tives for ad­vi­sors to dis­trib­ute mu­tual funds of­fered by CI and SLGI rather than mu­tual funds of­fered by third par­ties,” the set­tle­ment states.

Sun Life’s pro­grams have been re­vised since to re­ward ad­vi­sors for their sales of pro­pri­etary and third-party funds alike, the set­tle­ment doc­u­ment notes.

In ad­di­tion to Sun Life’s firmwide pro­grams, the MFDA also found that a hand­ful of Sun Life branches (two in each of Man­i­toba, On­tario and Saskatchewan) also op­er­ated in­cen­tives pro­grams that re­warded ad­vi­sors, in part, for sales of Sun Life mu­tual funds with non-cash prizes, such as tick­ets to sport­ing events and trips.

Un­like the long-run­ning in­cen­tives pro­grams that were estab­lished be­fore the MFDA’s sales rule took ef­fect, these branch­spon­sored con­tests were much more re­cent phe­nom­ena — op­er­at­ing be­tween Jan­uary 2016 and May 2017.

This is an is­sue that may be catch­ing some firms by sur­prise, McGuin­ness says: “[Firms] know what head of­fice is do­ing with com­pen­sa­tion prac­tices, but know­ing when branch man­agers de­cide to take mat­ters into their own hands can be dif­fi­cult.”

The MFDA re­ports that it un­cov­ered these prob­lem­atic sales in­cen­tives pro­grams as part of a tar­geted com­pli­ance re­view of in­dus­try com­pen­sa­tion pro­grams, car­ried out i n 2016 i n con­cert with provin­cial reg­u­la­tors and the In­vest­ment In­dus­try Reg­u­la­tory Or­ga­ni­za­tion of Canada. The re­view also un­cov­ered the other in­stances of al­leged sales rule vi­o­la­tions now work­ing their way through the en­force­ment process at the MFDA.

Al­though the com­mon is­sue in each of these cases is com­pen­sa­tion struc­tures that favour in-house funds over third-party funds, the spe­cific prac­tices that caught reg­u­la­tors’ at­ten­tion varies from firm to firm, McGuin­ness says.

In­deed, the MFDA’s re­port on the re­view that un­cov­ered these is­sues notes that the firms in­volved had “multi-di­men­sional com­pen­sa­tion struc­tures” fea­tur­ing el­e­ments that favoured pro­pri­etary funds — such as bonuses or ad­di­tional com­mis­sions that are paid only for in­house funds — along with re­wards and re­tire­ment pro­grams that are struc­tured in a way that cre­ates in­cen­tives that favour pro­pri­etary funds. In some cases, the firms in­volved be­gan sell­ing third-party f unds only re­cently, but failed to re­jig their ex­ist­ing in­cen­tives struc­tures to level the play­ing field for in-house and third-party funds.

In ad­di­tion, reg­u­la­tors are be­gin­ning to en­force vi­o­la­tions of other as­pects of the sales prac­tices rule. For ex­am­ple, in the Sun Life case, the MFDA found that the firm hosted sev­eral con­fer­ences in 2015 and 2016 that didn’t com­ply with the MFDA’s re­quire­ments to the ex­tent to which fund com­pa­nies can fi­nance the cost of these events.

Reg­u­la­tors have been con­cerned about com­pli­ance with the re­quire­ments for pro­vid­ing in­dus­try con­fer­ences for a cou­ple of years. In 2016, the On­tario Se­cu­ri­ties Com­mis­sion (OSC) pub­lished guid­ance on com­ply­ing with spe­cific re­quire­ments in­volv­ing con­fer­ence ex­penses. The OSC’s first en­force­ment ac­tion in­volv­ing al­leged vi­o­la­tions of the sales prac­tices rule, brought forth last year, fea­tured al­leged vi­o­la­tions in­volv­ing con­fer­ences.

That case, brought against Toronto-based Sen­try In­vest­ments Inc., in­cluded al­le­ga­tions that the firm hosted a con­fer­ence in Bev­erly Hills, Calif., as well as pro­vided ex­ces­sive gifts to ad­vi­sors — such as tick­ets to the For­mula 1 race in Mon­treal — that also vi­o­late the sales rule.

This re­cent reg­u­la­tory at­ten­tion to in­dus­try con­flicts of in­ter­est raises the ques­tion of whether the sales rule should be broad­ened to cover a wider range of prod­ucts beyond mu­tual funds. In­deed, the MFDA re­ports that its re­view un­cov­ered sales prac­tices that would be pro­hib­ited if the prod­ucts in­volved were mu­tual funds.

Yet, at this point, deal­ers tech­ni­cally may not be off­side when they en­gage in prac­tices that would be pro­hib­ited in the mu­tual fund world, such as hold­ing sales con­tests for other types of prod­ucts.

This di­chotomy raises con­cerns that as mu­tual fund deal­ers ex­pand their busi­nesses beyond the tra­di­tional func­tion of ad­vis­ing on and sell­ing mu­tual funds, the rules that gov­ern con­flicts of in­ter­est may have to be ex­tended to other prod­ucts and busi­ness ar­range­ments.

The ques­tion of whether the sales rule should be broad­ened to cover a wider range of prod­ucts has been raised

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