On January 7, 2011 IIROC published its latest request for comments on proposals to implement the Client Relationship Model (CRM). Comments are due by March 8, 2011 and should be addressed to:
Richard J. Corner
Vice President, Member Regulation Policy
Investment Industry Regulatory Organization of Canada
Suite 1600, 121 King Street West
Angie F. Foggia
Policy Counsel, Member Regulation Policy
Investment Industry Regulatory Organization of Canada
Suite 1600, 121 King Street West
A second copy should be addressed to the attention of:
Manager of Market Regulation
Ontario Securities Commission
20 Queen Street West
19th Floor, Box 55
The notice and attached draft rules can be found at click here. Comment letters will be published on IIROC's web site.
The current proposals reflect changes made in response to the publication in April, 2009 of a previous request for comments on the CRM proposals.
A bit of background
Before going into the proposals in detail, it may be useful to recall the history of this effort. It all started with a proposal by the OSC for something called the "Fair Dealing Model." The name was later changed to cover up the initial attitude of the whole proposal, which is that all that existed at the time was unfair dealing.
The Fair Dealing Model sprang from a simplistic view of the investment world, the premises of which we would summarize as follows:
1. All investors are the same. They start the investment process as simple children, devoid of any knowledge and therefore ready victims of the unscrupulous advisor. And unfortunately, most advisors are unscrupulous.
2. The current requirements placed on investment advisors, like KYC and suitability, are ineffective. In essence, government regulation and self-regulation are lost causes.
3. The only way to ensure "fair dealing" is by teaching these poor saps (investors) everything they need to know about investing and informing them of everything that's being done to them in excruciating detail. That way they will recognize when they are being cheated and take steps to stop it.
Quite aside from the inanities of this view of the world, we all know that if it were accurate there is simply nothing that some new set of requirements could do to change things. If the current rules don't work, what makes anyone think that a new set would?
Nonetheless, the OSC persisted, partly by forcing implementation on the SROs and partly by getting the buy-in of a reluctant CSA by softening the hard edges (like changing the name) and making it part of the grand coming together of Provincial regulators in the Registration Reform Project that was destined to forestall forever further consideration of a national securities regulator.
Since its beginning as the Fair Dealing Model concept paper some seven years ago, the project has gone through several rounds of working groups, committees, in-person consultations and requests for comments. This is in fact the third round of requests for comments on specific rule proposals: the first in February 2008 and the second in April 2009 as noted above.
Now we stand second to none in our admiration for the amount of effort and thought that the SROs, both staff and Member committees, have, amidst much rolling of eyes, put into trying to turn this sow's ear into a silk purse. We say that even where we disagree with the result. They have, we think, used the opportunity to fill some gaps in the rules that needed filling. But overall, we just can't get away from the nagging thought that is always at the back of the mind when looking at these proposals - what is all this really going to accomplish?
The big picture
The current notice contains summaries of the IIROC Staff's responses to the most common criticisms of the proposal in the last round of consultation. We are therefore left wondering why this consultation is happening at all. We know that in most instances the industry tends wrongly to see something a regulator publishes for comment as a fait accompli. Comment letters can cause significant changes in initial proposals. But these aren't initial proposals. We have difficulty seeing how anything new can be said to effect changes, particularly where the IIROC staff and Board have already agreed to override fundamental industry objections. So we offer our comments for what they are worth, without no hope that we or anybody else can accomplish anything further.
The proposed rules have four areas of coverage:
- Relationship disclosure
- Conflicts of interest management/disclosure
- Suitability assessment; and
- Account performance report.
We will deal with each separately.
The latest notice also notes that the CSA is going to get into the act directly by proposing changes to National Instrument 31-103 - Registration Requirements and Exemptions to require new cost and performance reporting disclosure applicable to all registered dealers and advisers.
The proposed rules will mandate an initial plain language disclosure document entitled "Relationship Disclosure." The only change to this requirement since the last go-round is an expansion of the previous requirement that a dealer maintain a record of the client's acknowledgement of receipt of the disclosure document. The new version requires maintenance of a similar acknowledgement of 'receipt of the "know your client" information form.' It continues to allow some other form of acknowledgement than a signature, although states that a signature is preferred.
This being the only change in the face of any previous comments, the relationship disclosure requirements are clearly not going to change, so little further comment is required. But we'll make a few anyway. Here's what the disclosure will have to include:
D "A description of the types of products and services offered by the Dealer Member."
Why? A Dealer Member may offer all types of products and services that aren't of the remotest relevance to the client. Does a client opening a TSFA need to know that the dealer provides valuations to corporate clients?
D "A description of the account relationship to which the client has consented." The italicized bit appears in the notice but not the rule.
The client passivity in the formulation of the notice reflects the underlying philosophy carrying over from the Fair Dealing Model. The client never comes in wanting something concrete, the advisor proposes and the client consents.
Discount brokers get an exemption, rightly. Beyond that there is only managed or advisory, and we wonder why this wouldn't be apparent to the client without specific disclosure. After all, a managed account client signs something called a managed account agreement.
- "A description of the process used by the Dealer Member of assess investment suitability, including a description of the process used to assess the client's "know your client" information, a statement as to when account suitability will be reviewed and an indication whether or not the Dealer Member will review suitability in other situations, including market fluctuations."
C For a long time the suitability rules applied only when making a recommendation, but all the while dealers marketed themselves as advisors. So we are in agreement with putting ongoing suitability obligations, triggering events and all that, into the rules.
D But beyond the when, what is the point of explaining the how? Clients who go to dealers for advice expect good advice. If they want details about the why of a particular piece of advice, they should get it. But some general process description is just a waste of time; it will be lost on many clients and ignored by the rest. The result - more useless boilerplate added to all the stuff clients currently don't read.
CD"A description of all fees, charges and costs associated with operating the account and in making or holding investments in the account."
Fair enough, but already in the rules. We have previous expressed concern (see our Commentary No. 7 - December 2010) about anything other than generic disclosure about commissions.
- A description of account reporting the client will receive, including a statement identifying when account statements and trade confirmations will be sent to the client and a description of the Dealer Member's obligations to provide account performance information and a statement indicating whether or not percentage return information will be sent."
D Any client who doesn't know about statements, confirmations and obligatory performance information will soon find out, so why bother?
? As the provision of percentage return information is being made mandatory, there is no "whether or not" to deal with.
The sum total of all this? To us it seems like a couple of rule changes could have accomplished it all - mandating ongoing suitability obligations and a disclosure if the dealer member decides not to provide percentage return information.
Conflicts of Interest
After noting that conflicts of interest are already amply covered by existing rules, the notice explains that amendments have been made to "clarify the application of the general conflicts management/disclosure standard," principally by creating separate rules setting out the obligations of Approved Persons and Dealer Members.
We can't see how the proposed rules do anything but repeat what is already there in sections 13.4 to 13.6 of NI 31-103. One of the principles of Registration Reform was not to duplicate rules at two levels - Provincial regulator and SRO. This proposal is therefore going backwards.
(Aside - could conflicts of interest time not have been more productively spent reassessing the research restrictions in light of the last few years experience?)
Proposed changes to Rule 1300 will require a Dealer Member to make a suitability determination not only in accepting an order or making a recommendation, as currently required, but also in response to any of three triggering events:
- receipt of securities into a client's account
- change in RR, IR or portfolio manager
- a material change to the client's circumstances or objectives that has resulted in a revision to the client's KYC information as maintained by the Dealer Member.
We have not difficulty with the concept but:
- We wonder why a change in IR is included. By definition, IR's can only take orders - they can't give advice. So how can an IR be "responsible for [an] account" and how can a change in IR result in a requirement to assess the suitability of the portfolio? Does this mean that every time a RR loses a sales assistant registered as an IR every one of the RR's account has to be reviewed?
- We wonder about the requirement that the material change have "resulted in a revision to the client's KYC information as maintained by the Dealer Member." Surely the material change should be the trigger, not its recording on a form. If the RR fails to record a material change, is she or he then absolved of any responsibility to reassess the suitability of the client's portfolio in light of the change? We would have thought the latter failure to be the greater transgression, but apparently it pales against faulty record keeping.
Proposed new section 1300(s) clarifies that the dealer's obligation whenever a suitability review is required is to give appropriate advice to the client. Presumably this means that if the client insists, for example, in directing the dealer to enter an unsuitable order, the dealer can proceed once the suitability advice has been given and ignored. This would correct the problem we noted in the current and proposed plain language rule (see our Commentary No. 7 - December 2010) which effectively prohibits a dealer from taking an unsuitable order from a client even if the client has been warned that it is unsuitable.
The notice notes that revisions to a proposed guidance document on suitability assessment are being proposed "as a separate initiative." The original notice was published on October 2, 2009 and was the subject of our very first commentary. The notice makes it appear that we can expect a separate publication for comment of the revised guidelines, even though a black line version and responses to comments on the previously published version are included in an appendix to the current request for comments. If we are wrong in this interpretation, IIROC should clarify that it is expecting comments on the revised guidance as part of the response to the CRM proposals.
Performance reporting is probably the most controversial of the proposals. This is where IIROC seems to have been persuaded to adopt the investors as children attitude of the Fair Dealing Model. If there are different offerings in the market, investors can't be relied upon to select the dealer that offers the reporting they need. They can't keep their own records, can't figure out whether they are making or losing money or, even if they can, what kind of percentage return they are making.
The belief that every investor should get performance information is, of course, predicated on the belief that all investors rely totally on their RRs. The investor doing his or her own thing is off dealing with a discount broker. Performance results in an advisory setting are always the responsibility of the RR.
So all retail dealers will have to provide:
- Original cost and current market value information at least annually. This must be actual cost, not tax cost. The reason given for the adoption of actual cost is that "we believe original cost provides the most useful information for the purpose of account performance." How is not explained, and given that separate performance reporting is to be mandatory, the reason given is hardly persuasive. For many clients it is the tax cost that is most important. As for the many dealers who already provide tax cost, well they'll just have to add another column to their reports. No options allowed.
- Realized and unrealized income and capital gains and losses, at least annually.
- For accounts over a year old, 1, 3, 5 and 10 year and since account inception annualized compound percentage return, calculated using a time weighted or dollar weighted method acceptable to IIROC.
The reporting will have to cover all client securities held in nominee name or physically in client name and any securities held elsewhere for which the dealer receives compensation (i.e. client name mutual funds for which the dealer gets trailers).
The percentage return reporting is the major point of controversy. The main argument of the industry has been that percentage return reporting should be optional - a service offering and therefore a basis for competition.
IIROC's response? Only a full quote will do:
IIROC's primary mandate is however to protect the interests of investors and this responsibility involves, in part, setting minimum service levels for clients. IIROC's position is that it is reasonable to expect that clients receive position cost and account activity information to enable them to determine whether they have gained or lost money on the investments in their accounts and to receive percentage return information to enable them to determine the reasonableness of any gain or loss earned/incurred.
We could argue all day about most of this. Yes, IIROC is there to protect investors, but extending that objective to meaning it should set minimum service levels that don't really attack improper dealing is something new in securities regulation. Granted there are some service level regulations in place already, like transfer regulations, but they are clearly directed at preventing abuses: in the case noted, transfer delays that put the dealer's competitive efforts to retain clients ahead of the client's interest in a speedy transfer. We fail to see what abuses percentage performance return attacks that aren't covered by a host of other regulations already.
The IDA looked at mandated percentage return years ago and recognized all the difficulties involved. For example, in many cases, it will be redundant because the issuers themselves (we're talking about investment funds, of course) provide percentage return information themselves. In some cases pricing information is not available so, under the rules, the value of a position has to be set at zero. In other cases, like flow-through shares for example, a good deal of the benefit of the transaction is gained through tax benefits that may vary from client to client and are not reflected in the current price used to calculate percentage return. The conclusion was to pass a rule saying that a dealer does not have to provide percentage return information, but if it chooses to do so it must use a recognized method of calculation applied consistently.
We could also argue that the other performance disclosure requirements already provide the basic information a client needs to get at least a reasonable idea of how his or her investments are doing - but we forget, clients are too simple to understand anything but a single stark figure. Yet somehow these same clients are supposed to know whether their percentage return is good, bad or indifferent in relation to...what? Market indices showing returns on baskets of securities that would be totally unsuitable for them?
IIROC is the only regulator or SRO adopting this requirement. Others like the MFDA, FINRA and the FSA have looked at the issue and wisely turned away. The FSA requires it for managed accounts, but the IIROC rule covers all retail accounts, managed and advisory.
We usually deal at some length with the consequences of regulatory proposals, but think that in CRM's case they have been covered at length and are well understood to the industry.
The only thing we can add is the that IIROC's decision to venture into the kind regulatory nannyism that infected the original Fair Dealing Model is an aberration rather than a permanent change of course.
Under changes proposed last year, NI 31-103 would be re-titled: Registration Requirements, Exemptions and Ongoing Registrant Obligations for no good reason we can see. See our Commentary No. 6 - September 2010.
If this issue is of concern to you, Sutton Boyce Gilkes Regulatory Consulting Group can help you draft a comment letter.