More thoughts on best interest standards, regulation, common law and carve outs

Forgive me for posting less well prepared items, but time is short and the thoughts themselves are valid.  Noted below are some brief thoughts I sent in a recent e mail exchange (with some minor amendment) re the Ontario FINAL REPORT OF THE EXPERT COMMITTEE TO CONSIDER FINANCIAL ADVISORY AND FINANCIAL PLANNING POLICY ALTERNATIVES

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One thing that has become increasingly clear to me over the years is that many securities regulations, that are supposedly there to protect Canadian investors, appear to operate as de facto carve outs from common law duties.  

Under agency law an advisor acting under instruction to buy a security would not I believe be allowed to sell you a product that is more expensive than another (and pocket the difference without your knowledge) because he gets paid more for doing so; he would owe a duty of loyalty to the principal and not to the third party to do otherwise.  

From Disloyal Agents, Demott D, 2007: “only the principal can assess how best to further the principal’s own interests and objectives. The prospect of acquiring a side benefit may distract the agent from focusing on accomplishing the principal’s objectives by biasing how the agent interprets instructions received from the principal and understands what the principal wishes to achieve. This is so even when the side benefit received by the agent does not come at an explicit cost to the principal. If the agent, in contrast, duly discloses the prospect of the side payment, in determining whether to consent, the principal may assess how the payment may compromise or aid the agent’s performance. “ p1055

Current regulations allow advisors to earn more on some products than others, thereby disadvantaging the investor and this is compliant with securities regulation.  The present best interest standard proposals via the CSA Consult appear to me to be attempting to right this carve out in an attempt to prevent advisors from recommending higher cost similar products – this is a best product standard and conforms to agency law with respect to duties of loyalty and performance.  It is not a best interest standard for advice.

At a fundamental level a fiduciary standard is a legal obligation attached to a common law duty, and in the case of advice, this common law duty is applied to advice.  Securities Acts allowed a carve out from a fiduciary duty for advice incidental to the transaction in the US in 1940 and Canadian Securities Law, I believe, is drawn from this root.    At present there are no material regulatory or statutory protections for advice provided by dealing representatives in Canada and this is affecting legal decisions in terms of establishing the relationship deemed to be at issue. 

The “Suitability standard“ is a half way house, a recognition that advice is being provided, that the typical agency relationship of instruction is actually one that includes advice and that regulation of the transaction on its own omits important liabilities associated with this non regulated duty.  But how to acknowledge and regulate without attaching fiduciary duties?  The suitability standard!

The SBIS from the expert committee appears to be a best interest standard applied to advice with carve outs from common law that weaken the duties and obligations of the fiduciary duty.  The expert committee should provide an explanation as to what the carve outs are exactly.  Its standard complements the CSA proposed standard in that it deals with different duties: one is the best product, the other the best advice.   But the SBIS, as I said, has critical carve outs that would not, I presume, be allowed at common law.  

Critically from page 52 of the Expert Committee’s report:

Historically, the common law relating to fiduciary duties carries strict rules relating to loyalty and conflicts. Importing these rules to the financial sector would likely cause confusion, especially because breach of fiduciary duty may give rise to equitable remedies which may be more generous than is appropriate. A SBID would insulate against the importation of undesirable or unnecessary elements of a fiduciary duty, and permit a customized articulation of the standard that is tailored to the financial advisory context.

These carve outs will weaken attempts by individuals to take complaints to court in that a determination has already been made, at a statutory level, that the duty to advice in a client’s best interests is not a fiduciary duty as such and not deserving of its protection.

Note the following taken from my submission to the CSA Consultation 33-404

The issue of how courts interpret regulatory rules is discussed in the UK Law Commission’s 1995 review of Fiduciary Duties and Regulatory rules

Should fiduciary law take account of rules made by regulatory bodies operating in the public – law sphere? Our provisional view is that it should: either because there is statutory authority for rules to modify common law and equitable obligations … or because the court should take account of reasonable regulatory rules in ascertaining the precise content of the common law or equitable duty…our provisional view that problems of mismatch between what is required or permitted by regulatory rules and the obligations imposed on fiduciaries by the common law and equity lie principally in the field of financial services.”

“the decision to use a particular form of regulation and a particular regulatory body was a legislative one, and the regulatory bodies to whom Parliament has delegated the achievement of the new statutory purposes are likely to have expertise in the areas remitted to them….Thus, although the new system is described as self-regulating, it is the product of legislation and is a form of public law regulation. It is, therefore, appropriate to take some account of regulatory rules when assessing liability for an alleged breach of a fiduciary obligation.”

Issues with respect to CSA and Expert Committee Best Standard Proposals

A recent e mail exchange allowed me to briefly raise again some of my issues with the current proposed best interest standards; one of the held within the recent CSA consultation and the other in the recently released Expert Committee report .  I note my comments here mainly because they raise important issues that I have not previously emphasised.

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I do not believe that there is an existing Best Interest Standard for personalised investment advice in Canada; the personalised investment advice relationship under dealing representative categories is not recognised under the securities act and regulation. 

If there is a best interest standard it applies to the responsibilities of the broker relationship with respect to the scope of the transaction relationship as per agency law.  A best interest standard for the provision of personalised investment advice should be a fiduciary standard and I note that there are many academic and legal references to the fiduciary duties of agents with regard to the lesser common law scope of agency.

To gain a better understanding of the scope of the current best interest standard, as stated by regulators like IIROC, you need to understand the historical legal precedents and regulation applying.

I elucidate here with respect to an element of my understanding: http://blog.moneymanagedproperly.com/?p=5831 with respect to the historic of regulation and legislation.

There is nothing specific in the securities act, possibly because the basic common law duties of an agent are already covered and the act has its roots in regulating primarily transaction based relationships (Prof Deborah DeMott: “Basic unit of interaction in an agency relationship is not contract but instruction...”). 

Determining whether duties extend to the provision of personalised financial advice has hitherto been the realm of the courts, but the introduction of a best interest standard should have acknowledged, IMO, this duty for advisors (who represent themselves as providing these services) in statute (note no other jurisdiction that I have read has specifically attempted to distance their best interest standard from a fiduciary responsibility, indeed legislative intent has been that the best interest standard is a fiduciary duty – i.e. UK/Australia).  Instead regulators and expert committee have spent some time eviscerating these standards/principles of such responsibility.  

The best interest standard IIROC et al are confusing, I believe, is with respect to the scope of the traditional client/broker relationship and other activities of the dealing registration and not that of the provision of personalised investment advice.

From Arthur Laby’s Fiduciary Obligations of Broker-Dealers and Investment Advisers

“under agency principles, one’s fiduciary duties are tied to the scope of one’s responsibilities…Under agency law, the extent of one’s fiduciary duty is limited by the scope of one’s agency. The scope of one’s agency depends in turn on the power that the principal has accorded the agent over the principal’s interests. Thus, in determining the nature of a broker’s fiduciary duty, one must analyze the broker’s power over the assets or affairs of the customer. This principle often is stated in the language of trust: a broker’s fiduciary duty is limited to matters relevant to the affairs entrusted to him or her”

“The court stated that the fiduciary relationship between a broker and its customer is limited to the narrow task of executing the transaction…generally speaking, in the case of a non-discretionary account, brokers are not held to fiduciary standards, except perhaps in the narrow task of executing a trade…Why then did some nineteenth and early twentieth century courts hold that brokers were fiduciaries? The reason had little to do with the advisory function performed today. Cases that labeled brokers as fiduciaries centered more on execution or custody-non-advisory-related services-than on the provision of advice. Today, however, cases addressing whether brokers are fiduciaries focus heavily on the broker’s advisory function. The question often presented is whether an investor has placed sufficient trust and confidence in the brokerage firm to justify the imposition of fiduciary obligations. The trust and confidence referred to, however, is trust and confidence in the broker’s advice.”

But, as we know the nature and scope of the actual relationship has changed, and thus has the fiduciary duty implied likewise shifted to the wider scope.  As Laby says, fiduciary duties are defined by the scope of the relationship, so to say that fiduciary duties are impractical with respect to Canadian retail financial services to a certain extent ignores the fact that they already likely apply but are restricted in scope.  This restriction in scope is to the benefit of the industry and to the detriment of the individual investor. 

I am not a legal expert, but it would seem to me that the current regulation of the transaction has effectively allowed advisors to carve out exclusions from the fundamental duties of agency law with respect to the impact of commissions on fund selection, for example, re performance and loyalty.  The best interest standards proposed by the CSA and possibly the expert committee (I have not thoroughly reviewed this yet) seem primarily focused on reemphasizing these duties via a focus on what is really the best product, the transaction, as opposed to the best outcome, the personalised investment advice from which the transaction emerges. 

From Arthur Laby’s Fiduciary Obligations of Broker-Dealers and Investment Advisers ; “Although the scope of activity can be altered by contract, in the case of non-discretionary accounts, a broker’s activity generally is limited to conduct surrounding a particular transaction, whereas the scope of an adviser’s activity extends beyond a particular trade. The different scope of activity yields different duties….. If an adviser has agreed to provide continuous supervisory services, the scope of the adviser’s fiduciary duty entails a continuous, ongoing duty to supervise the client’s account, regardless of whether any trading occurs. This feature of the adviser’s duty, even in a non-discretionary account, contrasts sharply with the duty of a broker administering a non-discretionary account, where no duty to monitor is required.  The two accounts in this example are similar in nature-both the broker and the adviser hold themselves out as providing non-discretionary investment advice-yet the adviser’s duty entails ongoing diligence while the broker’s duty is episodic”

From “DISLOYAL AGENTS” Deborah A. DeMott: “The (US) common law defines agency as the “fiduciary relationship that arises when one person (a ‘principal’) manifests assent to another person (an ‘agent’) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents so to act…Moreover, agency law, at least in the United States, requires explicitly that an agent act “loyally for the principal’s benefit” in all matters connected with the agency relationship. A principal may reasonably expect loyal service, not simply the due performance of the agent’s other duties.

Someone obligated to act in their client’s best interests with respect to personalised investment advice has a different set of responsibilities to someone obligated to act in the best interests of their client with respect to the transaction within the scope of the traditional brokerage relationship.

The OSC BIS is not, IMO, a best interest standard for personalised investment advice, it is a best product standard (a de facto best interest standard for a transactional relationship) because its focus is on the end point of a process that is still attached to its fair dealing (transactional) root; in other words, paraphrasing Demott, a response to the basic unit of interaction of the agency relationship, the instruction.  

I believe the CSA consultation and quite likely the Expert Committee have muddied the water with respect to the best interest standard. 

Re the BIS/SBIS: what are its roots and where does it fit within agency law (does it reinforce, refresh or replace existing duties and if so which?) and what are the scope of the relationships being considered?  If the fiduciary duty is not being assigned to the provision of personalised investment advice then why not?  Is it through difficulty defining scope, in which case if the definition of scope and duty is being left to the courts what on earth is the standard itself and its weight and why risk defining a duty at all if not to aid clarity with respect to the duty at common law?  We know that courts take note of regulatory declarations of duties and their accountability.

The Expert Committee’s BIS wishes to keep out undesirable elements of fiduciary duty with respect to loyalty and conflicts.  Yet, if we look at US commentary, fiduciary duties would already appear to exist at common law with respect to the narrower scope of agency, so just what are these undesirable elements and what components of these elements are they excluding?  

Andrew 

Fiduciary Obligations of Broker-Dealers and Investment Advisers – http://digitalcommons.law.villanova.edu/cgi/viewcontent.cgi?article=1050&context=vlr

CURRENT ISSUES IN FIDUCIARY LAW SEC v. CAPITAL GAINS RESEARCH BUREAU AND THE INVESTMENT ADVISERS ACT OF 1940 – http://www.bu.edu/law/journals-archive/bulr/documents/laby.pdf

The Fiduciary Character of Agency and the Interpretation of Instructions By Deborah A. DeMott* http://www.law.harvard.edu/programs/olin_center/papers/pdf/323.pdf

DISLOYAL AGENTS Deborah A. DeMott – http://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=2481&context=faculty_scholarship

My take on Best Interests: The CSA’s Roundtable on Consultation Paper 33-404, 6 December 2016

What was my main takeaway from the roundtable with respect to best interest standards?

Not only was there a lack of overt consensus over exactly what the proposed best interest standard is, but the elephant in the room, the distribution model, around which the standard is to be wrapped, was left unmentioned.  Or was it?

In Maureen Jensen’s introduction she made the following statement: “But any changes that we’re going to make must be appropriate for Canadian investors and the Canadian marketplace.” 

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Double charging/dipping on fee based transaction accounts in Canadian Retail Financial Services

Double dipping is where “advisors” and/or their firms charge investors, with fee based transaction accounts, a fee on their accounts at the same time as taking commissions and other transaction returns on the underlying investments.  Since these accounts are meant to swap payment of transaction remuneration on securities held within the accounts for a simple annual fee that favours those with high levels of transactions, knowingly taking commissions and other transaction returns on investments held within these accounts would be a fraudulent act.

Double dipping appears to be a systemic issue in Canada with TD, CIBC, HSBC and Scotia all having been found wanting in this respect.   Canada’s regulators have, for some reason, decided to treat these breaches of firms’ and registrant obligations and regulations as uncontested settlements with no admission or denial of the charges, and have to date seemingly relied on self reporting of issues.

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Will the real Best Interest Standard Please Stand……..UP!

Further comment on the CSA “PROPOSALS TO ENHANCE THE OBLIGATIONS OF ADVISERS, DEALERS, AND REPRESENTATIVES

In 2012 we were led to believe that the CSA was looking to introduce a fiduciary type best interest standard into the Canadian retail financial services market. The CSA referred to a “statutory fiduciary duty” which “would likely support a private law cause of action for damages by a beneficiary against a fiduciary…The principal question is whether advisers and dealers should have an obligation to act in the best interests of their clients when providing advice to them. “

The current CSA Consultation states that its best interest standard is not a fiduciary duty and would not interfere with existing client/registrant relationships. The standard would be a standard of care and operate as a principle. The CSA document did not explain the reasoning behind the framing of the rule but it may have left some clues.

My attention was drawn to the fact that the “best interest standard” was to be inserted into the existing obligation to “deal fairly, honestly and in good faith”.

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Best Interest Standards And Legislative Intent: a global view

In conclusion, Europe, Australasia and the US have all exhibited legislative intent with respect to implementing best interest/fiduciary standards for part or all of the investment advisory market place; Europe to date is set to implement best interest standards for the wider market place and much more restrictive and higher standards for those who wish to be seen to be delivering independent financial advice.

Canada is the odd one out! It neither has legislative interest in best interest standards nor does it have unified regulatory interest in best interest or fiduciary standards. Indeed, its best interest standard, as should become clear, is not a best interest standard per se but a best product standard, which places Canada’s regulation, in say UK regulatory time, somewhere in the mid 1980s.

I append a section from my submission to the CSA CONSULTATION PAPER 33‐404 PROPOSALS TO ENHANCE THE OBLIGATIONS OF ADVISERS, DEALERS, AND REPRESENTATIVES TOWARD THEIR CLIENTS, April 28, 2016

UK

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The Tone From the Top: The CSA’s Best Interests Standard Consultation

A few submissions picked up the nuance in the proposed best interest standard, but not all.  As with much change in the regulation of the retail side, it started out as intended and got beaten down.  Like many things in Canada’s financial services industry you really have to know what you are doing.  Otherwise you have no other choice but to trust in the expertise and professionalism of those you rely on for advice or protection from bad advice.  

The OSC (Ontario Securities Commission) and the FCNB (New Brunswick Commission) are in favour of watered down change that is being paraded as the real deal, but in truth is not.  I do not blame them for trying to salvage something from the grand project.  The BCSC (British Columbia’s Securities Commission) is not and does not even want to hear Canada’s voice on the issue.  The rest have “reservations”. 

I think the fact that most Canadian regulators (our regulators are provincial) appear not to believe it is important for advisors to act in investors’ best interests is poignant.  Pure and simple it means regulators are not willing to act in investors’  best interests.  This is amongst other issues a tone from the top!    

If you cannot trust your advisors and you cannot trust your regulators, then who can you trust, and for what?  There are a few canaries in the coal mine, the OBSI being the most important, but these look like they can keep on singing, for no one who counts appears to want to hear them.  

In other countries the tone has been set by the legislature, that is the democratically elected government.  Governments around the world have pushed for higher standards. 

The lack of tone in Canada goes all the way to the top! And so here is the introduction to my submission:

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The Consultation discusses a “best interest standard” for the Canadian Retail Financial Services Market place. The standard is stated as a standard of care and is effective in regulation as a principle (as per statements made in the benefits of a best interest standard) and not a rule. The proposed best interest standard is an about turn from the 2012 statement of intent which was framed as a fiduciary standard and a marked change in direction from the 2004 Fair Dealing Model which acknowledged that the relationship in the industry had transitioned from that of providing transactions and incidental advice to that of advice and incidental transaction.

The proposed standard is not a best interest standard. The CSA or rather the OSC and the FCNB have distanced it from a fiduciary duty and thus removed its regulatory intent and have clearly stated that it will not interfere with current registration categories. This is material. One of the reasons for introducing a best interest standard was to acknowledge that the advisory relationship no longer remained that of an arm’s length commercial relationship where common law would only grant a fiduciary relationship under extreme circumstances, but one where the representation of service had moved to that of the provision of advice and the duties thus elevated. The consultation provides clear instructions to the courts that the relationship is transactional, of the product, where advice is episodic and incidental.

Instead, the consultation, as part of the Proposed Targeted Reforms, has recommended that services that provide advice under a discretionary authority be accorded a clear statutory fiduciary duty. Investors receiving advice under non discretionary mandates, which rely on the same processes, should not be accorded less protection and lower standards of care. The fiduciary liability with respect to advice is represented by the gap between service representation and the integrity of a firm’s service processes to deliver the represented standard of service. These are processes over which the advisor and firm have complete discretion. We know that service representation does not promote the advisor as just a product seller, but this is the relationship which the CSA are regulating and failing to disclose.

To have a fiduciary duty for the provision of investment advice means that you are responsible for making sure that the representations of service are matched by the processes that construct, plan and manage. The Consultation has therefore framed the advisory service as one focused primarily on the point of the transaction. The act of according fiduciary status to the discretionary form of the advice has thus isolated the non discretionary service as one without discretionary process worthy of reposing trust, and placed investors advised under these services to a far lower standard of investor protection and regulatory care. The CSA has effectively prioritised the interests of the industry over those of the client. In this instance, and given the presumption that transaction remuneration is set to continue (note the extensive work on conflicts of interest in the consultation) it is difficult to see how instructions to registrants to prioritise investors’ best interests possess any rigour or tone from the top.

Instead of noting the fiduciary liability that exists via industry representations of service, the consultation chooses to focus on consumers’ misplaced trust and behavioural issues as two of the core reasons behind impaired service outcomes; that and a need to make regulatory expectations with respect to suitability clearer and enforcement of rules more effective. The consultation appears to ignore its own research, with the exception of the Brondesbury report laden with bias over investor responsibility (support for which was not found in any of the research referenced in the report), and the burgeoning literature in this area.

Canada stands alone in the world with its intent to distance itself from imposing fiduciary standards and higher professional standards for the provision of investment advice, and I detail the arguments for this in the submission. In Australia, UK and the US there is clear legislative intent to establish fiduciary standards and while the term fiduciary does not appear in UK and Australian rules for reasons of definition, it does appear in legislative intent. In the US there is both legislative intent and common law precedent for fiduciary duties for non discretionary investment advice. Canada is the only jurisdiction where there is a complete absence of legislative involvement, where the blame for impaired outcomes fails to mention the role of advisors and industry. What would a reasonable person think? A reasonable person would think that regulators are not concerned about advice, but about maintaining the market for products as is.

The proposed best interest standard is nevertheless a progress of sorts. But it is not a best interest standard, rather it is a best product standard and should be inserted as such, either as principle or as a rule into current regulation. It should not be termed a best interest standard as it will further the misunderstanding and misrepresentation of service, exacerbating the existing and unattended fiduciary liabilities within the system. Likewise the Proposed Targeted Reforms, irrespective of how unwieldy and complex they are going to be to regulate and comply with, represent some progress with respect to the standard of care in the suitability assessment.

But the progress is minor and the fractures in the system are clear. We cannot continue to stretch the transactional model. Investment is process driven, if the industry is to evolve regulators needs to encourage the development of process for the construction planning and management of assets, not regulations for transaction compliance. The Proposed Target Reforms talk of pushing transaction ideas through a suitability assessment, but the reality is transactions should come out of such a process. This is all back to front. In order to solve issues such as the advice gap, a problem not occasioned by regulatory change, but a persistent and long standing problem of the masses, we need to develop process. The reason why the advice gap has taken centre stage is because process has taken centre stage and the imperative of process is where the future of the industry lies.

The CSA may have good intent but its ignorance over investment process and construct is obscuring its understanding of the problem. It wishes to keep the horse and cart and forsake the car, to regulate the car as if it were the horse and cart, to blame the outcome and to effectively enforce consumers to comply with an archaic understanding of the financial services industry.

Presentation to the Expert Committee To Consider Financial Advisory And Financial Planning Policy Alternatives on Behalf of SIPA

Please note the following small presentation I provided with respect to the above on behalf of the Small Investor Protection Association on 3 May in Toronto.

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The Small Investor Protection Association fully supports recognising the importance of professionalism in financial planning. 

Financial planning is an important component of a wealth management universe focused on the processes and frameworks that underpin the efficient planning, construction and management of personal financial assets and their liabilities over time.  

Wealth management is a complex area and those firms and individuals providing advice within it have considerable discretion over the processes that plan, structure, manage, educate and communicate.  We believe that this discretion, the complexity of the processes and the asymmetry of knowledge and experience place the professional advisor and the firm in a position of great responsibility.  SIPA believes that this places fiduciary duties, accountabilities and responsibilities on advisors for the processes that plan, structure, manage and communicate outcomes irrespective of whether the service’s nomenclature is discretionary or advisory and irrespective of title.   

Existing regulation, at the advisory level, needs to widen its remit to those services’ processes that underpin wealth management outcomes and away from a predisposition with the transaction.

It fully supports raising the standards and the integrity of service processes involved in the planning the construction and management of financial needs service processes while deemphasising the role of the transaction in process, regulation and remuneration.

The problems we see in the delivery, quality and accountability of service outcomes lie with a system that rewards the transaction and that overly focuses on the transaction in its service processes.  The focus on the transaction de-emphasises the importance of construction, planning and management in advice based service processes and constrains the development of services that put the client’s best interests first and foremost in the process.  The current system does not operate wholly in the best interests of the investor, whether this is at the advisor, firm or regulatory level.  

As the CFA institute and the Canadian Advocacy Council for Canadian CFA Institute Societies both point out, “the current regulatory scheme is incomplete”. 

SIPA is concerned over the division amongst Canadian regulators as to the merits of introducing best interest standards and the removal of commissions.  It is also concerned that even the proposed statutory best interest standard may itself be diminished by industry interests and calls on Canada’s democratically elected legislatures to become directly involved in the modernisation of Canada’s regulatory system. It believes that advisors’ responsibilities and duties with respect to advice, processes and communications are indeed fiduciary ones. 

And from SIPA’s own submission on the subject:

“This illusion fed to the general public is unfair. It results in many personal tragedies when hard working people lose their lifetime savings quite often late in life when they do not have the time to recover. It creates desperate life-altering events that result in health issues, loss of hope and faith, disruption of families and sometimes victims taking their own life.”

We live in a trusting society. Canadians believe they can trust professionals that are regulated like doctors, lawyers and other professionals. Yes, they trust their “Financial Advisors” because they believe they are regulated professionals. They are not aware they are simply sales persons without responsibility to look after clients’ best interests; they do not feel a need to study medicine or a need to study finance and investments. They are busy with careers and family.

A small investor exclaims and asks “why are regulators not collecting fines for serious violations of securities regulations?”!

This is a brief post on a very important and highly complex issue that cannot be done justice in the space provided.  There are many issues today, in Canada’s financial services industry, where funding for independent research of issues impacting consumers would be of tremendous value to the continuing debate over standards and regulation

Canada’s Small Investor Protection Association (a small non profit organisation that serves as a voice and resource for Canadian investors who have been subjected to financial abuse and/or bad advice by the financial services industry) recently released a report by one of its members on unpaid fines levied by regulators on industry participants but which have not yet been collected.  The report has been discussed in numerous articles, the most detailed of which is found in a piece written by Yvonne Colbert of CBC news.

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Comments on Advocis’ Consumer VOICE Survey 2015 – Part 1

It is frustrating to see so much energy expended on trying to argue what should be, so clearly, an indefensible position: that commissions are such an essential part of the provision of professional financial advice that their removal would destroy the value, rational and delivery of advice itself.     

Advocis’s Consumer Voice Survey 2015, “Investor Insights on the Financial Advice Industry” makes some bold statements about the risks to the provision of advice in the event of a ban on commissions and reports on what I believe to be a heavily biased survey of “consumer views” on the value of advice, conflicts of interest and the impact of commissions on financial advice.  I will delve further into this report in a subsequent post.

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Regulators have been attempting to live with the addiction for too long: end it in the best interests of all.

ADVOCIS talk with gusto about the need for change and the importance of advice, but when it comes down to the most obvious of all the required changes, removing the conflict that stands in the way of best interests’ advice, they appear blindly intoxicated by the charms of the conflict itself. What would Socrates have said about an organisation that placed commissions at the centre of its reason for being?

The Second of two research pieces commissioned by the CSA, a report titled “A Dissection of Mutual Fund Fees, Flows, and Performance ” prepared by Professor Cumming of York University-Schulich School of Business, as part of its review of “how embedded compensation could give rise to actual or perceived conflicts of interest”, is now out.  

The report is the first of its kind to analyse Canadian mutual fund flows, mutual fund fee structures and performance.   The international body of work in this area is large and it is no surprise that the Cumming’s report conclusions largely reflected this much wider body of work. 

The report confirms that mutual fund flows are impacted by embedded commissions, that where embedded commissions exist flows are much less influenced by past performance and that even performance (at the gross return level) is negatively impacted by progressively higher embedded commissions.  So yes, at a purely impersonal data level, embedded commissions give rise to actual conflicts in fund distribution: these conflicts are highlighted by the sensitivity of flows to compensation as opposed to performance.

No surprise then that the trade body representing financial/investment advisors in Canada, Advocis, cautions against reading too much into the report:

“any decisions with respect to product sales or offerings in the market place must ensure that advice is broadened not restricted”

“it appears that the report does not consider the monetary value of the financial advice provided to client”.

Advocis is a staunch supporter of commissions which they say are integral to the advice industry in Canada: commissions they say allow advisors to service the smaller investor and their removal will restrict the availability of advice for the smaller investor and should not be entertained.  

Advocis is also coincidentally championing an upgrade to financial advice in Canada, promoting higher standards of professionalism and enhanced training as keys to improving financial advice and consumer protection.  In its recent submission to  the “Expert Committee to Consider Financial Advisory and Financial Planning Policy Alternatives”, it made the following observations:

“We identify and describe four major problems with Ontario’s existing regulatory framework at the level of retail financial services:

1. anyone can call him- or herself a financial advisor and offer financial advice, including planning;

2. existing regulation focuses on product sales, at the expense of proper regulatory oversight on the critical financial relationship between the advisor and the client;

3. there is no firm, clear, and universal requirement for advisors to stay up-to-date in their core areas of knowledge; and

4. there is no effective, industry-wide disciplinary process”

“Regulatory reform in Ontario’s financial advice sector cannot and will not succeed unless the foundational nature and importance of advice is formally recognized at the outset of any reform effort.”

“the various inadequacies of the current regulatory scheme result in unnecessary and avoidable consumer exposure to fraudsters and advisor incompetence;”

“the needs of consumers and advisors have outgrown the existing, largely product-based model which currently regulates Ontario’s financial services industry; and,

“Ontario’s current web of regulatory structures and relationships produce unnecessary complexity for all stakeholders — and needless confusion for consumers.”

The consideration of the impact of commissions on financial advice and the need for higher standards and professionalism is a global phenomenon.   Most other international regulators that have overhauled their financial advice system have recognised that conflicts of interest impact the advice that investors receive and that removing these conflicts are an integral part of upgrading the advice and regulatory landscape.   The transition has been towards a best interest standard investment process that puts the client and advice at the heart of the process. 

Logically, Advocis’ submission to the “Expert Committee to Consider Financial Advisory and Financial Planning Policy Alternatives” covers much the same ground, with the exception that it wishes to retain conflicts of interest.  This is a non sequitur.

They talk with gusto about the need for change and the importance of advice, but when it comes down to the most obvious of all the required changes, removing the conflict that stands in the way of providing advice that is in the client’s best interest, they appear blindly intoxicated by the charms of the conflict itself.  What would Socrates have said about an organisation that placed commissions at the centre of its reason for being?

But, the history of the world is littered with the consequence of the hold of the status quo, yet somehow we do eventually manage to move forward and gradually change the human outcome. 

Regulation in this country is perverse and, yes, only removing commissions from mutual funds is a dumb solution.  Wholesale regulatory change is needed and that is the rub: does Canada have the guts to make the necessary changes? 

Regulators have been attempting to live with the addiction for too long: end it in the best interests of all.

The Zone of Interest…I think Ellen has argued very forcefully for best interest standards!

The Zone of Interest is a book by Martin Amis that fictionalises the administrative zone of Auswchitz (and I highly recommend it).  An investment world without best interest standards, where the old, the infirm, the weak and vulnerable are maligned, abused and consumed, is too a Zone of Interest:

I was particularly drawn to a recent article by Ellen Bessner, a lawyer representing financial firms and “advisors”, entitled “Serving senior clients is becoming a more risky endeavour”.

The article is about the increasing prevalence of complaints made by elderly investors and highlights a generalised case of a senior who complains, with the help of a family member, about investment performance (i.e. losses) brought about by unsuitable investments for his or her age.

The article then goes on to flesh out 4 reasons as to why this is happening, none of which discusses the fact that “advisors” are rarely trained to professional standards; commissions drive advice and transactions drive commissions; suitability standards drive transactions and not portfolio and hence risk management structures; recommendations and rationale are not required to be in writing and little or no point of reference with respect to the risk/return/asset & asset allocation/liability profiles of the often mixed bag of investments are ever provided.  Moreover no disclosure of the true nature of the relationship is likewise provided, and this has not changed under the CRM.  The construct is designed to deceive, designed to place people in a place where they are least likely to be able to accept the risks of the transaction relationship they have been guiled into. 

And, according to Ellen, the reasons why there are more complaints:

Number 1

Perversely Ellen blames the fact that aging populations has led to a drive to educate investors about their rights in contractual relationships: this education and information she says has led seniors to take their advisors to court, to seek independent judgement on their advice via the financial services ombudsman (OBSI) or to take their complaints to the regulators.  Perhaps Ellen would like no education over contractual investment relationships or dare I say it human rights: ignorance does indeed breed a blissful transaction relationship.

Number 2

The second point is really point 1 again, but I will elucidate: it complains about the fact that there is no cost to taking a complaint to OBSI, that you can hire a lawyer for free (though she does not let this one hang) and that “lawyers” see dollar signs when they see an elderly client with a financial complaint…those damned lawyers!  Ellen tends to omit a great deal of the road that often leads people to the point where they have no other option but to seek help from OBSI, lawyers and regulators, as well as the road beyond, and she also omits to opine on those “advisors” who never pay their regulatory penalties or those firms named and shamed by OBSI who refuse to pay up.  The picture has not been fully painted, but one point is clear, investors have rights and this a problem.

Number 3

Point 3 is about investors buying the highest yielding investments available, the highest risk investments available, because they have not saved enough and they need the highest returns possible to meet their expenditure needs.  So we have here an admission that yes, investments were not suitable but that the “advisor” was not responsible.  Responsibility is an important issue and present “suitability standards” allow “advisors” to avoid this nicety, this responsibility to balance risk/return and financial needs through portfolio structure, advice and education.   Ask yourself this question?  Where is the record of the process whereby the “advisor” made recommendations over structure and content appropriate to financial needs and risk aversion, the client declined and wanted something much more risky?  Well, it ain’t there and that is the problem, or a good part of it.

Number 4

Point 4 is a different matter and I am not sure why it has been slid into this argument, but it has its uses and I will aside here: in a best interests standard regime, advice and recommendations would focus on the needs and disposition of the investor of interest and manipulations of the sort described would find it very hard to survive. 

I think Ellen has argued very forcefully for best interest standards!

Compromised by its many biases the Brondesbury report completely misses the point about fees!

From one critical perspective this report appears to blame consumers of advice for the outcomes of a business model compromised by transaction remuneration.  Little is said of the inadequacies of suitability standards and their regulation or of the failings of investment processes focussed on the transaction.  Lacking such balance the report appears to advocate for the transaction model and thus is pared of its credibility!

If you had stopped reading the Brondesbury report into Mutual Fund Fees at the first summary conclusion on page 6, you might have walked away thinking the report was in favour of fees for the right reasons:

“Evidence on the impact of compensation is conclusive enough to justify the development of new compensation policies.”

If you had read on you should be left in some doubt as to how much of a marginal benefit a move to fees would have on investor outcomes.  The report appears to build an argument that suggests investor behavioural biases are the most important vitiating impact on outcomes and that advisors are merely responding to their transaction requests.    

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The Brondesbury Report & Cultural Bias in the Regulation of Canadian Retail Financial Services…

I am going to delve into the Brondesbury report shortly, but first we need to step back and look at the frame we are in, because neither the Brondesbury report nor the CSA have fully explained this.

The CSA have unfortunately addressed mutual fund fee issues separately from the wider problems in the Canadian financial services industry and, most notably, separate from that of best interest standards.  There may well be a reason for this!

Aside from the investment counselling/discretionary client portfolio management segment of the industry, whose standards and responsibilities appear, to all intents and purposes, to be ignored as valid reference points in current deliberation, the frame we are looking at is the one that holds the advisory segment. 

The advisory segment is still regulated on a transaction by transaction basis with responsibility for the transaction effectively lodged with the individual investor.  This is a simple parameter to parameter model that aligns risk preferences and investment objectives, adjusted for some nebulous assessment of investment experience (often arbitrarily assigned), to a product recommendation.  The product recommendation passes through the parameters.   In the Securities Act, for instance, the provision of a transaction recommendation within an advisory registration capacity is not technically considered to be advice.

The KYC is not a portfolio/optimisation process.  In fact, if you were to hand a KYC to an investment professional they would have to bypass it to a more sophisticated investment process to construct, plan and manage an asset allocation and security selection that matched a given investor’s risk preferences/asset liability profile. 

The current culture assumes that investors come with requests on a transaction by transaction basis, that the KYC process is effective and sufficient and because of its simplicity is therefore simply understood.  An investor in this frame should be able to own the transaction with the advisor only responsible for the product advice and not the management, or the construction or the planning.  If we refer to the careful delineation in the Securities Act, the investor is not actually being advised. 

In this frame “the culture” assumes that it is the investor’s own behavioural biases that drive mis-selling and that the advisor must accommodate these biases or risk losing business: I phrase this with reference to comments that I will, in a later post, draw from the Brondesbury report.

I have a number of issues with this framing of the KYC process and so, it would seem, did the OSC way back in the late 1990s and the early 2000s –note the FAIR DEALING MODEL and earlier Financial Planning Project initiatives: 

In 1999, the Canadian Securities Administrators committee on financial planning proficiency standards identified conflicts of interest in financial planning advice as a more significant concern than representatives’ proficiency. The CSA committee undertook to pursue this area as the second phase of the Financial Planning Project. Around the same time, OSC Chair David Brown determined that changes in the social and economic environment, and in the business structures and objectives of the securities industry, warranted a fundamental re-examination of the regulations governing the delivery of financial advice to retail investors. He recognized that our regulations are still product-based, as they have been for decades, even though the industry has moved to an advice based business model. In early 2000, the OSC launched the committee that has led to this Concept Paper.

The promise of service has long since exceeded that of the simple transaction. It has long since extended to the provision of advice that relates to overall financial needs and financial assets.  The process needed to manage these needs and assets is more sophisticated/complex than that provided by the KYC parameter model.

Today the KYC remains as the barometer of the suitability of product advice and the assessment of the suitability of advice.  In order to deliver the promises that the industry is effectively making the investor today you would need to move your focus of attention to a more complex and integrated service process.  In truth investors should be paying for the process and not the transaction.  Unfortunately the industry remains mired in a culture that rewards the transaction and not the process, and hence focus has remained on the transaction and transaction remuneration. 

If we are to deliver on the service promises being made we need to develop our processes and thereby raise our standards of advice.  By removing remuneration from the transaction and aligning it to the process, i.e. a fee for service process and advice, we change the industry from one focussed on transactions delivered by a rudimentary process to one focussed on advice delivered by modern technology and knowledge that better matches the promise.   At the moment advisors can effectively promise best interests yet remain regulated on the transaction.  This risks a disconnect between the processes needed to deliver the wider promise and those needed to satisfy minimum standards.

The Brondesbury report, along with many others, is stuck in the transaction mindset: 

It believes in a world where investors initiate and are able take control of their investment decisions, where the KYC is simple and effective in delivering investment solutions, where advisors are not promising a higher standard of advice and are hostage to investor behavioural biases and where advisors are not responsible for educating the investor over their process and disciplines.  It believes in a world where the cost to the investor of delivering the transaction solution is of equivalent value to the investor and where there is no other promise than the transaction and no other alternative spectrum of advice.  The report ignores the fact that today’s promises exceed the boundaries of KYC suitability and require more advanced processes that naturally differ from those required to deliver stand alone product recommendations.

The Brondesbury report is looking at the problem through the rear view mirror, replete with longstanding cultural biases that have impeded the development not only of higher professional standards but more efficient and cost effective wealth management solutions.  This is a very complex area. I will address some of the wider issues as I explore the Brondesbury report in subsequent posts. 

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I discuss issues with the current parameter to parameter suitability model in my submission to the CSA on Best Interest Standards in Appendix A.  Also in this document are a number of excerpts from many of my blogs on best interests and the KYC process. 

Also worth reading is “Fiduciary Obligations of Broker-Dealers and Investment Advisers” by Arthur B Laby. 

Are Canadian regulators ring fencing consumer investing behavioural biases in favour of transaction returns?

“we suspect that much of what we see as impact of compensation is just investors failing to make rational decisions.” P53 of the Brondesbury Report on Mutual Fund Fees.

I am in the midst of reviewing the CSA commissioned Brondesbury Report on Mutual Fund Fees and am ploughing through the reference material which supposedly underpins its conclusions.  Amongst the many nuggets I have unearthed is the following taken from “Investors’ Optimism: A Hidden Source of High Markups in the Mutual Fund Industry” :

Previous works have identified investors’ optimism bias towards equities issued in their domestic market. In particular, academic research on mutual funds has focused on investor’s lack of financial literacy. …These empirical findings of investor’s deviation from rationality are in line with our model’s emphasis on investor’s limited financial knowledge of the mutual fund industry.

Investors’ optimism bias can be closely related to their lack of knowledge of the fund market, leading them to choose sub-optimal benchmarks such as bank savings instead of low-cost index funds or ETFs. Besides, investors’ optimism bias is probably influenced and reinforced by the marketing practices of mutual funds, which promote the sale of fund shares.

The reference to sub-optimal benchmarks is both noteworthy and ironic because both the new Point of Sale disclosure documentation for mutual funds and the performance reporting requirements laid down in the CRM2 lack mandated performance benchmarks. 

Interestingly the Canadian Securities Administrators had earlier proposed a GIC or cash based benchmark for Point of Sale mutual fund disclosure documentation, but baulked at the last minute for a number of reasons. 

So why were Canadian regulators looking to implement “sub optimal benchmarks”?  Were they ring fencing consumer behavioural biases in the interests of transaction remuneration or were they themselves acting in ignorance?  We may never know but the point is an interesting one and much more so given the deeper contextual focus in the  Brondesbury report on investor behavioural biases (chapter 5):

“Behavioral biases of investors are not easy to overcome. Behavioral biases affect advisor behaviour (just as advisors affect investor behaviour), investor choices of investment, and ultimately, investor outcomes”

“Time is a precious commodity to most advisors. There is only so much time an advisor can afford to spend to overcome the behavioral biases of investors, regardless of how they are compensated”

Investor behaviour biases lead to sub-optimal returns and these biases can be confused with compensation impacts

Behavioral biases of investors are not easy to overcome and they are a key factor in sub-optimal returns on investment. This poses a real limitation of the conclusions we can draw from the research literature, when we look solely at clients of commission-based advisors.

If there is no comparison between different forms of compensation, one can easily be misled into believing that sub-optimal behaviour is the result of the advisor’s recommendations and not, at least in part, the behavior and attitudes of the investor.

There are two issues related to behavioral biases that must be mentioned here. The first is the question of who is responsible for overcoming the behavioral biases of individual investors. While helping clients to do so may be something that a top-notch advisor will choose to do, we are not aware of any rule or principle that points to de-biasing as an advisor or a firm responsibility, regardless of compensation scheme unless a failure to do so impacts ‘investment suitability’ in some way.

“we suspect that much of what we see as impact of compensation is just investors failing to make rational decisions.” P53 of the Brondesbury Report on Mutual Fund Fees.

This quick post introduces some of my concerns with the Brondesbury report and my belief that many of its conclusions and analysis remain mired in a transaction mindset that continues to beset regulation of advice in Canada.   Regulators and, it would seem, some esteemed others appear mired in a perplexing behavioural bias towards “what does and does not represent investment advice”. 

Does the disclosure received by retail investors help them to make optimal investment decisions?”

I was happy to attend the Capital Markets Institute’s discussion on disclosure at Toronto’s Rotman School of Management.  But some 3 and a 1/2 hours after the start, the panellists had still not answered the headline topic of discussion: “Does disclosure help investors make optimal investment decisions?”

Outside of the academic presentations by Sunita Sah and an interesting but jocular presentation on behavioural issues affecting choice, focus seemed to be almost entirely on documentation underpinning investment details, costs and performance, i.e. the disclosure of detail. 

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Are they advisors or salespersons and do we have a transaction or an advice based service process?

IMPLEMENTATION OF STAGE 3 OF POINT OF SALE DISCLOSURE FOR MUTUAL FUNDS – POINT OF SALE DELIVERY OF FUND FACTS

I was thinking of submitting a few arguments to round 3 of the point of sale framework, but flogging a dead horse gets kind of tiresome after a while and also raises questions over one’s own intelligence.  

Needless to say I have not been surprised by many of the industry or “industry funded” comments.   I would like nevertheless to draw attention to some points made in the Fasken Martineau submission.

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Naming and shaming and business titles

Two recent additions to arguments I have been following: the first from a CFA Institute blog and the second from FAIR Canada.

“Naming and Shaming”: Canada’s Move to Call out Bad Actors Sets Investment Industry Example

Our profession could do with quite a bit more of this practice, whereby we don’t shrug and wait for regulators or the media to call out the bad actors and bad practices in our midst

IIROC Guidance re Business Titles and Designations

“..the overarching problem with titles and designations is that Approved Persons at IIROC are allowed to hold themselves out as “advisors” when there is no statutory obligation to act in the client’s best interest and this is inherently misleading to consumers. “

Would the Canadian government and regulators please take note:

From A New Era of Fiduciary Capitalism? Let’s Hope So, written by John Rogers, CFA, president and chief executive officer of CFA Institute.

“In the public policy arena, governments that promote long-term savings, reduce taxes on long-term ownership, and require transparency and good fiduciary governance can help hasten this welcome change in our financial markets.”

The definition of suitability is being warped by an insane distribution culture.

OBSI is fighting a losing war against leverage, and with its latest name and shame the mark is on the current point in time.  

While all the recent leverage name and shame cases are to do with the last market downturn, the refusals to pay are all to do with the next.   If companies were to pay these cases now, they would put a line in the sand about the suitability of leverage and set a precedent that would cut them off at the knees in the next downturn. 

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Adviser, advisor, financial adviser: but should we have the word advise in there at all…?

We all know that most financial advisers provide advice as to how much to save, how to invest, where to invest, what to invest in and when and how much to sell, if at all.

The trouble, in Canada, lies in the accountability and responsibility for that advice.   I am not going to quote any one particular study, or name any one particular company or firm, but most consumers (in most countries) believe the advice they receive is made in their best interests by advisers/ors committed to professional standards of conduct, and most firms market their advice as a very important, if not the most important, component of their service.   So are they advisers/ors?

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OBSI Name and Shame

I would like to refer readers to the recent OBSI name and shame press release.  It concerns Richardson GMP, a firm that has been accorded a Fiduciary Certification on its discretionary mandates.

The OBSI reports are sparse and it is difficult to discern just what the securities at issue are, but I would hazard a guess that they are in the asset backed/collateralised loan/mortgage backed area given that the problems arose during 2007 and 2008 and looked to relate to once highly rated paper.

I can see why many firms would not want to reimburse investors for normal market losses, and in most instances, where a portfolio is properly structured, I would agree with them.  But it looks as if structure and transparency over structure were found lacking and I do wonder why Richardson took the risk to their good faith message in this particular instance.  I fear perhaps the lawyer’s hand and not pragmatic business logic.   But then again there is too little information here to really go on.  

However, what concerns me in the “power of ten realm” is that we are at heady market valuations and who knows how many shaky foundations are set to be levelled in the months and years ahead.

Principle based versus rule based regulation and the hidden benefits of a best interests standard.

Regulation and investor protection begins at home, not at the regulatory level or with the courts.

There is a lot of confusion amongst the regulated that a move towards a best interests standard will lead to more rules.  This is incorrect.  They will lead to more principles and fewer rules, less conflict and better outcomes, greater self regulation and higher levels of investor protection and much reduced regulatory intrusion.  But not overnight!

The ability to deliver best interests standards depends on well structured processes that depend on a well defined set of decision rules.  Strong processes need only be regulated by principles, as the processes contain all the rules.   The trick is to make these processes transparent and accountable to a standard (best interests).  

Regulation + process = leverage. 

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