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.
Regulation of most Canadian retail financial services is tied to a lesser transaction standard, akin to the US Fair Dealing model established during changes to US regulation in the 1930s; but the US model developed another leg via the 1940s Investment Advisers Act and subsequent case law – and the global regulatory model, as a whole, has also long since surpassed the base Canadian model.
The current Canadian standard of conduct is meant to require registrants to “deal fairly, honestly and in good faith with its clients”, but the conflicts associated with a transaction culture and the wide parameters of the suitability standard create outcomes at odds with the obligation. At the moment Canada is in the midst of a painfully long and drawn out review into upgrading standards of conduct to include a (now sadly watered down) best interests standard (see my comments and my submission on this).
The “double dipping” scandal should be a relevant issue when addressing the need for reform, yet it failed to attract a direct mention in the CSA in its best interest standard consultation – although notable failures in firms’ ability to manage conflicts of interests were referenced (i.e. links were provided to regulatory documents that detailed the issues).
Industry pushback has consistently been that current regulatory standards are more than sufficient to deter wrongdoing and to establish and enforce standards of conduct that are de facto best interests irrespective. Likewise the industry has argued that the banning of transaction remuneration would be both damaging and unnecessary. Revelations from HSBC, TD, Scotia and now CIBC with respect to double charging of investors weighs heavily on the credibility of industry arguments.
For an issue that has long been whispered, note a Globe and Mail article in 2013 that suggested that RBC had had similar issues, that surfaced formally in 2014 with TD’s“self reporting” and by HSBC, Scotia and now CIBC, you have to ask yourself:
Why are the regulators not being proactive?
Why are they allowing self reporting?
Why are they allowing non contested settlements for critical, relatively easy to prove, systemic issues? They appear to be prioritising the interests of industry over those of the investor?
The developing double dipping “scandal” confirms not only that current standards of conduct are insufficient and ineffective to protect investors (they appear to have little resonance throughout the organisations per se and hence failings are systemic), but also raises numerous other serious questions about the role of our regulators in enforcing them.
How many other firms are being investigated and what of those firms that have not self reported?
To what extent has the introduction of CRM2 cost disclosure rules influenced the way in which firms have been dealt with with respect to breaches of regulations? Have the regulators been lenient because of the transitions associated with the CRM?
It is worth noting that many firms and financial lobby groups were against the introduction of trailer fee reporting during the 2011/2012 NI 31-103, Cost Disclosure and Performance Reporting, consultation period.
The whole point about fee based accounts is that transaction based remuneration (commissions etc.) are not to be deducted from client funds. Yet firms have done so, as far back as 2000 in some instances. To date (publicly) HSBC, TD, Scotia and CIBC have received moderately small fines for their actions and have been forced to pay back, with opportunity costs, much more sizeable sums to investors.
To date no firm has had to acknowledge fault for the breaches.
A quick look at the CIBC Settlement details which include:
1 – Total compensation to clients of $73m ($73,260,104 to be exact), a voluntary payment of $3m to the OSC (to the Consolidated Revenue Fund) and $50,000 towards costs.
2 – “The CIBC Dealers neither admit nor deny the accuracy of the facts or the conclusions of Commission Staff as set out in Part III of this Settlement Agreement.
3 – 21,621 clients were charged excess fees on mutual funds and structured notes between January 2002 and January 2016 on mutual funds and structured notes, with a total payment of $23.58m.
4 – Between January 2006 and January 2016, 981 client accounts were charged excess fees on trailer ETFs for a total compensation payment of $275,852.
5 – Between Jan 2006 and Jan 2016 35,286 clients were affected by payments of trailer fees on closed end funds, for a total compensation payment of $18.85m
6 – Between Jan 2006 and Jan 2016, investment in fund share classes with higher than available MERs on alternatives available, affected 23,867 accounts, and a total compensation payment of $30.55m.
Under the microscope were CIBC WMI (i.e. Wood Gundy & IIROC registered), CIBC Imperial Investor Services (IIROC registered and its tagline “Professional financial advice – here’s why you need it”) and CIBC Securities Inc (registered with the MFDA). CIBC apparently self reported to regulators from March 2016 onwards. The OSC investigated but has not provided the salient details of its investigation.
The breach is described benignly by the OSC as:
“inadequacies in the CIBC Dealers’ systems of controls and supervision which formed part of their compliance systems…which resulted in certain clients paying, directly or indirectly, excess fees that were not detected or corrected by the CIBC Dealers in a timely manner.”
The OSC also stated that they “do not allege, and have found no evidence of dishonest conduct by the CIBC Dealers”. As a result of the of Control and Supervision inadequacies the OSC stated that CIBC was in breach of section 11.1 of the NI 31-103:
11.1 Compliance system
A registered firm must establish, maintain and apply policies and procedures that establish a system of controls and supervision sufficient to (a) provide reasonable assurance that the firm and each individual acting on its behalf complies with securities legislation, and (b) manage the risks associated with its business in accordance with prudent business practices.
However there were clearly issues at the advisor and firm level that transcended mere compliance. I do have issues with the “no evidence of dishonest conduct”, and while there has been no detail provided in OSC communication that would support such, there are countless dots; thousands of accounts and transactions, a number of product lines, a period of 10 to 15 years involving a growing number of companies. Similar problems across a number of organisations would suggest a systemic issue. Yet, we are told that there was not one conscious decision amongst all this and no-one noticed?
This is difficult to believe given that there would have existed numerous points of interaction at which someone would have noted that commissions that should not have been paid, were in fact being paid: the advisor and the dealers reporting somewhere would have shown these payments, auditors and accounting would have noted these payments, commission grid rewards would have been based on these payments, programmers and software design would have coded for the flows and the accounting and indeed, regulators (IIROC and MFDA) should also have had ample opportunity to assess controls and supervision in this area.
Simple reconciliation of earnings by both advisors and firms would have identified an unexpected/higher margin of revenue for the service segment noted. Is no one monitoring the profitability and costs of these operations, and what of the role of compliance personnel? Is this yet another instance of conflicts of interest prioritising the firm and the advisor above those of the client? We do know that transactional fee based accounts have been more profitable for firms and perhaps this area of profitability has hindered closer inspection:
Form the Globe and Mail March 23, 2012 “PriceMetrix data shows that fee-based accounts have 26 per cent of the assets, but generate 43 per cent of the revenue for advice firms.”
“Advisors who are more aggressive and move a significant percentage of their assets into fee-based accounts benefit more quickly from higher RoA, revenue, and assets.” Pricemetrix November 2013
It is only recently that regulators appear to have paid closer attention to conflicts of interest: we note that IIROC reviews of supervision and management of conflicts of interest with respect to transaction remuneration confirms the state of supervision and monitoring. Note the following excerpts from IIROC’s April 2016 Rules Notice, Managing Conflicts in the Client’s Best interest:
In late 2014 we reviewed the conflict-of-interest-related issues that arose during our normal course examinations of Dealer Members during a 13-month period in 2013-14, to determine the extent to which they were complying with our conflicts of interest rule. Our review showed deficiencies in: (i) policies and procedures concerning conflicts of interest; (ii) documentation concerning the analysis of specific conflicts; and (iii) disclosure of conflicts to clients. These findings suggested weaknesses in the oversight of the conflicts of interest management process within some IIROC-regulated firms.
As a follow-up, in June 2015 we …found that Dealer Members in the sample had improved their policies and procedures for dealing with basic conflicts in areas such as outside business activities, separation of corporate finance and research activities from retail sales activities, and the disclosure of affiliated entities and proprietary products.
However, when it came to compensation-related conflicts, most firms sampled lacked a meaningful process to identify, deal with, monitor and supervise compensation-related conflicts. For example, most firms did not have mechanisms in place to identify advisors who recommend products that yield higher fees and bonuses, when there are other suitable but less expensive alternatives available.
They also did not have a process in place for implementing additional monitoring of advisors approaching compensation thresholds based on the amount of revenue generated. Furthermore, we found that there was confusion among some firms regarding the best interest standard as set out in our conflicts of interest rule and guidance. Although most Dealer Members responded that they always put clients’ best interests first, we found little supporting documentation as far as compensation-related conflicts were concerned.
The IIROC sweep finds significant compliance issues of the type that would be expected to encourage/ignore double dipping in fee based accounts. The recent CSA Consultation on best interest standards and targeted reforms confirm that there are serious issues with respect to a sales led financial services culture. Quite how we are going to retain the commission/distribution frame while attempting to “prioritise” investors interests is difficult to imagine.
And what of the similarities with between the CIBC and Scotia, TD, HSBC?
Let us briefly look at the Scotia settlement details that involved the following entities: Scotia Capital Inc (IIROC), Scotia Securities Inc (MFDA), Hollis Wealth Advisory Services (MFDA):
A total payment of $19,997,821 to clients, considerably lower than the CIBC payment, a voluntary payment of $800,000 to the OSC and $50,000 in costs.
Again we have a similar set of investments affected: non exchange trade mutual funds (111 accounts) and structured notes and closed end funds (2009 to 2015), exchange traded funds with trailers (2,623 accounts from 2009 to 2015), and lower MER mutual fund options that should have been recommended but weren’t (2008 to 2015). Interestingly structured products (from outside issuers) affected 30,218 clients and comprised the single largest payment of $10.3m to clients. 12,751 clients were affected by MER differential funds, and a payment to these clients is to total $8.9m.
It is notable that outside non proprietary structured products represented the single biggest violation of securities regulations: these products would have to have been approved within the organisation at some point and advisors would have known that these products would have had embedded fees within them.
Scotia self reported in February 2015 (a month before CIBC) and again we have the same refrain from the OSC:
“inadequacies in the Scotia Dealers’ systems of controls and supervision which formed part of their compliance systems (the “Control and Supervision Inadequacies”) which resulted in certain clients 2 paying, directly or indirectly, excess fees that were not detected or corrected by the Scotia Dealers in a timely manner” .
And….”Commission Staff do not allege, and have found no evidence of dishonest conduct by the Scotia Dealers”
And…”The Scotia Dealers neither admit nor deny the accuracy of the facts or the conclusions of Commission Staff as set out in Part III of this Settlement Agreement. “
And similar with CIBC the breach of regulations was of “section 11.1 of National Instrument 31-103”.
Let us look at the TD settlement affecting TD Waterhouse Private Investment Counsel (OSC regulated, exempt market dealer and portfolio manager), TD Waterhouse Canada Inc (IIROC, investment dealer) and TD Investment Services Inc (MFDA).
TD self reported May to September 2014 the same issue:
“ inadequacies in the TD Entities’ systems of controls and supervision which formed part of their compliance systems (the “Control and Supervision Inadequacies”) which resulted in clients paying, directly or indirectly, excess fees that were not detected or corrected by the TD Entities in a timely manner.”
And again the “Commission Staff do not allege, and have found no evidence of dishonest conduct by the TD Entities;”. Total payments to clients were noted as $13.5m, a voluntary payment of $600,000 to the OSC and $50,000 to cover costs.
The issues included TDAM mutual funds with embedded fees (I series) being included in fee calculations (available for purchase from 2000 to 2011). This issue was found in July 2012 and was reported in May 2014. 4,700 clients were affected with compensation calculated at $1.7m.
“Excess asset management fees paid by TD Waterhouse clients”, noted as embedded fees in certain investment products over the period 2007 to 2013. This was self reported to IIROC in June 2014 and to the OSC in July 2014. 1,840 client accounts were affected with compensation calculated as $780,000.
Excess fees paid by clients in the TD Managed Assets Program: 16 funds were available with different series, with higher MER series being incorrectly allocated to a number of clients over the period Nov 2005 to June 2014. 3,960 client accounts were affected and total compensation of $11.08m (an average of $2,800 per account) calculated and a further 40 clients for an additional $291,000 (or $7,275 per account).. These are not inconsequential numbers. The settlement notes a further class of investors exposed to paying higher MERs and this calculation had yet to be made by the time of the settlement.
Again the rule breach denoted by the OSC in the settlement agreement was section 11.1 of National Instrument 31-103.
Finally, let us look at the BCSC’s settlement agreement with HSBC: the companies at issue were HSBC Investment Funds (HIFC) Inc (MFDA). and HSBC Private Wealth Services (Canada) Inc (portfolio manager and hence Security Commission oversight). The HSBC units reported the issues in April 2015.
Again we have the same refrain “ inadequacies with internal controls and policies caused some clients to pay excess fees”. Again the issue seemed to lie with higher paying funds for clients who should have been invested in a lower MER series (HIFC), which affected 4,651 clients for total compensation of $7.076m. A voluntary payment of $300,000 was to be paid to the BCSC and $20,000 to be paid in costs.
The regulators have not shed sufficient light on the specifics of the inadequacies found in control and supervision in the name firms with respect to double charging on fee based accounts. What would have happened if regulators had not been looking to upgrade disclosure of costs and performance? One could credibly argue that fee based accounts were being knowingly gamed: the issues noted were similar across all firms who have self reported to date and had been going for some time. The most significant of the transgressions that indicated, in my opinion, that investors interests were clearly not being prioritised was the allocation to higher MER funds, when lower cost funds were available. Why? While one could tenuously argue that systems should have been able to adjust for embedded fees in calculating the net fees on fee based accounts, there could be no such assumption with respect to the MER differential issue.