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.” 

The implications of retaining the current distribution model as the “market place”, per se, are enormous.  The regulators are failing to explain how model and standard are meant to operate, but there are countless data points which support regulators intent to retain an advice-lite distribution model with products at its core.  For example:

From OSC brochures, Working with a financial advisor: What is your investment knowledge and experience? If you’re an experienced investor, you may want an adviser who offers a wide range of products and lets you choose. If you’re newer to investing, you may be more comfortable with fewer choices and more guidance from your adviser.

I felt that investor advocates on the panels appeared largely unaware of the distribution model’s impact on the proposed standard, the scope of the standard and hence liability of advice covered by the standard; scope is key to defining fiduciary responsibilities and liabilities and lies at the heart of the fiduciary divide between traditional brokers and advisers – see Arthur Laby’s many papers on these issues.

Roundtable lawyers were clearly aware of what they were talking about, on one level, but remain ostensibly clueless about the difference between the distribution model and advice based service processes.  There are lawyers who get it, but these tend not to be under the employ of financial institutions. 

Distributors’ understanding was difficult to parse, but the wire they are balancing on is finely balanced between that of accepting, on the one hand, a best interests standard that stops short at the product (a win), while, on the other, adopting much more rigorous regulation of each transaction (a loss).  

Without centralised construction, planning and management disciplines (required of fiduciary standards), regulating the transaction at higher levels of objectivity is likely an onerous obligation and one that may well require considerable flexibility to be practical.  

Indeed, how do you define every transaction in best interest space where there is no fiduciary responsibility for the underlying investment process?

Margaret Mcnee, the OSC selected lawyer on the panel, emphasised the flexibility in the standard: she stated that this flexibility would benefit the industry and that only egregious cases would likely be pursued; with respect to products and costs she said that there would be a wide interpretation of the standard. 

Importantly with respect to the boundaries of the best interest standard, Margaret said that the courts would defer to the experts at the OSC and that the best interest standard was not a fiduciary one: “there won’t be some of the distractions in terms of foreseeability and damages”.  She felt that there would “just be a straightforward analysis of conduct” with a focus on “examining the conflict of interest….to whose benefit this advice or transaction was directed....”.

A true best interest standard would be a standard that raises all boats in a one time transaction based industry, while lowering the complaint threshold for instances of bad advice.  To define the proposed standard as being anything but is illuminating!  If the OSC selected Mcnee for a reason we should pay attention to her words.

A best interest standard that focuses on advice should see a focus on process (decision rules and assumptions and disciplines and frames that determine and deliver the financial planning and investment constructs) and not necessarily conduct alone (in fact outputs that differ from those determined by process are the outputs that should be honed in on), and while conflict of interest should be removed in a best interest sphere, here we have the focus of the standard being as “to whose benefit was the advice/transaction directed”, which is a lesser standard than one focused on the integrity of the process, the communication and the representation of service etc.  The proposed standard is not really tied to anything that I can see and, I find it hard to see it as described,i.e. overarching. 

Determining conduct, to me, risks being a woolly and wide approach, hence the flexibility and, indeed, would otherwise be redundant where we have a well defined process that creates outcomes.  What we should be looking at is the integrity of the process and its appropriateness for servicing the objectives, assets and needs at hand.  Hence deviations from the rails of the process and their intent (the point to which structure, planning and management point) can be ascertained at the core via the disciplines, decision rules and constructs used to construct, plan and manage assets. 

To rely on conduct, undefined, as the method by which you divine the regulatory breach belies again a lack of awareness of the dynamics and structures of process.  Clearly the regulators and a great many lawyers do not want industry to focus on developing disciplined structured processes.

As it is, the proposed best interest standard and the targeted reforms seem obdurately dialled into the product/transaction as the outcome of significance and, of course, conduct takes you to this point as opposed to the rails of a fiduciary standard.  Assessing conduct without rails is schwierig (difficult) and hence the need to interpret widely, to allow flexibility and to focus on clear and cut egregious cases. 

With respect to the distraction of foreseeability that Margaret Mcnee pointed out as being a positive for the industry: advice based service processes, where portfolios and planning are derived from disciplined constructs with clearly identified principles and assumptions would comfortably accept a best interest standard with a fiduciary root and all its attendant liabilities (foreseeability etc). 

But regulators and industry are steering clear of developing and instituting a proper advice based model.   Why?  Because the root of the present model is the distribution of product, and this is the process around which the proposed standard is to be wrapped. Regulators are starting from the premise that there is no alternative to advice around the product as opposed to advice of and with respect to the frame and assume that the market for products is what we need to retain with a little fine tuning.  

Portfolio constructs are designed to manage foreseeable risks and the magnitude of those risks are more or less known in advance, even though their incidence (probabilities) may not be exact.  Certain risks can mitigated, others managed via structure, costs and assumptions, and some, the wide extremes of risks that threatened the financial system in 2008, are not manageable at all: indeed it could be argued that the risk event of 2008, an event which threatened the supposed lowest risk asset of all (cash) was headed off at the pass.  Careful construction, planning and management disciplines can help mitigate and manage risks within a reasonable frame of reference so that liabilities associated with fiduciary boundaries can likewise be contained.  We can define fiduciary standards for financial advice but these standards are not to be found at the point the product is sold, but well before in the process that not only constructs, plans and manages but that interacts with the client’s needs/objectives and financial  preferences.

The whole point about investment constructs is their foreseeability, their ability to incorporate the various assets, risks, liabilities and probabilities into their frame.  Forseeability therefore is very much an issue in financial advice!  To ignore it is unprofessional, unethical and reckless guidance.

Naturally a product distribution model is going to have issues of foreseeability if it lacks formal disciplines.  So it would seem, that the old wide enough to drive a bus through suitability standard will still be wide enough to drive something large and wide through. 

Is there any real change here, or is it all for show?  I believe it is on the one hand for show for investors (they are being sold “best interests”), while on the other it is, meaningful, if misled, change considered necessary to control the rough edges of the transaction.   Regulators believe that the product distribution model is the efficient market place for advice and refuse to acknowledge the need for disciplined, responsible and accountable advice platforms.  They see investors as individuals out buying components for their computers, where the decision rests as to what graphics cards, CPUs, power supplies, motherboards they want, with most being able to make these product purchases and assimilation decisions.

To date regulators have not argued why investors should be considered capable of making the product decisions implied by regulation.  They are not interested in the market place for advice, per se, but products in a frame where manufacture and distribution and product biased advice (and biased product advice) lie on the same axis. 

Ursula Menke asked why the frame used to apply fiduciary standards for discretionary management could not be similarly applied to the wider retail market.  This is an obvious question and the only direct answer provided by other panelists was that this would cost too much.   Surely the fundamental disciplines used to construct, plan and manage should be the same for all portfolios irrespective.  Whether assent is given for discretion for transactions or not, the agreed parameters and strategy and structure should be very similar: both advisory and discretionary services have discretion over these processes. 

The only thing you can conclude is that retail advisors are not required to support recommendations with the type of planning and structure that should be axiomatic when providing personalised investment advice.  Ursula, by implication, therefore also asked what is the frame?   If it is not clear to the OSC’s Investor Advisory Panel then clearly it is not going to be clear to the vast majority of investors.

So back to the proposed standard: it is clear to me that the dealing construct around which the earlier standard of conduct was constructed (deal fairly, honestly etc) is being retained and a finer point is being applied to that standard via the insertion of a best product standard which the CSA has misleadingly termed a best interest standard.  Acting in the best interests of someone is at the core a fiduciary duty and I discuss this in my submission.  So what is the CSA/OSC doing? 

Ursula Menke, of the OSC’s Investor Advisory Panel, talked about “investors…being harmed by the lack of a fiduciary duty or best interests standard” so the IAP assumes that the objective of change, as would any rationale being, is to institute a fiduciary type best interest standard. 

On the other hand, Lawrence Haber, formerly an industry executive with National Bank Financial and DundeeWealth, as well as a lawyer formerly practicing securities law, said that we should not be conflating best interest standards with fiduciary duty (which he said requires trust and reliance and is very fact specific), that a best interest standard does not equal a fiduciary duty, that there was “no reason in the world why regulators have to imply or include a fiduciary duty in the context of a best interest standard, it can stand on its own…”.  

He did not of course explain the scope of the relationship to which he was referring or what the liability of a best interest standard was with respect to the investment process and the resulting integrity of the decision?  He did not explain to what part of the process the best interest standard was being applied and who would be accountable for errors, omissions and misrepresentations of process and service?  To what degree does a best interest standard exist outside of trust and reliance and what key facts regarding the standard preclude a fiduciary root were also questions left hanging.   All too often we have so called experts in fields other than portfolio construction planning and management claiming that personalised investment advice in the retail market place is not deserving of a fiduciary duty because there is “no reason” why a best interest standard should be a fiduciary standard.  

I feel that many legal professionals do not fully grasp the concept of discretion over the investment process or what processes comprise that discretion and the importance of the resulting process and structure that envelops the transaction.  Perhaps they fail to see how the product recommendation, with all its disclosure, can possibly be the product of a fiduciary relationship.  

I believe that at its core, the construction, planning and management of assets, whether or not the “formalities” require client asset, are fiduciary in nature to the extent that these processes lie outside the realm of the client and it is to these which the client, via the relationship, is reliant and hence exposed.   If the process has integrity, then the fiduciary liability is extinguished and the client takes responsibility, and this is the surely the case whether or not the client accepts a discretionary or advisory mandate.  One of the bogeymen of the fiduciary standard is the unlimited liability of retail investment advice to the ignorance and failings of the consumer.   To a large extent, the ignorance and failings of the consumer are a product of the gun slinging investment culture that is slowly winding its way to higher professional standards.  If your advisor thinks investment advise is all about taking the product toys out of the cabinet and the investor choosing which ones he or she wants to play with, then yes, who would want this liability.  But the product distribution culture is not the advice market and regulators should be forceful in creating a clear divide between the two, so the consumer can properly choose.

Lawrence also stated that “costs of compliance would go down not up”, that “compliance and supervision would be simplified.”  This is of course true if the industry were to embrace process and responsibility and accountability for the process, since the decision rules, assumptions and component parts of disciplined processes are tiny compared to the numerous different outcomes they are capable of producing.   But, should the standard be elevated to a nebulous best interest standard without the fiduciary root and, should the product distribution model and process fail to evolve, compliance will not be simpler and it will not be less expensive. 

The proposed best interest standard is a best product standard.  A best product standard is not a fiduciary standard and there is no reason in the world a regulator would impose such an obligation on such a standard.   But investment advice doth have a fiduciary root and the evolution of a foundation capable of managing the liabilities of the root is required, just as the disciplines and processes of investment have evolved to mitigate and manage asset and liability risks across time.   

Leave a Reply