Regulating Investment Funds in Canada: A Tsunami of Reform

The stream of regulatory work in the investment fund industry has risen over the past few years, and more reforms are coming next year
Regulating Investment Funds in Canada: A Tsunami of Reform





The stream of regulatory work in the investment fund industry has risen over the past few years, and more reforms are coming next year

lthough the cacophony surrounding regulatory fatigue emanates with regularity from a wide variety of sectors in Canada’s business community, the $1.22-trillion investment fund industry and its 97,000 advisors are surely among the hardest-hit in recent times.

“The across-the-board scope of regulatory reform in this industry has been incredibly intense for the last few years,” says Alix d’Anglejan-Chatillon of Stikeman Elliott LLP in Montréal. “The changes are very complex, the rules are a lot more detailed than they were in the past and there is a lot at stake.”

Not surprisingly, enforcement is on the rise.

“In the past decade, regulators have become much better equipped to do compliance audits and force firms to be on their toes,” says François Brais of Fasken Martineau DuMoulin LLP in Montréal.

By all accounts, there’s no relief in sight. “The next 12 months is going to see even more movement, with the big issue on the mutual fund side of things being the debate over ‘best interests’ standards and the controversy over trailer fees,” d’Anglejan-Chatillon predicts.

In Québec, the Minister of Finance recently published a report that recommended an overhaul of An Act respecting the distribution of financial products and services, which establishes the regulatory regime that governs investment fund dealers in the province.

The rules relating to reporting, clearing, trading and registration requirements for over-the-counter derivatives trading is also high on regulators’ radar.

“Asset managers with portfolio-level investments in derivatives products are probably getting at least twice the level of change as the industry in general,” d’Anglejan-Chatillon adds. “Important rules to address systemic and counter-party credit risks, byproducts of the financial crisis, are on the horizon.”

None of this even takes into account the effects of globalization. To a greater extent than ever, the investment fund industry must take into account what’s happening outside the country. By way of example, Lynn McGrade of Borden Ladner Gervais LLP in Toronto points to the Volcker Rule in the Dodd-Frank Wall Street Reform and Consumer Protection Act, which restricts American banks from making certain kinds of speculative investments.

“The rule is so broad in its application that it’s even touching on the policies of Canadian-based investment funds,” McGrade says.

Then there’s the impact of the US Foreign Account Tax Compliance Act (FATCA), which led to an intergovernmental agreement (IGA) with Canada that exponentially expanded the sharing of tax-related information between the two countries. Under the agreement, which came into effect in July 2014, investment funds, among other financial institutions, were mandated to use due diligence in identifying accounts belonging to American citizens, and then to report the information to the Canada Revenue Agency on its way to the US Internal Revenue Service.

Advisors to affected institutions could start on the tasks only after familiarizing themselves with the intergovernmental agreement’s 47 pages as well as the more than 500 pages that make up the US Treasury’s regulations under FATCA. No wonder, then, that observers have described the obligations, which are subject to stiff fines for non-compliance, as “daunting.”

The overall picture, then, is one of time-consuming and very expensive change that shows no sign of slowing down or ending.

“Compliance, which has become much more tedious and therefore expensive, continues to take up an ever-increasing part of industry budgets,” Brais says. “In Québec, for example, the AMF [Autorité des marchés financiers, Québec’s financial markets regulator] has moved from promoting general concepts of due diligence and honesty to focusing on mandatory adherence to particular rules.”

No surprise, then, that lawyers’ services are in high demand.

Brais, who started out as a general securities lawyer, recalls that he met with considerable skepticism from his then partners when he announced less than a decade ago that he was going to focus on an investment funds management practice. As it turned out, Brais made the right decision: there are now four lawyers engaged in the practice full-time in Fasken Martineau’s Montréal office.

“It’s getting to the point where providing an answer to the client is almost as hard as it is in tax work,” Brais says. “For every question a client has – even for something seemingly as simple as whether they have to register in the US because they have clients there – there’s an analysis that ends in the conclusion that they need to get relief from some regulatory body or rework their operations in some way.”

To be sure, private lawyers in this area of practice have hardly been immune from the general trend among clients to move work in-house. “It is true that clients are doing more internally, but there is still lots and lots of work,” says McGrade.


The current stream of regulatory intensity that has been shaking up the investment fund industry can be traced back to July 2013, when the three-year phase-in of CRM2 (Client Relationship Model - Phase 2) commenced.

The amendments introduced new requirements for reporting to clients about the costs and performance of their investments, and the content of their accounts. These amendments applied to dealers and advisors in all categories of registration, with some application to investment fund managers. Minor enhancements to the Canadian Securities Administrators’ National Instrument 31-103 were implemented in July 2013. As of July 2014, dealers and advisors were required to provide pre-trade disclosure of change and to report on compensation from debt securities transactions. In July 2015 – about two months after managers had started to amend their documents to reflect other regulatory changes affecting the most commonly used prospectus exemptions – expanded account statements became mandatory, including requirements to position cost information and determine market values using a prescribed methodology for most securities.

And there is going to be more to come.

As of July 2016, registered firms will be required to provide an annual report on charges and other compensation that show, in dollars, what the dealer or advisor was paid for and which products and services were provided. As well, the amendments prescribe an annual investment performance report that covers deposits and withdrawals to the client’s account, changes in value of the account, and percentage returns for the previous year, three years, five years and 10 years.

“Over the next 12 months, the industry will be significantly impacted by the changes and [new] disclosure requirements of CRM2, [even as] many managers are still implementing the disclosure requirements already in force,” says Kimberly Poster, Chief Legal Counsel, Investment Funds at AUM Law in Toronto.

The compensation disclosure charges, however, will not be the first shockwave of reform in 2016. In May, requirements for pre-sale delivery of the Fund Facts will take effect. Fund Facts is a document designed to give investors key information about a mutual fund, in language they can easily understand, at a time that is relevant to their investment decision. Since January 1, 2011, fund managers have been required to file Fund Facts for their funds and to post them to their website. Since June 2014, dealers have been required to deliver the document within two days of buying a conventional mutual fund.

Next May, however, dealers will have to supply the information to clients before they accept instructions to buy shares of the mutual funds. The change in timing is a significant issue.

“This will create operational difficulties because dealers don’t know what funds the client will instruct them to buy at the time they set out to get those instructions,” François Brais explains.

At the same time, dealers will have to disclose the amount they receive in “trailer fees,” also known as “trailer commissions.” Mutual fund managers pay trailer fees to salespeople who sell the fund to investors. The trailer fee pays the salesperson for providing the investor with ongoing investment advice and services. The fee is paid annually so long as the investor holds shares in the fund.

From an investor’s perspective, knowing whether a mutual fund salesperson has received a trailer fee can be important because of its potential to influence the advice given to clients.

“The upshot is that more dealers are moving to fee-based models that charge the client directly for advice,” says Michael Bunn in the Toronto office of Norton Rose Fulbright Canada LLP. “Consequently, the mutual fund managers, who no longer have the trailer fee expense, can lower the prices of their products. But to do that, they have to change their documentation, including their prospectuses, and that of course is expensive.”


To complicate things even more, the Canadian Securities Administrators (CSA) has proposed changes in risk classification methods for retail investment funds. Historically, such methodologies have been chosen by the manager, with volatility risk the preferred approach. CSA, however, is leaning to a 10-year annualized standard deviation as the risk indicator.

“If the changes are enacted, the Fund Facts for all retail mutual funds would be affected,” Poster says.

And so might the proposed summary disclosure documents, similar to Fund Facts, which the CSA recently proposed for exchange-traded funds (ETFs). As well, the CSA recently released new reporting requirements for exempt distributions in early summer 2015.

Otherwise, at press time, the CSA was poised to complete its public consultations on the Alternative Funds Proposal, the final phase of the CSA’s ongoing effort to modernize regulation of investment fund products. The group expects to publish proposed amendments for comment by the end of 2015.

Then there’s the day-to-day regulatory compliance that doesn’t make the same splash as the more controversial issues.

“Managers are facing the practical implications and expenses of new marketplaces and ensuring that the order protection rules [designed to prevent inferior-priced orders from taking precedence over better orders] and to the extent applicable, best execution dealer obligations [requiring dealers to seek the best execution of trades reasonably available], are met,” Poster says. “They’re also dealing with issues relating to email communications with their clients as a result of CASL [Canada’s anti-spam legislation], FATCA registration, and due diligence on client accounts.”

Finally, a host of minor reforms adds to the burden. “A lot of small things come out in the form of guidance, but small as they may be, they often require resources to deal with them, and over time that adds up,” McGrade says. “Sometimes it takes a great deal of creativity by our lawyers to help clients manage these changes in a cost-effective way.”

And cost-effective the industry must be, seeing as how it’s currently riding a wave of downward price pressures driven partly by the competitive challenges from exchange-traded funds (ETFs) and robo-advisor platforms, partly by the new focus on fee transparency and partly by current economic conditions. Also among the challenges are new proposals to open up the Canada Pension Plan to voluntary contributions.

“If these proposals crystallize, and the mandatory CPP contribution is increased or people are allowed to make additional contributions, there could certainly be a drag on the amount of money flowing to the investment fund industry,” Bunn says.

As the compliance-driven and other pressures mount, they’re putting something of a spotlight on the uneven playing field that exists between some of the investment products.

“Segregated funds [funds administered by Canadian insurance companies in the form of individual, variable life insurance contracts offering certain guarantees to the policyholder such as reimbursement of capital upon death], for example, are considered to be insurance products and are not subject to OSC oversight, so dealers selling these funds will not have to disclose the fees they receive to clients,” Bunn explains. “This could result in dealers who are selling both mutual and segregated funds to favour the latter.”

Conventional investment funds have also complained, to some effect, that structured products, also called market-linked investments and usually found in the form of closed-end funds, enjoy unfair advantages. While the CSA has not made its position totally clear, there are indications, in staff notices and otherwise, that regulators are turning their minds to keener regulation of structured products.

“An upsurge in regulation wouldn’t be surprising because regulators tend to view linked funds and investment funds through the same lens,” says Brooke Jamison of Davies Ward Phillips & Vineberg LLP in Toronto, who works with structured funds.

But Jamison believes that it doesn’t always make sense to impose traditional investment fund rules onto structured products like linked bank notes.

“Changes in the fee structure, for example, that might make sense in the investment fund context don’t necessarily make sense with respect to linked notes,” she says. “That’s not to say that there shouldn’t be some similarity in the rules, but we do want a level playing field and a clear and transparent regulatory context.”


As the wave of reform swells, its impact has gone beyond operational consequences to affecting the very construct of the investment fund market.

As Bunn sees it, the regulatory scheme has become so complicated as to pose a barrier to entering the industry. “The basic process of registering a portfolio or investment fund manager with a securities commission has become so lengthy and complicated that it is hard for new entrants, especially single-person shops, to break into the industry,” he says.

The increased regulatory burden, including the need to upgrade systems to comply with new reporting standards, is also making it hard for existing smaller players to compete. So is the Ontario Securities Commission’s renewed emphasis on the requirement that chief compliance officers have prior compliance experience.

“The requirement for compliance experience has been around for a while, but the new rigidity with which it is being enforced is creating problems for the smaller shops,” Michael Bunn says. “So, overall, we may well be looking to a period of consolidation in the industry.”

Going forward, moreover, there are two large elephants looming on the horizon in the form of the CSA’s investigation into the feasibility of introducing a statutory “best interests” standard and its inquiry into mutual fund fee reform.

The CSA first introduced the notion of a best interests standard in 2012. In December 2013, the CSA published a status report indicating significant disagreement about whether the current framework adequately protected investors. Nothing has happened since.

“The regulators may be waiting to see the results from the full implementation of CRM2, which requires, among other things, annual performance reporting and additional client disclosure on charges and commissions,” Poster says.

With regard to mutual fund fee reform, the CSA has so far focused on enhancing transparency, particularly through the Fund Facts and CRM2. In December 2012, however, a CSA discussion paper requested comments about how embedded advisor compensation and other forms of tied compensation could give rise to actual or perceived conflicts of interest.

After comments were received, the CSA commissioned independent research to determine whether regulatory action was required. It ultimately awarded a research contract to the Brondesbury Group to assess whether fee-based advice changed the nature of advice that might be given under commission-based compensation. The CSA also engaged Professor Douglas Cumming of the Schulich School of Business at York University in Toronto to consider whether trailer fees influenced mutual fund sales.

The Brondesbury report was released in June 2015. The study concluded that compensation affected advice sufficiently to justify developing new compensation policies. “According to the Group’s findings, there is conclusive evidence that commission-based compensation creates problems that must be addressed,” Poster says. “Fee-based compensation may be a better alternative, but the report suggested there is not enough evidence to state with certainty that such compensation would lead to better long-term outcomes for investors.”

Before taking further steps, the CSA is awaiting Cumming’s report, which had not yet been released at press time, but was expected soon.


Despite the drawn-out process relating to these reforms, Poster believes that change will actually transpire. “Both the review of the statutory best interest standard and potential issues relating to current compensation structures in the mutual fund industry have garnered extensive debate that will be difficult for the regulators to ignore,” she says.

But the implications of both initiatives, whose reviews have been co-ordinated, are still unclear.

To begin with, the effects of a best interests standard depend in part on who becomes subject to the duty and the circumstances in which the duty applies.

“Commentators have suggested, for example, that certain business structures, such as exempt market dealers that only distribute products on a one-off basis, may no longer be able to continue their operations if they are required to apply a best interests standard to that relationship,” Poster says. “There will be certain activities, such as the sale of proprietary funds and certain compensation structures, which may be called into question in a regime where all advisors would have to ensure at all times that their clients’ interests are placed ahead of their own. There may also be fewer competing products available if the only distinguishing factor is fees, and it is possible that advisors could shy away from suggesting riskier products for their clients.”

As for the mutual fee review, the impact will vary depending on the method chosen to address CSA concerns. “[These] could range from an outright ban on trailer commissions, [as is the case in certain countries], a requirement to disaggregate trailer fees from management fees for more transparent disclosure, to a regulatory cap on fees,” Poster says.

But d’Anglejan-Chatillon points out that there are compelling arguments on both sides of the mutual fund fee debate. “It’s hard to know where all this is going, but it will unfold very slowly and with a close look at what’s happened in places like Australia and the UK, which have moved to best interests, and the US, where the SEC has recommended the implementation of that standard as part of the Dodd-Frank reforms,” she says. “But if it happens, it’s certainly going to bring about significant structural changes to compensation methods and product offerings because funds could well migrate to other products, like segregated funds, that are not regulated in the same way.”

Although the investment fund industry is seeking equality of treatment to ensure that such a migration does not happen, d’Anglejan-Chatillon is skeptical that this will occur.

As it turns out, nobody in the investment fund industry is really sure what will happen next. What the industry does know is that evolutionary change, in some form, is not going to abate, and that revolutionary change could well be in the cards.