Report underscores fund dealer conflict of interest

Lawyers advising mutual fund dealers are bracing for more regulatory change in the wake of a report commissioned by Canada’s securities regulators. The report points to a widespread conflict of interest that may come at the expense of clients.

In particular, the report by the Canadian Securities Administrators (CSA) finds that mutual funds sold by affiliated dealers tend to underperform, while those with trailer fees – regardless of past performance – tend to enjoy higher sales.

“It is an impressive amount of quantitative work that has been undertaken,” says Ron Schwass of Wildeboer Dellelce LLP. “It is going to be interesting to see the firefight that breaks out between the industry participants around whether or not the data supports the strength of the conclusions that they have in the executive summary.”

The study was prepared by York University Professor Douglas Cumming. It follows a June 2015 report by the Brondesbury Group, which compared investment outcomes of funds with commission-based compensation structures against those with fee-based structures. Both reports may prompt to CSA to clamp down on trailer fees or even impose a higher standard of care on financial advisors.

The CSA has said it aims to communicate a policy direction on mutual fund fees by the first half of 2016. “Generally speaking the results of the report will probably add ammunition to the argument against trailer fees,” says Michael Bunn at Norton Rose Fulbright Canada LLP.

Many lawyers in the industry hope the CSA refrains from coming down too hard on mutual fund dealers given that upcoming disclosure requirements, coming into effect in the summer of 2016, may already address some of the concerns highlighted in Cumming’s report.

The third and final phase of the Client Relationship Model - Phase 2 (CRM2) regulatory changes, will require registered firms 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.

“Hopefully the regulators will allow these new CRM2 changes to come into force and they will let themselves work their way through the system and see what the results are from those changes before they dive head first into further regulatory initiatives such as a ban on trailer fees,” says Bunn.

Many in the mutual fund industry also claim that banning trailer fees would have a negative impact on the affordability of financial advice for lower-income consumers. “The UK and Australia have banned trailers, two or three years ago, [and the] preliminary conclusion is that less wealthy people have less access to advice,” says François Brais of Fasken Martineau DuMoulin LLP. “Any regulatory scheme that reduces the access to advice is not good.”

“When you look at people, somebody for example who is just starting out as an investor, somebody who has a relatively small amount of money to invest,” says Bunn, “then there certainly are areas where they could be economically further ahead by having their dealer be compensated through a trailer structure … than they would be if they had to dig into their pocket and pay the dealer $200 to $300 an hour for financial advice.”

For Edward Waitzer at Stikeman Elliott LLP, however, Cumming’s report simply confirms what was already known. “The answer is, and has been for a long time, the need to broaden the fiduciary standard through the financial services supply chain, and impose obligations on those who provide financial services to act in the best interests of clients.”

Waitzer thinks commissioning more reports has simply slowed down this process. “What is surprising is how long it is taking Canadian securities regulators to move on this. These are issues that have been addressed. We are now into a second and third generation of policy responses by other regulators in the UK and US and Australia.” (Australia and the UK banned embedded commissions in 2012 on mutual funds and they have imposed a “best interests” standard on financial advisors.)

But other lawyers are not so sure that imposing a higher standard will have the intended effects. “Faced with two equally performing funds that on a qualitative basis are equal, should the dealer be forced to sell the lower-commissioned fund?” asks Brais. “Perhaps, but then the question is, how do you build that in? How do you make sure somebody sells something that is cheaper when it is equal to something else, when there are so many funds out there? How does a dealer implement that?”

Brais also points out that imposing more regulation on mutual funds may simply cause dealers to move to other investment vehicles. “It is one thing to regulate mutual funds, but mutual funds are only one of several other financial products that are out there. The more you regulate mutual funds, without other financial products have the same kind of regulation, the less level a playing field you have for mutual funds, and dealers and advisors will adapt. If I can’t make enough money in this particular space, I will move into this other space that is less regulated and for which my fees are more hidden.”