With the consultation deadline looming (June 6) for a proposal from regulators to ban embedded commissions, the investment industry is being challenged to provide strong evidence supporting its position that such a ban would harm small investors.
In an industry consultation session held in mid-April, the Ontario Securities Commission (OSC) stressed that regulators are not interested in hearing well-worn arguments - such as the assertion that eliminating embedded compensation will automatically create an "advice gap" between large and small investors - without seeing concrete data to support these positions.
"We want to hear something new," said Chantal Mainville, senior legal counsel in the investment funds and structured products branch at the OSC, during that session.
Mainville stressed that the industry must demonstrate why serving small investors would no longer be viable if embedded compensation arrangements are outlawed and "direct pay" arrangements are mandated, which the regulators are considering.
"If advisors are able to serve small investors now under the embedded commission model, why would that change under direct-pay arrangements? Where would these additional costs come from? Can these be quantified?" she asks. "We want submissions that, to the extent possible, are supported by fact-based evidence and data about our market."
In early 2017, the Canadian Securities Administrators (CSA) launched a six-month consultation on the idea of banning embedded compensation. In that consultation paper, the CSA indicates that it has not definitively decided to ban embedded fees. However, the paper also suggests that after extensive study of the issue, regulators will need to see compelling new evidence in favour of allowing embedded fees to survive.
The CSA paper concludes that the embedded commission model encourages "self-serving behaviour" by the industry (including fund portfolio managers, dealers and reps) that potentially harms investors and distorts markets.
Those conclusions are backed by an academic study of the Canadian mutual fund market carried out by York University professor Douglas Cumming on behalf of the CSA. That study found that trailers create conflicts of interest that ultimately harm investors.
Given that the CSA's concerns are underpinned by data, the regulators want feedback from the industry that is similarly rigorous and supported by evidence. In addition to comments regarding whether action is warranted or not, the regulators also are seeking input on measures that could mitigate the possible side effects of a ban on embedded commissions and possible alternatives to such a ban.
As Investment Executive went to press, there were a couple of dozen submissions on the CSA consultation, many of them from individual advisors speaking in favour of the existing fee structure.
Many submissions argue that clients are happy with the current regime and that regulators shouldn't mess with it. Some submissions discuss the concern about the potential to harm small investors should embedded commissions be banned; others suggest that regulators should focus their attention elsewhere, such as on improving investors' financial literacy.
Meanwhile, a handful of submissions support a ban. The submission from the seniors' advocacy group, CARP, states: "There is no value whatsoever in permitting embedded fees to continue. There is no basis to support a fee structure that leads to misunderstanding for clients and, more important, deters financial advisors from acting in their clients' best interests. Financial advisors are certainly entitled to an income - just not to the detriment of their clients."
And at least one advisor favours a ban as well. That submission argues that charging clients directly is more transparent and upfront than an embedded fee; and notes that this transparency is consistent with how professions such as accounting and legal advice operate.
The major investment industry advocacy groups have yet to make formal submissions. One vocal opponent of the idea of banning embedded commissions - the Investment Funds Institute of Canada (IFIC) - has a task force working on its comment letter.
"The [mutual fund] industry is putting a great deal of thought into preparing a comprehensive response," says Sara Clodman, senior manager public affairs at IFIC. "We have several committees reviewing different aspects of the [CSA] paper and we are discussing our proposed response with our broader membership to ensure that all perspectives are taken into account."
As for possible alternative solutions, Luc Paiement, a former advisor and veteran executive in the industry (currently executive advisor to the president and CEO of National Bank of Canada), suggests in his comment that the CSA should cap trailer fees to eliminate any incentive to favour one product over another, as well as require that advisors provide clients with a minimum level of service (at least, an annual portfolio review and a retirement plan) as a condition of collecting any trailers.
The CSA paper indicates that the regulator considered introducing a fee cap, but ultimately decided against it for fear that it wouldn't fully address the CSA's concerns with the existing system and determining the appropriate cap could be difficult without introducing unintended consequences.
The idea of imposing minimum service levels on advisors who collect trailers also was proposed in the CSA's initial consultation paper on mutual fund fee structures back in 2012, but the regulator decided not to pursue that option.
There is still time for all sides in this debate to make their case. Both before and after the June 6 deadline for comments on the CSA paper, member regulators plan to hold further consultations.
On May 12, the investment funds branch of the Autorité des marchés financiers (AMF) will host a session at its offices in Montreal to discuss the CSA paper and solicit further feedback. The AMF also plans other meetings in the weeks ahead.
The OSC is planning in-person consultations in early autumn, and the CSA aims to reach a verdict on embedded commissions by the end of 2017 or in early 2018.
When that decision is reached, it will be driven by data rather than rhetoric.
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