Brush up on CRM2 referral fee rules

Last week IIROC released an updated version of its CRM2 FAQs, which includes new questions and revises some previous answers.

“People are nervous about everything; that’s why they’re asking these questions,” says Rebecca Cowdery, a partner at Borden Ladner Gervais in Toronto. She notes most of the updates are tweaks aimed at clarifying nuances. “What I find interesting is what they’re doing with referral fees,” she says.

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Referral fees and other types of third-party compensation are addressed in FAQs #23 through #28. Cowdery says advisors and dealers should pay particularly close attention to FAQs #25 through #28.

FAQ #25: Referrals for “registerable services”

It’s common for a dealer to refer a client to another registered firm when the referring dealer does not offer specific account types such as order execution-only or managed accounts, for instance, or where the referring dealer doesn’t offer a specific investment product the client wants. The referring dealer is typically compensated by the dealer that gets the new business.

FAQ #25 addresses this question: “Should […] referral fee amounts received from another registered firm be disclosed within an annual account fee/charge report provided to the client by the referring Dealer Member?”

IIROC’s answer covers two different scenarios.

When the following conditions apply, the referring dealer does not have to disclose referral fee amounts it receives in the annual account fee/charge report it gives the client:

• any previously opened accounts for the referred service offering have been closed at the referring dealer;
• an account for the referred service has been opened (or is being maintained) at the other registered firm;
• the referring dealer has no involvement in the operation of that account; and
• the referring dealer is satisfied that the other registered firm is providing adequate disclosure of the referral arrangement in the annual fee/charge report it gives the client for the referred account.

“In all other instances,” the FAQ document says, the referring dealer must disclose the referral fee amounts “within at least one” of the annual fee reports it gives the client. Richard Corner, vice-president and chief policy advisor, Member Regulation, at IIROC, summed up FAQ #25 in an email to Advisor.ca: “[It] makes an exception for certain registerable service referral arrangements where the referral is made to another registered firm who is reporting on the referral arrangement within the annual charge report they provide to the client. In essence, this exception eliminates the need to report the same referral fees to the client in separate annual charge reports issued by two different registered firms.”

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Cowdery notes that under the current referral fee regime (see NI 31-103 sec. 13.7 through 13.11), clients get significant disclosure before the referral arrangement is formally established. “When you set up a referral arrangement, you’ve got to give the client disclosure [on] what you’re going to be receiving. You have to tell them the nature of the fee as well as what the fee is, including the period of time [fees will be received]. That’s received by the client in writing before they sign up for the new account with the person who they’re being referred to.”

FAQ #26: Referrals for accounting, legal and other services

This section addresses cases where a dealer gets a referral fee for sending a client to a firm outside the securities world—an accounting or legal firm, for instance. In IIROC’s lingo, the firm is providing “non-registerable services.”

In such cases, fees the dealer receives do not have to be disclosed on the annual account fee report it gives clients. Corner confirmed that a referral to an insurance agent or broker would fall into the “non-registerable” category; any fees the IIROC dealer receives as a result of this referral arrangement would not, therefore, have to be disclosed on the annual charge report.

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So, when it comes to registerable services (FAQ #25), there are potential cases where the referring dealer needs to disclose the referral fee on the annual charge report for clients. This is never the case with non-registerable services. Corner explains the rationale for the different treatment: “The general intention of the annual charge report is to disclose all fees/charges earned by the firm with respect to registerable services so that the client can compare the fees they’ve paid to the performance of the assets they’ve invested in—these assets would exclusively relate to registerable services.”

FAQ #27: Back-office sharing arrangements

This section addresses the common scenario where a client-facing portfolio manager outsources services such as trade execution to an IIROC firm.

The question is whether the firm providing the outsourced services is required to disclose, on an annual charge report, the service fees it gets from the portfolio manager.

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Assuming the services provided are one or more of trade execution, custody, or clearing and settlement; and assuming the service provider is opening and maintaining separate accounts for each client, the service provider does not have to disclose outsource service fees on an annual charge report. This holds as long as:

• the firm that outsources the services (e.g., portfolio manager) is handling the client-facing relationship;
• the firm that outsources the services, and not that firm’s clients, is paying the service provider the outsource service fees; and
• the outsource service fees “represent a cost to the outsourcing registered firm of making a particular account service offering available to clients (in the same manner as if these functions had not been outsourced and the costs had been borne directly by the outsourcing registered firm).”

In all other cases, the firm providing the outsourced services has to disclose outsource fee amounts on clients’ annual charge reports. One such circumstance: the firm that provides the outsourced services directly charges the portfolio manager’s clients for the outsource service fees.

FAQ #28: New issue commission

Take a case where a big bank is underwriting a new issue. It provides both financing services through its capital markets division and marketing and distribution services through its wealth management arm. The issuer, of course, pays a handsome fee for these services. How much of it has to be disclosed on the statements of retail clients who purchase the securities?

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“Only the portion of the fee that relates to the distribution of the new issue to clients (the ‘commission portion’) must be disclosed within the applicable annual account fee/charge report,” the FAQ document says. This commission portion is “the amount that goes to the account advisor’s grid.”

Cowdery notes dealers generally like this rule. She adds there are industry watchers who “might say it’s not the right approach because it’s not full disclosure to the client of the firm’s involvement.”

For fee reports covering periods ending no later than December 31, 2016, IIROC is allowing dealers to use the following note (or something similar): For new issue securities sold to you during the period covered by the report, a portion of the amount you paid to purchase the new issue securities was paid to us by the company that issued the securities as compensation for the new issue distribution services we provided to you. Our receipt of these commissions may not necessarily result in a dollar-for-dollar reduction of your profit or increase of your loss on these investments.

For fee reports covering periods ending after December 31, 2016, the commission portion must appear as a line-item. IIROC also suggests including the above explanatory note.

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