Reforms mean closer scrutiny of referrals

One of the most significant changes that registration reform will bring for advisors concerns the use of referral fees. Advisors registered with the securities commissions will need to disclose all referral fee arrangements to clients.

At the Strategy Institute’s Registration Reform conference in Toronto, Marsha Gerhart, a lawyer with Borden Ladner Gervais LLP and Carold Dagher, senior counsel with CIBC, outlined that registration reform is creating a compliance headache for registrants that have a lot of referral business.

According to Gerhart, under the Canadian Securities Administrator’s National Instrument 31-103, which is effective Sept. 28, all referral arrangements must be disclosed. If an advisor derives income from a referral arrangement with another professional or service, the client needs to be made aware of that arrangement.

Under NI 31-103, “referral fee” refers to one time fees, ongoing royalty fee arrangements and most importantly, so called “brown dollar arrangements” where a successful lead creates a higher employee performance rating or bonus compensation.

“I would say that this rule even [applies] if you were referring someone to a local car dealership,” Gerhart said.

Regulating brown dollar arrangements is problematic, because it creates a whole new level of compliance recording for any cross-distribution selling arrangements. For example, currently, an advisor in a bank branch who refers his client to a mortgage specialist may receive compensation for that. Under the new regime, these relationships will be highly scrutinized.

“At our firm we have manuals upon manuals of how year-end compensation is affected by referral arrangements,” Dagher said. “At our firm we have about 10,000 referrals on any given day. We do have a centralized process to deal with that.”

Under the new rule, registrants cannot participate in a referral arrangement unless a written agreement exists for the fees, they are recorded and disclosed to clients and the registrant or their firm has conducted appropriate due diligence on the referred party.

Gerhart and Dagher pointed out that the referral arrangements cannot be perceived to be a conflict of interest. Firms must ensure referral fees are not excessive and do not motivate a registrant to act “contrary to their duties to their clients.”

While disclosure of referral fees will still be required, advisors will not have to conduct due diligence on intra-company or affiliate referral arrangements.

For third party referrals, Dagher and Gerhart suggest a due diligence process should be developed and documented. Advisors should take into account whether the receiving party of a referral is qualified and registered to perform the services they are being referred to do. The referred services should also be considered appropriate for the client being referred.

It’s important to note, that trailer fee arrangement between an investment firm and an advisor is not considered a referral arrangement. That’s direct compensation to an advisor for the service they render, which is typically financial advice and investment selection for the client. Referral arrangements would cover business services the advisor is not qualified to do or does not conduct.

Apart from the extra compliance burden that will be required to monitor and disclose referral fee arrangements is the potentially difficult conversations some advisors may need to have with clients about referral fees they may have earned in the past. According to Prema Thiele, a partner at Borden, Ladner and Gervais, in Toronto and the conference’s chair, under the new rule, if those fees are still be earned it will need to be made clear to the client.

Thiele said referral arrangements where no fee is paid do not have to be disclosed. Common referral arrangements between lawyers, accountants and other professionals and an advisor don’t come under this rule either. But, if money changes hands, the clients have to be informed.

“The biggest thing is the disclosure of the referral fee, it has to be a full, plain and true disclosure [to the client],” Thiele told Advisor.ca

Dagher suggests this may create an awkward situation for advisors with clients that may be unaware that they are still earning referral fees on certain accounts. Clients may be taken aback by the revenue advisors have generated off their account without their knowledge. Advisors unaware that a referral arrangement is still in place, may be embarrassed by the situation.

“From a public relations perspective is a very challenging situation,” Dagher said.

Since 31-103 is going to be enacted by all the provincial security commissions, it is expected the rules will become part of the by-laws of the Investment Industry Regulatory Organization and the Mutual Fund Dealers Association (MFDA). Although, Gerhart said, the MFDA does currently have a stringent referral fee rule currently in place.

(09/18/09)