Most firms falling short in conflict compliance

A regulatory review of industry compliance with conflict-of-interest provisions shows most firms aren’t meeting their obligations under the client-focused reforms.

In a joint notice setting out the results of their reviews, the Canadian Securities Administrators (CSA) and the Canadian Investment Regulatory Organization (CIRO) indicated that only about 20% of the firms they examined got a clean bill of health on their handling of conflicts according to standards in the client-focused reforms (CFRs).

The reviews involved 172 firms including investment dealers, fund dealers, portfolios managers and exempt market dealers.

Most of the firms the regulators reviewed were found to have compliance deficiencies — such as failing to identify material conflicts, having inadequate controls to address those conflicts, maintaining outdated policies and procedures for dealing with conflicts, and providing insufficient disclosure to clients of those conflicts.

The regulators found that 66% of firms had sub-standard policies and procedures for dealing with conflicts. Conflict disclosure fell short at over half (53%) of the firms they reviewed, while more than one-third (34%) failed to recognize one or more material conflicts.

“We found that, although some firms had appropriately identified certain conflicts of interest as material, they lacked controls to address the material conflicts of interest, or the controls implemented were insufficient to address the material conflicts of interest in the best interest of clients,” the regulators said in their notice.

“Also, while certain firms had controls in place to effectively address certain material conflicts of interest, they had not identified those conflicts of interest or assessed them as material,” they said.

For instance, some firms failed to recognize that their rep-compensation arrangements represent material conflicts of interest, that the payment of third-party compensation (particularly differential compensation) creates a material conflict, and that dealing in proprietary products is a material conflict.

The regulators said firms that only in deal in proprietary products often relied on performing suitability assessments and disclosure to address conflicts.

“In our view, this generally will not be adequate to address these material conflicts of interest in the best interest of clients,” they said.

Other conflicts that firms missed include conflicts created by tying a branch manager’s compensation to the production of the reps they oversee, conflicts that arise from the markups and markdowns charged by exempt market dealers, and conflicts related to certain referral arrangements.

The regulators also found one firm charged clients different fees despite investing them all in the same model portfolios and using the same investment strategies.

In that case, the regulators said using criteria such as a rep’s seniority to determine fees isn’t justified. Instead, a factor such as a client’s account size would be a valid basis for setting different fees, they suggested.

One area where firms did well was recognizing that the provision of gifts and entertainment create conflicts. But regulators also found that firms didn’t always have controls to resolve these conflicts in the best interest of clients.

In addition to spelling out the deficiencies that regulators uncovered in their reviews, the notice also provides further guidance on regulators’ expectations and on how firms can fully comply with the CFR conflict requirements.

“The CSA and CIRO are committed to ensuring compliance with the client-focused reforms,” said Andrew Kriegler, president and CEO of CIRO, in a release.

“We encourage all firms to carefully review this notice to identify opportunities for strengthening their compliance programs to ensure they meet the enhanced standards established by the client-focused reforms.”

The regulators indicated that they will be continuing to assess firms’ compliance with all of the CFR requirements, and that they will also be carrying out targeted reviews of compliance with the other aspects of the rules, including the know your client, know your product and enhanced suitability obligations.

“We’ll have a better understanding of the level of compliance once our reviews are complete,” said Stan Magidson, chair of the CSA and chair and CEO of the Alberta Securities Commission (ASC), in a release.

“If we observe that the high standards of conduct required by the client-focused reforms are not achieved, we will consider our course of action at that time, such as considering additional rules.”