The fee debate and your obligation to clients

(May 2008) Over the past several years many dealers and advisors have embraced fee-based accounts for a number of sound business and ethical reasons. These accounts are said to more closely align interests, as both clients and advisors benefit directly from an increase in assets. The temptation to engage in certain trading activities, such as churning or unsolicited trades to meet advisor revenue targets is also reduced.

Steady and more predictable income, meanwhile, is a blessing to the CFOs of dealer companies when preparing budgets, particularly long-term capital budgets, and to others in the dealer community who know what it’s like to deal with uncertain revenue flows.

The widely accepted mantra of aligning interests, though, can lead to excessive promotion of fee-based accounts, to the detriment of some clients.

The general duty of dealers and their advisors to clients is stated in many ways in a number of industry publications, in decisions issued by various tribunals and in National Instrument 31-505, which requires registered advisors and dealers to deal “fairly, honestly and in good faith with clients.” Sponsoring dealers have an additional obligation — they must supervise to ensure their advisors fulfill this duty.

The conflicts of interest that arise in transaction-based accounts are well known to regulators, litigators and those in the industry. These are minimized through supervision policies and procedures intended to expose and limit trading activities that are clearly detrimental to client interests, along with activities that benefit advisors and the dealers, without benefit to clients.

Whether or not the promotion of fee-based accounts has been accompanied, in all cases, by supervisory policy and procedures intended to ensure clients are being well served is debatable. Some may argue that full disclosure of the available account options is sufficient, but experience in the United States would suggest that disclosure alone is not enough.

A report prepared by U.S. regulators has called fee-based programs a best practice because the programs diminish the incentive to undertake unsavoury and abusive practices (high-pressure sales tactics, recommending unsuitable transactions or transactions of questionable benefit to clients), but it cautioned that such programs were appropriate for investors who prefer consistent and explicit periodic charges and who engage in a moderate level of trading activity.

When clients are faced with an assortment of options, they will often look to their advisor for advice, direction and recommendations. In many cases, they will accept and rely on the advice, assuming rightly or wrongly that the advisor is making a recommendation for only the most appropriate of reasons. This reliance, combined with fees that exceed, by a large multiple, the cost of having a commission-based account, would seem to be a breach of the advisor’s duty to the client.

U.S. advisors have been disciplined in situations where a fee-based account has clearly been detrimental — where commission-based accounts would have been significantly cheaper for buy-and-hold investors or for those who purchased mutual funds with embedded asset allocation or rebalancing fees included in the fund’s management fee. With such funds, significant trading activity is unlikely.

The associated cost is not the only factor to consider: The dealer and the advisor need to be able to demonstrate the benefit when a client chooses, or is encouraged to open, a fee-based account over a commission-based account when trading is expected to be moderate or minimal, or has turned out to be minimal or moderate over the passage of time. Where an account is no longer reasonable given the client’s goals, objectives and trading activity, the client should be advised to consider changing to a commission-based account.

Dealers should develop, and advisors should follow, policies and procedures to ensure that advisors make balanced representations about the advantages and disadvantages of different account types. An approval and review process should also be created to verify that accounts are reasonable and suitable for the client’s needs.

There is no bright line test, clearly defined rule, standard or formula that can be applied but the lack of policies and procedures can lead to considerable public embarrassment if a regulatory investigation, successful lawsuit or media report start revealing situations in which clients are effectively paying unreasonable or outrageous amounts for trades in a fee-based account.

Richard E. Austin is counsel with Borden Ladner Gervais LLP in Toronto, and specializes in financial services, with a particular emphasis on registration and compliance matters. RAustin@blgcanada.com

(05/16/08)