WHY YOU’LL WANT TO READ IT
Despite its name, the British Columbia Securities Commission (BCSC)’s 2022 Report Card (the Report Card) is a critical source of compliance information for firms registered in any CSA jurisdiction, and is relevant for 2023 and beyond. The BCSC publishes the Report Card to help CCOs and compliance staff improve their compliance programs.
Firms will want to read the Report Card in its entirety to ascertain whether any of the numerous findings offer compliance guidance relevant to their business. This PMAC summary is intended to highlight certain findings relevant to PMs and IFMs, including the first glimpse of findings from the Client Focused Reforms (CFR) Conflicts of Interest (COI) sweep conducted by the wider CSA.
CONFLICT OF INTERST SWEEP FINDINGS
PMAC’s understanding is that the CSA’s findings on the COI sweep will be published later this summer or in the early fall.
In the interim, the Report Card shares BC’s own much-anticipated observations about the COI deficiencies noted. The BCSC reminds firms that guidance on the COI requirements has been published by the CSA in the Companion Policy to National Instrument 31-103 (NI 31-103CP); however, given the nature of the findings highlighted in the Report Card, it is becoming clear that NI 31-103CP is a starting point, but is unlikely to be the final publication about COI-related compliance.
Processes relating to COIs remain deficient
Half of the COI deficiencies identified by the BCSC relate to firms’ COI processes, that is, their mechanisms to identify, assess, manage and/or disclose material COIs.
Firms are expected to consider all circumstances in which the interests of the firm or its registrants do not align with the interests of clients, and where such circumstances can be reasonably expected to impact either or both the decision of the client or the firm/registrant.
Some firms responded to the COI sweep by stating they have no material COIs in their business, failing to recognize and address common COIs such as fair allocation, personal trading, and outside business activities. In other cases, the BCSC found that firms incorrectly assessed a COI to be immaterial, and, as a result, failed to implement the necessary controls to address it. Other firms identified COIs but failed to undertake the required assessment of such conflicts or to determine any mitigation measures.
The BCSC reminds firms that all material COIs must be disclosed in writing and in a clear, meaningful manner to a client whose interests are affected by the COI, in the case where a reasonable client would expect such information. When disclosing COIs, the following criteria must be clearly described: the nature and extent of the COI; the potential impact on/risk that the COI could pose to the client; and how the COI has or will be addressed. Boilerplate COI disclosure or disclosure of COIs that do not exist at a firm are also considered inadequate. Moreover, material COIs identified by firms in their internal documentation must also be disclosed to clients. Firms that failed on any of these fronts were found to have made inadequate disclosure of their COIs.
Policies, procedures, and records of COIs
While a few firms were found to have no written policies and procedures at all to identify, assess, and respond to COIs, most policy-related deficiencies were in the context of firms that did not have policies with respect to specific types of conflicts, such as firms without a gifts and entertainment policy or a policy regarding referral arrangements. Firms that had identified material COIs but failed to itemize and document them in their policies & procedures manual, as well as those that failed to provide information on their COIs to employees, were also deficient in this respect.
Most prominent COI deficiencies for portfolio managers/IFMs
Referral arrangements almost always give rise to material COIs and the Report Card notes that some advisers/IFMs failed to identify these material COIs and made inaccurate client disclosure as a result. The BCSC flags both paid referral arrangements with financial planners as a commonly missed COI, as well as service fee collection agreements where the financial planner refers clients to the portfolio manager firm and the firm agrees to deduct both the financial planning and the portfolio management fees from the referred client’s account. Despite this type of arrangement being unpaid, it remains a COI since there are benefits to the firm from having an increased AUM and management fees, and the financial planner benefits from receiving the financial planning fees. As a result, the Report Card notes that these referral arrangements may not always be in the best interest of the client. Disclosure regarding referral arrangements must:
- describe the nature and extent of the COI, including disclosure about how the interests of the registrant may not align with the interests of the client;
- disclose the potential impact of the COI to the client: this includes a description of what would happen if the registrant were to place its interests before those of the client or harm the client; and
- disclose how the COI has or will be addressed, including a description of controls adopted in respect of the COI.
Compensation arrangements that are entirely or partially variable based on revenue and sales targets is another common COI deficiency. These include: incentives that are based on revenue generation, sales and revenue targets, annual awards, promotions or the chance to make partner at the firm; any negative compensation consequences for failing to meet any targets (including the repayment of any advanced commissions to registered individuals should they fail to meet their targets); and paying different commissions for certain products and/or for certain clients.
Disclosure of compensation-related COIs to clients sometimes lacked details regarding how the conflict will impact clients’ interests. The Report Card reiterates that disclosure may not be sufficient to address certain types of conflicts created by particular compensation practices.
Noting that gifting can cause favouritism or suppress client complaints, the BCSC highlights that gifts both to and from clients can result in material COIs. The Report Card noted that some firms did not have (or had insufficient) policies regarding gifting and/or did not monitor and track gifts given and received. Tracking must be in place to ensure that gifts are neither material nor frequent.
Other COI-related deficiencies were found in respect of the following types of conflicts:
- Proprietary and related party products – this is almost always a COI that requires disclosure and controls, several of which are outlined in NI 31-103CP. Disclosure alone is insufficient to manage proprietary and related-party conflicts.
- Negotiable management fees – fees that differ from the firm’s standard fee schedule need to be disclosed in writing to all clients to prevent unfair dealing between clients who are unaware that some of the firm’s clients are able to negotiate their fees.
- Registered individuals’ outside activities – some firms failed to disclose how they control COIs arising from outside activities, including with respect to shared CCOs or individual registrants having roles at issuers, such as sitting on an issuer’s board of directors. As firms work on the National Instrument 33-109 – Registration Information changes to outside activities that must be completed by June, they should also revisit their disclosure regarding such outside activities.
RELEVANT INVESTMENT MANAGEMENT EXPERIENCE COMMENTARY
Several PMAC members have noted challenges in having individuals registered as Advising Representatives (AR), with some firms observing that there appears to have been a shift in the type of experience that the CSA will consider relevant investment management experience (RIME) required to be registered as an AR.
The Report Card outlines the BCSC’s concern over individual registration applications and the quality of disclosure made with respect to candidates’ RIME. The BCSC reminds registrants that CSA Staff Notice 31-332 – Relevant Investment Management Experience for Advising Representations of Portfolio Managers and NI 31-103CP remain the current guidance on RIME, and that filers have an onus to demonstrate that individuals possess the appropriate proficiency and RIME for the registration category they are seeking.
While PMAC will continue to engage with the CSA with respect to the RIME requirements, for the time being, firms should be alert to the following guidance from the BCSC when submitting AR registration applications:
- Do not exaggerate or include promotional submissions with respect to an individual’s tasks that do not demonstrate RIME
- Do not use internal titles showing an individual’s role within the firm where such title does not having a bearing on establishing RIME
- Do verify that the registration application demonstrates high quality experience that is clearly linked to discretionary portfolio management
- Do ensure you have read all available guidance before filing a registration application [or reach out to PMAC for a referral to a law firm or compliance consultant who can assist]
- Do be very specific about the applicant’s experience and include all relevant information, omitting anything promotional or extraneous
The Report Card also highlights an enforcement action taken and settlement agreement reached between the BCSC and an individual for conducting registrable activity prior to becoming registered. This individual’s registration application included a number of responsibilities, intended to demonstrate their RIME, that revealed that the applicant had been meeting with and advising clients prior to being registered.
CONSISTENT CATEGORIES OF COMMON DEFICIENCIES
In 2022, BC had 85 directly-regulated adviser firms (including IFMs). The BCSC undertook 27 compliance reviews in 2022 and, of those, 17 reviews were part of the COI sweep. A full 73% of the total deficiencies identified by the BCSC fell into the following six categories:
- Policies & Procedures;
- Advertising, marketing and holding out;
- Client statements and reporting;
- Know-Your-Client (KYC) and suitability; and (tied for 5th place most common deficiency category),
- Record keeping.
Other general deficiencies
The BCSC identified the following additional deficiencies:
- Misleading titles – firms appointed registrants as corporate officers to enable the continued use of corporate titles, but the commission found these individuals did not have any substantive corporate responsibility or authority. Note that when updating NI 33-109 information, firms should not be providing the registered individual’s registration category, but are required to disclose the title the individual uses with clients.
- Insufficient KYC information – the KYC requirements apply to all clients (other than those who have provided a waiver as allowed under NI 31-103) and some firms had not updated their KYC questionnaires to include the elements of personal circumstance, investment knowledge and risk profile that were introduced under the CFRs.
- Failure to make best efforts to identify a trusted contact person (TCP) – firms must take – and document – reasonable steps to obtain the contact information of a TCP.
- Financial filings – the Report Card outlines a number of deficiencies related to financial filings including that NI 31-103 requires audited annual comparable financial statements and the IFRS requires disclosure of compensation for key management personal, related-party transactions, and outstanding related-party balances. Pages 9-11 of the Report Card set out additional financial filing findings in detail and should be reviewed carefully.
- “Renting out” registration / payment to unregistered parties – building on the BCSC’s findings from the 2021 Report Card, arrangements used by PM/IFMs that are intended to circumvent registration requirements (by having an unregistered entity receiving a sizable portion of the compensation, conducting registerable activities and holding itself out as being registered), will continue to be regarded as a serious compliance breach that merits compliance and/or enforcement action.
 PMAC Members can access the PMAC Guide to Collecting and Maintaining KYC Information which includes a section on Considerations in Developing a KYC Questionnaire
BCSC NEW RISK QUESTIONNAIRE – JUNE 2023
In June 2023, the BCSC will introduce a new risk questionnaire for firms that have BC as their principal regulator. BC undertook a project to create a new risk model ; the questionnaire will help the commission identify whether a registrant has undergone any changes, including significant growth, management changes, new products and higher risk investment strategies (similar to the OSC’s Risk Assessment Questionnaire). PMAC understands from BCSC Staff that the 2023 questionnaire will be similar to previous versions in terms of both themes and key areas in which the commission will be asking for information. The new questionnaire will not, however, have any written essay-type questions and, as such, the BCSC anticipates that it will be less burdensome for registered firms to complete.
The information gleaned from this survey will assist the BCSC in selecting firms for compliance examinations based on factors or patterns that may increase risk. As is the practice in other provinces, firms that have not recently been subject to an audit may also be selected for review on the basis of the time elapsed since their last review.
COMPLIANCE ACTIONS AND LOOKING FORWARD
Non-compliance may be dealt with via enforcement action (which does not require actual client harm as a pre-requisite), settlement actions, or administrative penalties imposed by notice under the Securities Act (British Columbia).
2023 compliance examinations will take a hybrid approach and firms should expect an expanded review of their compliance with the CFRs, including on KYC, know-your-product (KYP) and suitability.