Findings from the CSA and CIRO (IIROC and MFDA) (collectively, the Regulators) Conflict of Interest sweeps (Staff Notice) were released on August 3, 2023. The Regulators conducted reviews of 172 firms; 50% are registered as portfolio managers (most of these firms were also registered as IFMs and/or EMDs). Only 22% of registrants reviewed did not have deficiencies with respect to conflicts of interest; almost 80% of firms had not met the regulators’ expectations and were required to correct the deficiencies noted.
The most common deficiencies identified were (i) inadequate policies and procedures related to conflicts of interest, and (ii) missing or incomplete disclosure related to material conflicts of interest.
The Regulators identify and discuss the following primary issues in the Staff Notice:
- Identifying material conflicts of interest and addressing material conflicts of interest in the best interest of the client
- Missing or incomplete disclosure related to material conflicts of interest
- Inadequate policies and procedures related to conflicts of interest
- Lack of or inadequate training on conflicts of interest
- Conflicts of interest record keeping obligations
Identification of material conflicts of interest
With respect to the identification of material conflicts of interest, the Regulators recognize that determining whether a conflict of interest is material involves an exercise of professional judgment. They note that registrants should determine whether the conflict may influence the decisions of the client in the circumstances, or influence the recommendations or decisions of the registrant in the circumstances.
PMAC members may refer to the PMAC Conflict of Interest Resources to assist with the identification and handling of material conflicts of interest.
Even where material conflicts were properly identified, some firms lacked controls to address the conflicts in the best interests of clients. Conflicts must be addressed by either (i) avoiding the conflict, or (ii) using controls to sufficiently mitigate the conflict to demonstrate that it has been addressed in the client’s best interest. If there are insufficient controls to address the conflict in the best interests of the client, the conflict must be avoided.
The Staff Notice provides 10 examples of conflicts that the Regulators viewed as material, and outlines suggested controls to address the conflict in the best interest of clients. We encourage members to review all of the examples provided to determine whether they apply to your particular business model. The examples in the Staff Notice are in addition to the examples of conflicts of interest outlined in the Companion Policy to NI 31-103.
We believe that the following examples of conflicts may be of particular interest to PMAC members:
1. Conflicts arising from internal compensation arrangements and incentive practices
The Regulators note that internal compensation arrangements and incentive practices must be considered from a conflicts of interest perspective. Although the Staff Notice acknowledges that certain incentives associated with performance may align the interest of the client and the registrant, the Regulators nevertheless caution that compensation can influence registrants to disregard the best interests of the client in favour of monetary gain (in the form of a bonus, for example). Suggested controls include avoiding compensation arrangements that differ by product, service, or account or client type. The Regulators also recommend conducting periodic reviews to determine whether inappropriate behaviour is occurring in the pursuit of bonuses or other compensation, and performing periodic client account reviews where investments or performance may be tied to a registered individual’s compensation to determine whether the account activity or investments are in the client’s best interest.
2. Conflicts arising from fees charged to clients
The Regulators take the view that fee schedules that distinguish between products or clients can represent a material conflict of interest. This is especially the case if clients are charged different fees for substantially similar products or services. The Staff Notice states that disclosure alone is not sufficient to address this conflict in the best interests of clients. This includes situations where some clients are able to negotiate fees or deviate from the standard fee schedule or where new clients are offered different fees compared to legacy clients for the same products or services.
Suggested controls to address these conflicts include establishing a standard fee schedule based on measurable criteria. Measurable criteria may include: the client account size or AUM, account type, product type, customized or model portfolio offering, the nature of the client-registrant relationship and the level of service provided; these criteria can be relied upon to justify a fee differential. All clients should be provided with disclosure with respect to the circumstances under which the client can negotiate fees. Where deviation from the standard fee schedule is contemplated, a process by which prior approval from a designated individual such as the CCO or manager should be implemented.
Notably, in situations where firms had only non-individual permitted clients, and fees were negotiated based on the specific circumstances of the client, this was not found to be a material conflict of interest and it was acknowledged that this is general industry practice.
The Staff Notice indicates that Regulators will continue to monitor conflicts associated with fees, and may issue additional guidance.
3. Conflicts related to referral arrangements.
The Staff Notice reminds registrants that the term “referral fee” is interpreted broadly and may include benefits other than monetary fees. Where a client is referred to a registrant, the client should not be charged higher fees compared to other clients for the same products and services (to compensate for referral fees paid).
Where the registrant refers clients to other service providers in exchange for a fee, the referral must be in the client’s best interest, and must not be solely based on the receipt of a referral fee by the registrant. This includes referrals to an affiliate of the registrant.
The Staff Notice sets out a fairly complex and onerous due diligence process that firms may use to determine whether the referral is appropriate. This could include: searching available databases to determine the licensing status or registration of the provider, their financial status, professional qualifications, disciplinary actions or investigations, complaints, claims or other matters that would impugn their professional reputation.
Some of the controls suggested with respect to monitoring include sending annual questionnaires and interviewing registered individuals within the firm who participate in referral arrangements, ongoing assessment of compensation received under referral arrangements, regular calls to investors referred by the firm to assess how the referral process is being conducted, and assessment of complaints received in connection with referral arrangements.
Disclosure
The client focused reforms (CFRs) require disclosure to clients of material conflicts of interest; the disclosure must include the following three elements: (i) the nature and extent of the conflict, (ii) the potential impact and risk that the conflict may pose to the client, and (iii) how the material conflict of interest will be addressed by the firm. Approximately 10% of the firms reviewed did not provide the required disclosure to clients. Where firms did provide disclosure, approximately 43% of firms were found to have inadequate disclosure. In particular, the potential impact and risk that the material conflict could pose to a client and how the conflict has been addressed were missing from the disclosure.
Some firms relied on disclosure prepared by another entity, for example the conflicts described in an issuer’s offering memorandum. The Staff Notice notes that this disclosure does not reflect the registered firm’s perspective and is therefore inadequate.
Inadequate policies and procedures
Approximately 66% of the firms reviewed did not have adequate policies and procedures regarding conflicts of interest. The Staff Notice includes a list of elements that should be included in a firm’s policies and procedures that merits close reading.
Lack of or inadequate training
The CFRs require that all appropriate staff be trained on conflicts of interest, including all registered individuals and supervisory staff, and other staff depending on their responsibilities at the firm. The sweep found that some firms did not provide adequate training with respect to conflicts of interest. For example, the training may have been generic and not specific to the firm’s business, it did not provide examples of conflicts that exist at the firm, or did not include details of the reporting process to be followed when a material conflict of interest has been identified. Firms must maintain adequate documentation of the training provided.
Record keeping obligations
The CFRs include specific record-keeping requirements relating to conflicts of interest. These records must demonstrate compliance with the conflict of interest obligations and must document compensation arrangements and incentive practices from which the firm or its registered individuals or affiliates benefit. Records should include the firm’s identification, review and analysis of conflicts, their determination with respect to materiality, and the controls used to address conflicts in the clients’ best interest. More detailed records may be required depending on the materiality of the conflicts that exist within the firm. Firms should maintain an inventory or matrix of conflicts that exist, and maintain evidence of periodic reviews of the conflicts inventory and controls. The Staff Notice provides detail as to what should be included in these records.
Please contact Victoria Paris if you have any questions or if you would like to discuss the Staff Notice further.