On December 15, 2016, the Canadian Securities Administrators (CSA) published CSA Staff Notice 33-318 Review of Practices Firms Use to Compensate and Provide Incentives to their Representatives (Notice) summarizing the results of a survey conducted in 2014 that gathered information relating to compensation arrangements and incentive practices that firms use to motivate their representatives (Survey).
The Survey was conducted as part of a larger framework of proposed reforms to enhance the client-registrant relationship, as set out in the CSA Consultation Paper 33-404 Proposals to Enhance the Obligations of Advisers, Dealers, and Representatives toward their Clients, published on April 28, 2016 (Consultation Paper). The Consultation Paper is part of the CSA’s initiative towards improving the relationship between clients and their advisers, dealers and representatives.
The Survey asked adviser and dealer firms to identify the compensation practices used to compensate their representatives. The Survey was focused on the incentive practices used for retail representatives who fell under the oversight of the Mutual Fund Dealers Association of Canada (MFDA) and the Investment Industry Regulatory Organization of Canada (IIROC), as well as representatives with portfolio managers or exempt market dealers working with high net worth clients.
The results of the Survey identified 27 compensation practices used by dealer firms. The following 18 compensation practices were identified by the CSA as giving rise to potentially material conflicts of interest:
- Certain referral arrangements: This compensation approach pays representatives a referral fee for business passed to a related or third party financial service provider. Potential material conflict of interest: This approach may encourage representatives to refer a client to a related or third party financial service provider to maximize their compensation, even if such referral is not in the best interests of the client.
- Compensation heavily weighted towards sales activity and revenue generation: This compensation approach bases compensation on sales and revenue amounts generated by the representative. It includes compensation that is entirely commission-based, compensation where a sales bonus potentially forms the substantial majority of the compensation, and scorecard compensation arrangements that tie a substantial portion of the compensation to sales or revenue targets. Potential material conflict of interest: This approach may encourage representatives to recommend products or services that a client does not need, in order reach their sales targets as quickly as possible. The Notice also identifies that this compensation approach is often associated with unwanted behaviour, such as sale churning, selling unsuitable products or services, and selling products or services in unsuitable amounts.
- Professional titles tied to sales or revenue targets: Titles are granted to representatives for achieving sales and revenue targets. Potential material conflict of interest: This approach may encourage representatives to recommend products or services that a client does not need, in order to achieve a title in the easiest way possible. Further, if a title is bestowed upon the representative for achieving a rank or sales target, clients may interpret this title as an indication of ability, rather than a measure of sales activity.
- Representative bonuses: This element of representative compensation is set by the representative’s superiors or by a committee. Potential material conflict of interest: Discretionary bonuses that provide little transparency regarding the criteria to determine the amount of the bonus may be used to encourage practices that create a serious conflict of interest for the representative.
- Monetary and non-monetary incentives to favour proprietary products: Compensation is increased when proprietary products and services are sold instead of third party products and services. Potential material conflict of interest: Encouraging the sale of proprietary products and services creates a serious conflict of interest, as it can result in inappropriate advice and inferior client outcome. The Notice raises that this type of compensation practice may contravene certain obligations found in National Instrument 81-105 Mutual Fund Sales Practices.
- “First past the post” incentives: Compensation is awarded based on a representative’s rank within the firm over a set period of time, or if the representative is one of a limited number of representatives within the firm to achieve a certain sales or revenue target. Potential material conflict of interest: This approach may encourage representatives to recommend products or services that a client does not need, in order to maximize sales and revenue as quickly as possible. Further, if a title is bestowed upon the representative for achieving a rank or sales target, clients may incorrectly interpret this title as an indication of ability.
- Non-neutral grids: Compensation differs depending on the product or service sold to a client. Potential material conflict of interest: This approach may encourage representatives to recommend products or services that a client does not need, or to recommend suitable products or services in an unsuitable amount.
- Investment amount incentives: Compensation is increased for larger individual investment amounts made by clients. Under this approach, representatives that sell the same aggregate amount, but sell to more clients than another representative, would be compensated less than the other representative. Potential material conflict of interest: This approach may encourage a client to invest more, to invest into a single product or services (as opposed to multiple products or services), or to group investments, each in a manner that is not suitable for the client’s needs.
- Cross-selling incentives: This compensation approach encourages representatives to sell a mix of services and products, penalizing representatives when only a single product or service is sold. Potential material conflict of interest: This approach may encourage representatives to recommend products or services that a client does not need. This approach may also result in representatives selling products and services only from related entities, which may not suit the client’s interests.
- Manager compensation tied to staff sales/revenue targets: A compensation approach used with managers, where a material amount of the manager’s compensation is dependent on the sales and revenue of his or her staff. Potential material conflict of interest: This compensation approach my encourage representatives under the manager to focus on activities that maximize the manager’s compensation, rather than to serve their client’s interests.
- Changes to representative grid minimums, tiering and/or payout rates: This compensation approach involves changing compensation based on tier levels (e.g., lowering compensation rates for lower tiers, increasing compensation rates for higher tiers) to meet firm sales and revenue targets. Potential material conflict of interest: This compensation practice may encourage representatives to favour clients whom they can generate more sales and revenue from, while ignoring others. This approach may also encourage representatives to sell unsuitable products or services to a client.
- Group sales/revenue targets: Compensation is tied to team or branch sales and revenue targets. Potential material conflict of interest: This compensation approach my result in a firm’s priorities being put ahead of a client’s. Group targets may also put pressure on lagging members of the group to focus on products and services that generate higher sales and revenue, which may not be in a client’s best interest.
- Retroactive compensation increases: Compensation is retroactively increased when certain revenue or sales targets are met. Potential material conflict of interest: This practice may encourage representatives to increase sales or revenue as a sales or revenue target approaches, which may lead them to focus less on the client’s needs and more on the easiest way to make such targets.
- Accelerator (stepped payments): Compensation is increased for sales or revenue generated over a target amount by the representative over a specific fixed period of time. Potential material conflict of interest: This approach may encourage representatives to recommend products or services that a client does not need, but which generate sales or revenue as quickly as possible. This practice may also encourage representatives to move the timing of a client’s investment forward to achieve credit in a specific period, where such timing may not be best suited for the client.
- Product and/or service specific promotions and competitions: Running a competition amongst representatives to encourage the sale of certain products or services. Potential material conflict of interest: This approach may encourage representatives to recommend products and services that a client does not need.
- Revenue recognition biases: The amount of revenue attributed to a representative varies depending on the type of product or service sold. Potential material conflict of interest: This approach may encourage representatives to recommend products and services that provide more credit to the representative, where such products and services are not suitable for the client.
- Lock-in incentives: Achieving sales or revenue targets set a higher compensation rate in subsequent periods. Potential material conflict of interest: This practice may incentivize representatives to prioritize actions that are needed to take them to the next compensation tier over the interests of their clients. This practice may also encourage representatives to move the timing of a client’s investment forward to achieve credit in a specific period, where such timing may not be best suited for the client.
- Deferred compensation: A portion of compensation (such as cash or equity awards) is deferred for one or more years, to encourage representatives to take a long term focus. Potential material conflict of interest: This approach may encourage a long-term firm focus over a client focus, such as recommending proprietary products or services to clients over third party products or services, where such proprietary products or services are not suitable.
The results of the Survey also identified the following 9 compensation practices, which appear to be acceptable compensation practices as the CSA did not identify any conflict issues for such practices:
- Capped or decreasing incentives (fee capping): Compensation across products and services is equalized through caps on commissions. This is designed to limit and/or temper the incentives of a representative to focus on revenue rather than the client.
- Qualitative client feedback: Compensation is tied to the quality of client feedback.
- Rolling sales/revenue targets: The sales and revenue targets that determine compensation for representatives are set on a rolling time period to somewhat reduce the representative’s motivation to make sales before a specific date.
- Risk based clawbacks: Compensation is “clawed back” if it was generated by high risk activities.
- Independent compliance staff compensation: The compensation of a firm’s compliance staff is not tied to sales or revenue goals of its representatives. This compensation practice encourages effective oversight of representatives and reduces the potential for mis-selling.
- Neutral grid: Compensation does not vary by product or service, account type or client type. This practice discourages representatives from focusing on an individual product or service that maximizes their personal compensation.
- Penalties for poor sales practices: Compensation is lowered if the firm finds poor sales practices are being used. This practice encourages a focus on the quality, as well as quantity, of sales.
- Client turnover: Compensation is tied to client turnover or the average length of client relationships. This practice encourages representatives to focus on long-term and high-value client relationships.
- Return on book oversight or alarms: A compensation practice where the firm monitors profitability metrics of representatives, and investigates representatives with unusually high returns. This practice helps to limit mis-selling and price gouging.
While the Notice identifies certain conflicts of interest that may arise in the use of some of the stated compensation practices, implying that such compensation practices may be bad practices, the Notice does not recommend which practices should be used and which should be avoided. Further, the CSA did not indicate in the Notice the popularity of each of the above 27 compensation practices to give a sense of what key potential material conflicts of interest are currently prevalent between representatives and clients.
The CSA have committed to continue to review their research on compensation practices of representatives to determine the appropriate regulatory response, if any, to address conflicts of interest arising from such compensation practices.