On January 10, 2017, the Canadian Securities Administrators (CSA) issued for comment CSA Consultation Paper 81-408 – Consultation on the Option of Discontinuing Embedded Commissions (the Consultation Paper) for a 150-day comment period. The Consultation Paper presents for discussion, the CSA’s position regarding the effects of sales of investment fund securities or structured notes through commissions, including sales and trailing commissions, paid by investment fund managers (embedded commissions), and proposes that the use of embedded commissions be discontinued in favour of direct pay arrangements.
The Consultation Paper currently anticipates that the new regulatory framework would aim to
discontinue any payment of money to dealers in connection with an investor’s purchase or continued ownership of a security described above that is made directly or indirectly by a person other than the investor.
This would, at a minimum, include ongoing trailing commissions or service fees as well as upfront sales commissions for purchases made under a deferred sales commission (DSC) option.
Should the CSA move forward with the discontinuation of embedded commissions, dealers would be required to move to direct pay arrangements. These direct pay arrangements would include upfront commissions, hourly fees, flat fees, fees based on a percentage of assets under management, etc. Additionally, the CSA are willing to permit the following types of dealer compensation payments:
- Referral fees paid for the referral of a client to or from a registrant;
- Dealer commissions paid out of underwriting commissions on the distribution of securities of an investment fund or structured note, that is not in continuous distribution under an IPO;
- Payments or other non-monetary benefits in connection with marketing and educational practices; and
- Internal transfer payments from affiliates to dealers within integrated financial service providers which are not directly tied to an investor’s purchase or continued ownership of an investment fund security or structured note.
Why Discontinue of Embedded Commissions?
Consultation Paper was drafted in response to concerns that the current regime results in distortionary market effects which inhibit competition, artificially inflate fees and leave investors misinformed about the costs of their investments. Additionally, the CSA feel that the use of embedded commissions create conflicts of interest for investment fund managers, dealers and representatives against the investors they serve. These misaligned interests, which the CSA hope the discontinuance of embedded commissions will address, include:
- Incentives for investment fund managers to use commissions instead of performance to increase assets under management;
- Incentives for dealers and their representatives to sell products on the basis of the embedded commission rather than on their suitability for the investor;
- Limiting the ability for the investor to assess the impacts of dealer compensation costs on their investment returns; and
- Cause investors to pay dealer compensation which does not reflect the level of services they receive.
Given the proliferation of embedded commissions within the industry, the Consultation Paper, acknowledges that huge changes are going to affect the industry and investors.
Impacts for Investment Fund Managers
For investment fund managers, the CSA foresee the industry urgently needing to adapt to the changes to the competitive market. According to the Consultation Paper, new low cost service providers and products are expected to enter the market putting downward pressure on fees of existing funds and spur greater focus on controlling costs from the investment fund managers themselves (initially through the simplification of fund structures for the purposes of removing classes with embedded commissions). Additionally, the CSA expect a shift of assets away from actively managed investment funds to ETFs and other low-fee passive investment products.
Moreover, as dealers lose their incentive to sell or hold underperforming products, the CSA expect a shift in assets across active investment fund managers. The CSA expect that for active investment fund managers with negative alphas, the proportions of assets under management at risk of redemption could be on average 53% of firm assets (59% for investment fund managers with little or no access to related party distribution channels). There is therefore a risk that investors which remain in these funds (including those subject to an advice gap as discussed below) see their investments subject to significant redemption risk.
The CSA do note however, that integrated deposit-takers or insurer owned dealers will feel little impact from the discontinuance of embedded commissions as these organizations have already moved away from embedded commissions.
Impacts for Dealers and their Representatives
As for the independent mutual fund dealers and representatives, the CSA expect a substantial decrease in the number of representatives, particularly those who are independent from deposit-takers and insurers.
The Consultation Paper notes that Canadian investors “have access to a relatively large number of representatives” (of which 87% were employed in the deposit-taker and insurer distribution channels). The CSA expect a significant reduction in the number of representatives in Canada, with the Consultation Paper drawing a comparison to the 23% decline in representative coverage over the 3 years following the ban of embedded commissions in the U.K. The CSA foresee these changes disproportionally affecting small-to-medium independent mutual fund dealers relative to full service Investment Industry Regulatory Organization of Canada (IIROC) member dealers as they rely more heavily on embedded commissions (27% of fee revenue compared to 16%), and to representatives of vertically integrated deposit-takers and insurers who are already largely insulated from the short-term impacts of the proposed changes.
The CSA expect that the downward pressure on compensation and costs will lead the affected dealers and their representatives to become more selective as to their clients (based on investable asset size) and products (shift from actively managed to passively managed). To compete, these dealers will need to justify their value proposition and “overall level of services and advice in a market that is likely to be transformed significantly by automated solutions and technological change”. It is also the CSA’ hope that these competitive market forces will ultimately deliver lower cost advice to investors while improving the quality of advice and products sold.
Impacts for Investors
For mass-market investors (less than $100k of investable assets) and mid-market investors (between $100k and $500k of investable assets), the CSA expect that both groups will benefit from the expected reduction in fees, better advice on certain products and the shift from actively managed to passively managed products.
The CSA note that there exists a risk that mass and mid-market investors could fall into an advice gap caused by some independent fund dealers choosing to no longer serve them. However, the CSA do not seem overly concerned by this potential risk. The Consultation Paper notes, that 55% of mass-market investors are already unadvised and those who purchase investment fund products tend to do so via integrated deposit-takers or insurers, while mid-market investors will be particularly targeted by product and service innovations such as online advising (robo-advisors). In fact, the CSA rely heavily on the expectation that product and service innovations such as robo-advising will come to mitigate many of the negative impacts of the discontinuance of embedded commissions discussed in the Consultation Paper.
With regards to affluent investors (more than $500k of investable assets), the CSA expect that they will be the least affected by the discontinuance of embedded commissions and would likely benefit from the expected decrease in fund management costs and the change in the habits of dealers.
The CSA are currently seeking stakeholder analysis on the Consultation Paper and the questions contained therein. In particular, the CSA are looking for perspectives not raised in previous consultations and evidence as well as data-driven analysis with a Canadian focus. Comments should be submitted in writing to the CSA on or before June 9, 2017.