The doors to the Ontario Securities Commission hearing rooms in Toronto.Melissa Tait/The Globe and Mail
Investor advocates are urging regulators to ban the use of controversial sales commissions that are paid out to investment dealers who primarily sell mutual funds from one company.
Known as “principal distributors,” these investment dealers obtain exclusive rights to distribute mutual fund investments from a single fund family. In some cases, the fund companies offer advisers upfront commissions when they lock in clients for a certain period, typically for about three years. If clients redeem funds earlier, the advisers are required to pay back a portion of their commissions.
During a recent regulatory consultation on principal distributor models, industry groups and investor advocates said the commissions – known as adviser chargebacks – are creating an “inherent conflict of interest” for advisers.
Michael Thom, managing director for CFA Societies Canada, said chargebacks put financial advisers in a position where they could encourage clients to continue to hold and not redeem mutual funds simply to avoid repaying a commission, even when that may not be in an investor’s best interest.
“Chargebacks carry the negative potential that advisers may consider their own interests above that of their clients,” CFA Societies Canada wrote in a consultation letter.
In the same consultation, the Canadian Securities Administrators – an umbrella group for provincial and territorial securities regulators – has also proposed an amendment to close a loophole in the current rules that allows principal distributors to continue to pay deferred sales commission (DSC), a controversial mutual fund fee that was banned in 2022 after a decade of industry consultations. The fee was found to be harmful to investors, who were hit with high penalties if they wanted to redeem their investments early.
But the DSC ban does not technically apply to principal distributors, because they were excluded from some regulatory provisions that apply to other investment dealers – a loophole the CSA now wants to close.
In 2023, the CSA announced another step to enhance investor protection through a comprehensive set of rules, known as the client-focused reforms, that require advisers to ensure they are providing products that are appropriate for clients.
Prominent investor advocate Ken Kivenko said in an interview with The Globe and Mail that he was “shocked” to learn chargeback fees were continuing after all the work to ban DSC funds and enhance investor protection. He said the death of DSC funds has prompted asset managers to find other ways to promote their funds.
“The entire principal distributor model is a slap in the face to the client-focused reforms,” Mr. Kivenko said. “How is it in the best interests of clients to limit their choice to one fund family? How is it in the best interest of clients to have an adviser who will be disincentivized to tell you to sell a fund if it is no longer working for your portfolio?”
Adviser chargebacks are reminiscent of DSCs. DSC funds typically lock in investors for five to seven years. If an investor redeems their money prior to the set date, the client is hit with an early redemption penalty.
In comparison, chargebacks do not penalize a client. Rather, the investment adviser has to pay back a part of their upfront commission if a client decides to redeem a fund.
“Chargebacks are evidence that advisers are in the business of sales, not advice,” Mr. Kivenko added.
The discussion of chargebacks goes back to 2023, when regulators first announced they were concerned with potential conflicts of interest in the chargeback commission structure, particularly in the insurance industry. Now, the topic has resurfaced in a broader CSA consultation on whether regulators need to revise the sales practices used by principal distributors, which could include a ban on chargeback commissions.
Mr. Kivenko wrote in a public comment letter about his disappointment that, two years later, regulators have “no action other than yet another consultation on the obvious.”
“We cannot begin to express our frustration with this glacial speed of investor protection compared with the quick reaction the CSA takes to reduce industry regulatory burden,” he added.
CFA Societies Canada’s Mr. Thom expressed similar confusion about how the principal distributor model could continue to exist without a more fulsome review in today’s regulatory environment – particularly since the introduction of the client-focused reforms.
“Most Canadians don’t know what regulatory regime they are facing when they seek investment advice, and the idea of the client-focused reforms was to provide some uniform, overarching obligations within the rules,” Mr. Thom said. “But for some reason, those rules seem to be partially suspended within the principal distributor model. And we don’t know why.”
Along with potentially banning chargebacks, the CSA is proposing principal distributors should be restricted to selling mutual funds from only one fund family.
In some cases, investment dealers have set up multiple principal distributor agreements with different fund companies, creating a larger conflict of interest if an investment adviser has an incentive to choose the fund family with the largest upfront commissions. In addition, the CSA wants principal distributors to provide greater transparency in the disclosures they provide investors about the total compensation paid to their investment advisers.
In its consultation, the CSA said that by restricting the agreements to a single mutual fund family, the conflict-of-interest concerns would be “less acute.”
However, the Canadian Independent Finance and Innovation Counsel (CIFC), which represents investment dealers across the country, disagreed with the CSA analysis, saying the limitation to one fund family would “significantly reduce” investor choice and “in fact may increase the potential for conflicts of interest.”
CIFC chief executive Annie Sinigagliese said in a comment letter that investment dealers challenge the CSA’s assertion that the principal distribution model, even with the proposed single fund family restriction, remains relevant in today’s “mutual fund landscape.”
Instead, the CIFC is concerned about the potential of the principal model to “suppress competition and limit market efficiency.” Along with CFA Societies Canada and investor advocates, the CIFC is calling on the CSA to expand the consultation process to have a “more extensive evaluation” of the principal distributor model.
“We would like to highlight potential negative effects on investor retirement savings, noting that reduced competition could result in higher fees and fewer investment options for retail investors,” Ms. Sinigagliese added.