On September 28, the Canadian Securities Administrators (CSA) published guidance in the form of responses to frequently asked questions (FAQs) about how to interpret and implement the client-focused reforms (CFRs) to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103). As our readers already know, the conflicts-related CFRs must be implemented by June 30, 2021 and the remaining CFRS must be implemented by December 31, 2021. If you need a refresher on the CFRs, you can download our recently updated publication In a Nutshell: Implementing the Client-Focused Reforms.
In our first look at the 34 just-published FAQs, we noted with interest the following topics:
Closed-Shelf Firms: Several FAQs address issues relevant for firms that only sell proprietary products (Closed-Shelf Firms):
- Comparative Analysis of Competing Products Encouraged but Not Required: In their response to FAQ 9, CSA staff indicate that Closed-Shelf Firms do not have to compare their proprietary products to similar securities available in the market. However, CSA staff also suggest that periodically evaluating whether the firm’s proprietary products are competitive with alternatives in the market is one way a firm can demonstrate that its product shelf development and client recommendations are based on the quality of the proprietary products that it makes available to clients. This does not mean, however, that the firm must use the information gained from such an analysis either to change the products it makes available to clients or perform a shelf optimization. However, the information gained from such an assessment might inform the firm’s analysis of whether its controls to address the conflict of interest inherent in its business model are sufficient.
- Assessing Competitors’ Prospectus-Exempt Products: CSA staff’s response to FAQ 11 acknowledges that it can be difficult to compare proprietary products to alternative products offered on a prospectus-exempt basis due to limits on publicly available information. They also stated, however, that most registrants and issuers have a general knowledge of the competitive space in which they operate and are able to gather enough information to understand how they or their offerings compare with others in that space. Staff also emphasized that if there are specific limitations to the information registrants can obtain, or necessary assumptions or caveats registrants have to make in their comparative analysis (for example, because competitive products are materially different), these limitations and assumptions should be documented. Staff also indicated that generally they will expect firms to be familiar with its competitors’ products at least at a high level.
- Know-Your-Product (KYP) for Non-Proprietary Products Offered on an Incidental Basis: FAQ 11 also asks what level of due diligence is expected where a registered firm mostly offers proprietary products but may recommend certain non-proprietary products on an ancillary basis. In their guidance, CSA staff emphasize that firms operating under a 100% proprietary model do not have to include non-proprietary products on their shelf or recommend them. However, if a firm incidentally recommends non-proprietary products, then the incidental nature of the recommendation doesn’t reduce the firm’s KYP obligations for that product. Also, the firm should document its due diligence and, from a conflicts and suitability perspective, document why it has chosen to recommend a particular non-proprietary product over others.
Consent (or Disclosure + Consent) Aren’t Enough: In their responses to several FAQs, CSA staff emphasized that once the CFRs are in effect, consent (or disclosure plus consent) without other action by a registrant will be insufficient to address a material conflict of interest in a client’s best interest. (FAQs 6, 7 and 11) Additional controls (such as pre-trade controls and/or post-trade reviews) must be used. In FAQ 7, CSA staff also indicate that if a client opens an account after receiving clear disclosure that the dealer or adviser will be using proprietary products, it is reasonable to assume that the client agreed to a client-registrant relationship on that basis. However, the dealer must also take other steps to address the conflict before it can proceed, and it cannot rely solely on the issuer or an affiliate for its product due diligence.
Referral Arrangements: The response to FAQ 17 reiterates that when a firm refers a client to a service provider, the firm is responsible for conducting oversight over that service provider. The response also outlines steps that registrants can take to conduct due diligence on prospective referral parties and then supervise any referral arrangements they enter into. CSA staff expect registrants to consult publicly available databases and search engines, and make inquiries of the other party (whether registered or not) to ascertain, for example:
- The referral party’s status (including licensing or registration status), financial health, professional qualifications and history;
- Whether the referral party has been the subject of any investigation by a securities or financial sector regulator, any disciplinary action relating to their professional activities under their governing body or organization; and
- Whether there have been complaints, civil claims and/or arbitration notices filed against them in relation to their professional activities.
Due diligence records must be maintained. CSA staff also list examples of controls that can be used to monitor referral arrangements, including:
- Ongoing assessment of compensation received by registrants under referral arrangements;
- Ongoing compliance calls to investors who have been referred to or by the firm to assess how the process is being conducted by each referral party;
- Annual questionnaires sent to registrants receiving referral fees regarding the nature and extent of their involvement in referral arrangements;
- Interviews of registrants receiving referral fees during the branch review process;
- Requiring unregistered referral agents who make referrals to the firm to: (1) attend training on how to conduct referrals; and (2) use only pre-approved marketing materials and social media content in relation to their referral business; and
- Assessing complaints and other information received in connection with referral arrangements to ensure compliance by all referral parties.
When is a Conflict Material? CSA staff’s response to FAQ 5 asking for further guidance on the concept of “material conflicts” does not provide any new information. Staff reiterated the guidance expressed in the revised Companion Policy to NI 31-103 (Revised Policy) that, in determining whether a conflict is material, registrants should consider whether the conflict may reasonably be expected to affect, in the circumstances, the client’s decisions and/or the registrant’s recommendations or decisions. They also pointed to their guidance in the Revised Policy listing the conflicts that they consider to be “almost always material”.
Conflict of Interest Records: FAQ 12 asked the CSA for more guidance on the level of detail required in conflict of interest records. CSA staff’s response emphasizes several points:
- As the materiality of the conflict increases, there should be greater detail in the records maintained to demonstrate compliance.
- The CSA has not prescribed a specific format for such records. However, staff expect firms to, at a minimum, document their identification, review and analysis of conflicts of interest, their determination as to whether a conflict is material, and the controls used by the firm to ensure that material conflicts have been addressed in the client’s best interest.
- The firm’s documentation can be part of its risk assessment or conflicts of interest assessment, and it can include cross-references to the firm’s policies, procedures and controls.
- Paragraph 11.5(2)(q) of NI 31-103 will require firms to create a complete record that documents sales practices, compensation arrangements, and incentive practices, and the guidance in section 11.5 of the Revised Policy describes what must be documented.
Supervisory Staff Compensation: CSA staff discuss approaches to supervisory compensation in their response to FAQ 10. They state, among other things, that they expect the majority of the compensation of supervisory staff to not be tied to the revenue generation of representatives, the branch, or the business line that supervisory staff oversee. If, however, a portion of supervisory staff compensation is tied to branch or business line profitability, CSA staff expect that:
- The other compensation factors should be sufficient to outweigh any bias that supervisory staff might have toward profitability over the clients’ best interest;
- Controls such as multiple level supervision should be in place to ensure head office or an otherwise independent review of the supervisory process; and
- Compensating controls should be tested periodically for effectiveness.
Staff also recommend that firms consider compensating controls such as setting a low level of bonus relative to base salary combined with strict measures that penalize non-compliance, such as tying supervisory staff’s bonuses (or even salaries) to:
- Branch and direct reports not receiving valid investor complaints; and
- Results from independent quality assurance calls to investors to assess compliance and sales practices.
Other FAQ Topics: Before the Thanksgiving Holiday, we expect to publish a second article on our website discussing other FAQs, such as staff’s responses to questions about the collection and maintenance of up-to-date know-your-client (KYC) information and questions about the revised relationship disclosure information (RDI) requirements. We also will monitor the CSA’s CFRs Resource page and update our readers when new FAQs are added.
AUM Law is helping firms make steady progress toward the CFRs’ compliance deadlines and we can help you, too. We can help you develop a project plan, systemically review and make any needed changes to your policies, procedures and operations, and train your employees so that they understand the revised rules and your firm’s updated protocols. And along the way, we’ll stay on top of regulatory updates like the just-published FAQs so that our advice to you keeps pace with regulatory expectations. Please contact your usual lawyer at AUM Law for assistance, or if you’re new to the firm, please contact us for a free consultation.
September 30, 2020