Fund Investing

Some dealers are still on the wrong side of sales practice rules put in place in 1998.
By Steven G. Kelman | 03/01/17

Back in 1998 I wrote the commentary for the Investment Funds Institute of Canada's booklet on National Instrument 81-105 - Mutual Fund Sales Practices and its companion policy. This national instrument regulates the sales and business practices that must be adhered to by fund companies, dealers and sales people. The companion policy provided some guidance as to the Canadian Securities Administrators' interpretation of the rules.

About the Author
Steven G. Kelman is president of Steven G. Kelman & Associates Limited. His company provides specialty publications and training for the mutual fund industries. Steven is the author of several personal finance books and is author or co-author of courses offered by the Investment Funds Institute of Canada, including the Ethical Conduct and Behaviour continuing education course and the Labour-Sponsored Investment Funds course. He received a B.Sc. from McMaster University, an MBA from York University and holds a Chartered Financial Analyst designation.

NI 81-105 came about because of sales practices and compensation arrangements that put the sellers' interests ahead of those of the clients, or as the rule put it: "gave rise to questions as to whether participating dealers and their representatives were being induced to sell mutual fund securities on the basis of the incentives they were receiving as opposed to what was suitable for and in the best interests of their clients."

Among the most egregious practices were trips to exotic places for salespeople who sold specific dollar amounts of a mutual fund company's products. The fund companies generally worked directly with the salespeople rather than through the fund dealers. Many mutual fund sales reps considered themselves as independent business people who could do as they pleased when, in reality, they were employees of a mutual fund dealer who was responsible for their behaviour.

There were some instances that involved a fund company working with a specific investment dealer rather than directly with salespeople. In such cases the fund company provided a program specific to that investment dealer's representatives. Also, stock brokers who sold mutual funds often expected and received trading commissions based on the volumes of mutual funds sold, a practice that ended with NI 81-105.

The rules applied equally to fund companies, distributors and sales representatives. What were permitted were sales commissions and trailer commissions. Commission rates could not increase with sales level or asset base, and no seasonal bonus rates were allowed. Dealers could not vary their payout rates to sales representatives to favour one fund group over another. And while fund companies could still hold educational conferences, the dealer would decide which of its employees would attend, and the fund companies were prohibited from paying travel and accommodation expenses. I wrote in my 1998 commentary: "don't get cute and try to find loopholes. For example, a fund company cannot overpay a printer or public relations firm with the understanding that it will use the extra money to provide benefits to certain dealers."

Here we are, almost two decades later, and in mid-December the Mutual Fund Dealers Association released Bulletin #0705-C, Review of Compensation, Incentives and Conflicts of Interest.

The MFDA found compensation and incentive practices "that have the potential to affect the behaviour of dealer representatives." A small number of dealers had compensation structures which the MFDA views as not complying with NI 81-105. Specifically, it found members who provided incentives that favoured house-brand funds or funds of a particular family over other mutual funds. In one case, a dealer paid additional commissions on the prior year's sales, but only for funds of two specific companies. It had a similar arrangement involving the purchase of a retiring representative's book of business.

The MFDA document states: "These cases have been referred to our Enforcement Department. All of the Members have been responsive to addressing the findings and are taking action to amend their compensation structures and eliminate the incentives favouring proprietary funds."

I'm sure investors reading that will sleep better tonight, and I'm looking forward to seeing at some future date who these fund dealers are, and details of the arrangements they had with the specific fund companies which I hope will be named. I can't predict what penalties will be applied for such behaviour, but I suspect that one or more of the law firms that specialize in class action suits will be looking closely at what will be disclosed.

The MFDA also found compensation structures that provided additional incentives to reps that recommended funds sold on a deferred sales charge basis that in its view "increase the risk of mis-selling and unsuitable advice."

It provided a couple of examples: One firm paid some representatives as little as 10% of trailer commission on client accounts. But new sales commissions on DSC funds were paid out to the rep at rates between 40% and 75%.

Another example was of a firm that paid 10% commission bonuses on sales in excess of $500,000 on DSC or low-load funds, and additional production bonuses for each $1 million of sales of DSC or low-load funds.

In my opinion as someone with some compliance experience in the fund business, these incentives were in conflict of interest with the clients and were not in compliance with NI 81-105. I'm certain that some investors who bought these funds might expect that the dealer should compensate them for any additional fees they paid for following their advisor's advice.

The MFDA is also concerned about incentives paid to mutual fund dealers who are also registered to sell exempt products, even though NI 81-105 applies only to mutual funds. The concern is that exempt issuers pay compensation rates that are often much higher than rates paid on mutual funds. "In addition, in many cases the types of compensation or benefits dealers receive from other investment products or referral arrangements are the types of compensation or benefits that are prohibited by National Instrument 81-105 for mutual funds." My suggestion to the MFDA is to simply ban its members from entering into any compensation arrangement that that would be prohibited for a mutual fund.

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