Risk Management and Crisis Response Blog

Regulators on both sides of the border pursue initiatives focused on investment adviser conflicts of interest

Mar 14, 2018 4 MIN READ
Lawrence E. Ritchie

Partner, Disputes, Toronto

On February 12, 2018, the U.S. Securities and Exchange Commission (“SEC”) announced a new self-reporting initiative that seeks to protect clients of investment advisors from undisclosed conflicts of interest when purchasing mutual funds. Under the new Share Class Selection Disclosure Initiative (“SCSD Initiative”), the SEC is offering to waive financial penalties against investment advisers who self-report cases where they failed to disclose a conflict of interest and sold higher-priced funds to collect bigger fees.

This new initiative by the SEC reflects an increasing focus by regulators in the U.S. and Canada on compensation related conflicts of interest in the financial industry as well as sales practices by financial institutions that may not be in the best interest of retail consumers.

The new SEC initiative

The U.S. Investment Advisers Act of 1940 imposes a duty on investment advisers to act in their client’s best interests, including an affirmative duty to disclose all conflicts of interest. The SEC stated in its press release that a conflict of interest arises, that must be disclosed, when an adviser receives compensation (either directly or indirectly) for selecting a more expensive mutual fund for a client when a less expensive share class for the same fund is available and appropriate.

Stephanie Avakian, Co-Director of the SEC Enforcement Division, stated in the press release that: “This focused initiative reflects our effort to allocate our resources in a way that effectively targets the continued failure by some advisers to disclose conflicts of interest around share class selection and, importantly, is intended to facilitate the prompt return of money to victimized investors.”

In exchange for self-reporting, the SEC will recommend settlements requiring the adviser to disgorge any ill-gotten gains, but will impose no civil financial penalties. However, the SEC warned that it expects to recommend stronger sanctions in any future actions against investment advisers that engaged in the misconduct but failed to take advantage of this initiative.

Canadian regulatory focus on conflicts of interest

Canadian regulators have also increasingly been focused on managing conflicts of interest in the financial industry. Since the Wells Fargo scandal in the U.S. and similar media scrutiny in Canada, there has been a focus by regulators in the financial sectors on compensation arrangements and potential conflicts of interest. In Canada, there has been a number of recent regulatory initiatives aimed at managing conflicts of interest in the financial industry:

  • In December 2016, the Canadian Securities Administrators (CSA) published a CSA Staff Notice that outlined compensation arrangements and incentive practices of surveyed firms and provided the CSA’s view on the potential conflicts of interest that could arise from some of those practices.
  • Similarly, the Mutual Fund Dealers Association (MFDA) released a MFDA Bulletin in December 2016 that identified: (i) compensation structures that favour mutual funds of one mutual fund company over another (i.e., do not comply with securities laws), and (ii) compensation and incentive practices that increase the risk of mis-selling and unsuitable advice (e.g., provide additional incentives to recommend deferred sales charge funds).
  • The Investment Industry Regulatory Organization (IIROC) has also released IIROC Notices in December 2016 and April 2017 on managing conflicts in the best interest of the client. IIROC conducted a targeted review which assessed how investment firms are meeting the requirement to manage compensation-related conflicts in the best interest of the client.
  • In addition, as we previously discussed, the Autorité des marchés financiers (AMF) recently released an issues paper on managing conflict of interest risk in relation to incentives in the insurance industry.

These regulatory initiatives are taking place in parallel to the ongoing review of sales practices in the financial industry by the Financial Consumer Agency of Canada (FCAC) and the Office of the Superintendent of Financial Institutions (OSFI). These Canadian reviews followed the review of sales practices in the financial industry started by the U.S. Office of the Comptroller of the Currency (OCC) in October 2016, shortly after the media reporting on the Wells Fargo scandal.

This flurry of regulatory action and scrutiny across the regulated spaces in the U.S. and Canada reflects a convergence of regulatory interest in conflicts of interest related to compensation. Regulators appear to be moving towards a more holistic approach that is focused sales practices by financial institutions that may not be in the best interest of retail consumers. These related regulatory initiatives indicate that business in the financial industry should have ongoing processes to ensure that there is enterprise-wide monitoring and management of potential conflicts of interest and regulatory requirements.