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Mutual Funds And Scholarship Plans

IMPORTANT NOTICE: On June 30, 2021, several amendments to Regulation 31-103 respecting Registration Requirements, Exemptions and Ongoing Registrant Obligations (the “Regulation”) and its Policy Statement, better known as the client focused reforms, came into force.

These amendments introduced new conflict of interest management obligations for advisors. The obligations of brokers were also significantly expanded.

The following situations involve a conflict of interest:

  • Two individuals have incompatible or divergent interests (e.g., client-client or advisor-client).
  • Situations where an advisor might be liable to put their own interests ahead of those of their client.
  • Situations where the monetary or non-monetary benefits available to an advisor or broker, or the potential harm that they might be subject to, may compromise the trust that a reasonable client would place in them.

 

The following situations involve a material conflict of interest:

The conflict could have an impact on:

  • The client’s decisions in the circumstances.
  • The advisor’s recommendations or decisions in the circumstances.

The materiality of a conflict of interest will depend largely on the facts and circumstances.

If the conflict of interest is material, the advisor must report it and address the situation in the client’s best interest (see “Obligations of the advisor” below).

  1. Take reasonable measures to identify existing or reasonably foreseeable material conflicts of interest.
  2. Quickly report any material conflict of interest to the broker.
  3. Address material conflicts of interest in the client’s best interest (see details below).
  4. Avoid any conflict of interest situation that cannot be addressed in the client’s best interest.

 

It is important to keep in mind that relationships with clients can change over time.

An advisor may only perform a transaction or offer a recommendation if the conflict of interest has been addressed in the client’s best interest and if they have obtained their broker’s permission.

What constitutes the client’s best interest is determined based on the facts and circumstances. A principle-based approach is used to ensure that the client’s interests are placed ahead of those of the advisor, broker or any other opposing interest.

The approach includes the following criteria:

  • Professional judgement
  • Relationship with the client
  • Broker’s business model

Disclosing conflicts of interest to clients

Conflicts of interest must also be disclosed to the client concerned, in writing and at the appropriate time, before opening an account or performing any transaction. Note, however, that client disclosure alone is not a sufficient means to address a material conflict in the client’s best interest. The information contained in the client disclosure must be:

  • exhaustive,
  • conveyed in simple language so the client can properly evaluate the conflict of interest and assess its full scope before making an informed decision, and
  • presented in a document which is separate from all other documentation provided to the client.

In practice, the advisor can play a front line role in this process: for example, by personally delivering the broker’s declaration or by disclosing this information in accordance with the broker’s rules.

Advisors must also remind clients of existing conflicts of interest if several months or years have passed since the date of the most recent disclosure. It is a good practice to provide these reminders in writing.

The disclosure must include the following details:

  • The nature and scope of the conflict of interest.
  • The potential impact of the conflict of interest on the client and the risk it represents for them.
  • The means by which the conflict of interest has been or will be addressed.

 

  • Offering in-house/proprietary products

Recommending a proprietary product almost always gives rise to a material conflict of interest.

 

  • Compensation from third parties

Receiving compensation from a third party constitutes a material conflict of interest. Receiving a higher level of compensation from a third party to offer or recommend a certain product over another almost always gives rise to a material conflict of interest.

 

  • Compensation mechanisms and internal incentives offered by brokers

Receiving a higher level of compensation from a broker to offer or recommend a certain product or service over another almost always gives rise to a material conflict of interest.

In addition, if a broker establishes a specific sales or revenue target, the risk of conflict of interest will increase if advisors are penalized for failing to meet this target.

Such practices can increase the risk of advisors placing their own interests ahead of those of their clients.

 

  • Supervisory compensation

Linking the compensation of compliance or supervisory staff to the achievement of a sales or revenue target by an advisor almost always gives rise to a material conflict of interest.

Furthermore, if these roles are also filled by an advisor, the risk of material conflict of interest is practically 100%.

 

  • Fee-based accounts

Fee-based accounts that include securities with embedded commissions almost always give rise to a material conflict of interest.

 

  • Conflicts of interest between two clients

Clients do not all share the same interests. Occasionally their interests may conflict, which can make doing business with both clients simultaneously a challenge.

Such conflicts should be addressed in a transparent and equitable manner between the clients.

 

  • Client referral arrangements

Client referral arrangements that involve compensation (monetary or non-monetary benefits) almost always give rise to a material conflict of interest.

Before referring a client, the advisor should ask themselves if the referral prioritizes the client’s interests. This analysis should consider the advantages of the referral to the client versus a different solution or the status quo.

Furthermore, if a client referral arrangement results in the client paying more for identical or similar products or services, the conflict would not be addressed in the client’s best interest.

 

  • Acquiring assets from a client outside the normal course of business

Acquiring assets from a client outside the normal course of business almost always gives rise to a material conflict of interest. For example, an advisor should not acquire a property or other highly valued asset from a client.

It is important to keep in mind that acquisitions made outside the normal course of business are particularly problematic given the degree of trust between the client and their advisor. For example, the client may not realize that the advisor is not acting on the broker’s behalf in such a situation.

Therefore, this practice should be avoided unless it is clearly demonstrated that it prioritizes the interests of the client.

 

  • Authority or total control over a client’s financial affairs

Exercising authority or total control over the financial affairs of a client who is a natural person (for example, by acting as liquidator for a client’s estate or holding a power of attorney on behalf of a client) almost always gives rise to a material conflict of interest.

 

  • Being a member of a board of directors

The Regulation prohibits advisors from acting as director for a registered company which is not a member of the advisor’s sponsoring firm.

Serving on the board of directors of any other company constitutes a material conflict of interest.

In such cases, the advisor could have a fiduciary duty to the company which is incompatible with the interests of their clients or their broker. In addition, the advisor could have access to inside information. Devoting time to these other activities could also negatively impact their advisor duties.

Furthermore, recommending securities issued by a company for which the advisor is a director, officer, shareholder, owner or partner would aggravate the conflict of interest.

 

  • Exercising a professional activity externally (dual employment)

Exercising a professional activity externally can give rise to a conflict of interest (for example, if the advisor receives compensation, or due to the advisor’s relationship with the external entity).

 

    Lending to clients or borrowing from clients generally constitutes a conflict of interest. Such conflicts are not easy to manage. However, there are exceptions.

    It is important to keep in mind that advisors still run the risk of violating their ethical obligations even if the conditions listed below are met. Whether or not a conflict exists will always depend on the specific facts and circumstances.

     

    Lending to clients

    Advisors are prohibited from lending money, extending credit and providing margin to a client, except if the following conditions are met:

    • The advisor and client are related persons as defined for the purposes of the Income Tax Act (R.S.C., 1985, c. 1).
    • The advisor has obtained written authorization from their broker to lend money, extend credit or provide margin to a client.

    Related persons may include, for example, individuals connected by blood relationship, marriage or adoption. Related persons are deemed to be “dealing at arm’s length”.

    Important: Some self-regulatory organizations have implemented rules that are stricter than those outlined below. For example, the Mutual Fund Dealers Association of Canada (MFDA) prohibits providing margin and, subject to strict exceptions, lending money to a client.

     

    Borrowing from clients

     

    Advisors are prohibited from borrowing money, securities or other assets from a client or accepting a guarantee in relation to borrowed money, securities or any other assets from a client, unless at least one of the following conditions is met:

    • The client is a financial institution whose business includes lending money to the public, and the loan to the advisor is in the normal course of the financial institution’s business.

     

    • Both of the following conditions apply:

     

    • The client and the advisor are related persons as defined for the purposes of the Income Tax Act (R.S.C., 1985, c. 1).
    • The advisor has obtained their broker’s written authorization to borrow the money, securities or other assets or accept the guarantee.

    Related persons may include, for example, individuals connected by blood relationship, marriage or adoption. Related persons are deemed to be “dealing at arm’s length”.

     

    As a reminder, advisors must be familiar with the rules established by their broker and comply with them, even if these rules are more stringent or more restrictive than those set out in the applicable regulations. If in doubt, advisors should contact their broker’s compliance manager.