On November 19, 2015 the Canadian Securities Administrators published CSA Staff Notice 31-343 Conflicts of interest in distributing securities of related or connected issuers.
In the notice they detail their serious concerns in terms of conflicts of interest posed by EMD’s raising capital from investors for connected or related Issuers with whom they share common ‘mind and management.’ The notice also discusses registrant obligations, how to respond to conflicts of interest, acceptable and unacceptable practices, and how they will assess and review captive dealers. The main theme of the notice comes through in their statement that:
The captive dealer business model creates a material conflict of interest between the captive dealer’s financial incentive to sell its related or connected issuer’s securities, and its regulatory obligations, including KYC, KYP, suitability, and its fair dealing duty.
We agree. There is no doubt that captive dealers potentially have a material conflict of interest with their clients that requires management. Where we disagree however, is that the focus of this notice is entirely upon captive EMD’s, and not the bank owned investment dealers, as the primary source of potential harm to investors when it comes to selling related issuer products. It is true that there have been instances in the exempt industry where captive dealers have not effectively managed their conflicts, or have even acted inappropriately. We also know that there was the possibility that captive EMD’s could have been disallowed from using the recently announced amendments to the Offering Memorandum (OM) exemption permitting Issuers to raise capital in Ontario from Eligible Investors, and that this could have been harmonized across Canada.
That they permitted captive EMDs continued access to the OM Exemption reflects, in part, an active effort by the exempt industry to educate regulators that captive dealers are an important part of the capital markets. In our case, while the majority of the capital in our funds has been raised through dealers, it did not start out that way. We may not have gotten to where we are today if we hadn’t had our own captive EMD and our cost of capital may have been higher. The Staff Notice also states:
Captive dealers should avoid material conflicts of interest that they cannot address through controls and/or disclosure. Avoidance includes ceasing to provide a service, or dealing with a client, or not trading in a particular product or products. Captive dealers that solely or primarily trade in related or connected issuer securities are most at risk of being unable to address conflicts of interest through controls and/or disclosure.
This statement by itself is not very controversial; but it is incomplete. The bank owned dealers have similar conflicts except that their scale is far larger, and the potential for harm exponentially greater. That these bank-owned investment dealers have deep compliance departments and sell primarily prospectus products does not change the fact that the conflicts at the branch level, where most Canadians bank and invest, cause more harm in terms of high fees and low returns than could ever be done by captive EMDs as an industry. Have you ever walked into a branch at any one of the big banks and noticed that the only products they sell are their own? If you had wanted to buy Canadian equities, for example, what were your choices?
For the purposes of this article, let’s consider it evident that indexing inexpensively will far outperform the vast majority of actively managed high fee funds in the long term, and that approximately 219 basis points in extra cost per year is just too high a price to pay for active management of vanilla products like Canadian equities. Take a look at Table 1 and you will note that all the big banks offer active funds and their own index funds which are extremely high fee in comparison to the offering by independent managers in Table 2 like Vanguard or Black Rock which offer index funds with fees between 5 and 6 basis points. In other words, you pay about 18 times the price for a bank index fund than a third party index fund managers’ offering and 41 times more in fees than if you had bought a bank actively managed fund for basically the same market exposure than an inexpensive index fund would give you. Will they tell you this? Of course not!
Now let’s look at Table 3 for a comparison of deposit rates between the big banks and the smaller institutions for insured deposits. You can get up to 75 extra basis points on a savings account going outside the big banks, and on average do 19 basis points better. For 5 year GICs you do up to 75 basis points better and on average 35 basis points better going to a smaller institution. No bank advisor will tell you to put your deposit elsewhere because you will get a higher rate and that they have a conflict of interest in selling you their house brand deposit, and not a competitors.
As a captive EMD, we hand to clients that subscribe directly a Relationship Disclosure Information (RDI) Form that describes the relationship of the EMD to the products it offers and the conflicts that it potentially may cause and how those potential conflicts are dealt with. Have you ever gotten a similar form at a bank retail branch where they tell you their conflicts in selling you a house brand fund or deposit and that you would be better served going elsewhere? Are they required to remind you that deposits above $100,000 are not insured and that it is in your best interest that if you have more than $100,000 to put on deposit, you should spread your deposits around? While the risk may be low, it still isn’t zero and you can eliminate this risk for zero cost to you.
Canadian depositors and investors are being ripped off, and the scale of the rip off is exponentially higher than the potential for harm from captive EMD’s. Banks want their average retail branch investor to stay in house, in either a low rate deposit, or a house brand high fee fund. The bank retail branches capitalize on the average retail clients’ trust and ignorance of alternatives, and the lack of any requirement for the banks’ to disclose their conflicts. They would lose money if deposits or investments moved to inexpensive third party products or to products where the management fee was paid to someone else. That is a conflict that remains unaddressed.
Among the suggestions the notice proposes to mitigate some of the conflicts facing captive EMDs is that they sell products other than those of related or connected Issuers. I just do not see how that is a serious solution. Many captive EMD’s are not profit centres but are a way to raise capital, potentially more cheaply than through other methods in the same way that the bank branch ‘Financial Advisors’ are there to raise cheap deposit money and to retain clients in high fee internally managed investment products rather than have the money ‘leak’ outside their closed system. Most captive EMDs are focused on their core business.
Being an EMD may be just part of what helps run that core business or get it off the ground. To start selling other products would be a massive distraction and most exempt market Issuers could not manage the dilution of focus on their core business. The banks could easily manage to sell third party products in their branches, whether investment funds or deposit products but it’s never going to happen, at least not until we have a fiduciary best interest requirement, and even then it’s probably not going to happen. Can you imagine walking into a TD branch and them being required to show you deposit rates at BMO, CIBC, or Laurentian Bank? The very idea is preposterous. But why would captive EMDs selling competitors’ products be considered as a serious potential solution?
These kinds of notices are worrisome as they demonstrate the regulators continued sceptical focus on a part of the investment industry where the potential for harm is small relative to the big banks in terms of where most Canadians invest and the overall total dollar amounts involved. Captive EMDs help build real businesses and regulating them out of existence is in no one’s best interest. Clearly there are conflicts and some bad actors out there. It is disappointing that they singled out captive EMDs and ignored the captive bank advisors. Unfortunately, the tone of the notice is clear. Captive EMDs be warned. You are being watched with a sceptical eye. We may someday lose the right to exist collectively if there are too many problems in compliance reviews in the industry. Thus, it is important to take the notice seriously and ensure that you have adopted some of the effective practices mentioned and managed your conflicts as best as possible. Your continued existence and that of our segment of the industry depends on it.
Mr. Romundt is the founder and President of Centurion Asset Management Inc., Centurion Apartment REIT and Centurion Real Estate Opportunities Trust. He has been engaged in investment in residential real estate since 1997 and investments and financial markets since 1991. He has real estate investment experience in Singapore, Britain, Australia, China and Canada. From 1991 to 1997, he worked for Citibank in Toronto, New York and Singapore as a financial derivatives trader in interest rate derivatives, major and emerging currencies and exotic derivatives. From 1997 to 2001, he worked for AIG International Group in Hong Kong, Britain and Singapore as head of emerging market derivatives and then as Senior Vice President and Partner (Emerging Markets). He was the group risk manager, overseeing all of the firms positions in emerging markets and was a member of the risk management committee. Mr. Romundt is a member of the Board of Directors of NEMA (National Exempt Market Association). He was nominated for and was a finalist in, the Ernst & Young 2014 Entrepreneur of the Year award and was named CEO of the year by Canadian Apartment Magazine in 2015. He graduated from the Richard Ivey School of Business at the University of Western Ontario with an HBA in 1991.