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OCTOBER 2005 ADVISOR’S EDGE REPORT
www.advisor.ca
The Old Switcheroo
Regulators have their eyes on mutual fund exchanges
COMPLIANT ADVICE BY PHILIP PORADO
Pop quiz: Your client has shares in a mutual fund and there’s a nearly identical fund into which the shares can be automatically converted. The only difference between the two is that one fund has deferred sales charge (DSC) units and the other carries a 0% front-end load. Do You: A. Go ahead and move the client to the other fund since it’s a dollar-fordollar switch and there’s no material difference in the products other than the sales charge? After all, these bulk switches are done all the time. B. Check with the client to see if it’s okay and then make the switch when he says, “Uh, I guess so,” but make sure you don’t tell him the switch to a front-end load will entitle you to a higher trailer commission? C. Obtain the client’s consent to the switch after disclosing any increase in your commission, including higher trailer fees. Make sure you
refer the client to the prospectus for the new fund – because it is a new fund – and outline any tax consequences that could result from the sale of the original shares? If you picked A or B, sorry but that’s called churning. The principal will be around to deal with you shortly. And the principal will take the form of the Mutual Fund Dealers Association or Investment Dealers Association, both of which recently issued notices to remind members about their expectations. For those of you who picked C, good work, but be prepared to show the regulators you have procedures in place to ensure fund exchanges are being monitored and made properly. Bruce Dickson, the IDA’s director of sales compliance, notes fund sellers are obligated to monitor all trading activity going on within their shops. So if a compliance officer or branch manager sees clients exiting one version of a fund and entering an almost mirror-like version of that same fund, then questions need to be asked. And if it happens repeatedly in the same client accounts, then that’s a
very red flag. The regulators are essentially concerned the switches amount to a raise for the advisor that wasn’t agreed to by the client, explains Susan Han, general counsel at AIM Trimark in Toronto. The DSC option gives a 50-basis point trailer, whereas the front-end load option ups that to a full 1%. “You can’t make these switches without consulting the client. You’re not entitled to do this without instructions, because investors have the right to know how much their advisors are being paid,” she says. “The client is giving the advisor a raise, because he’s now getting more commission from the trail.” Steven Kelman, president of Steven G. Kelman & Associates in Toronto, says it’s pretty easy to spot whether or not a rep is making the fund switch to generate commission: Just look at the size of the account. Reps don’t make a lot of money when they double the commission if it’s a small portfolio – it can be as little as a few dollars – whereas they make a lot when a large number of shares are swapped. “If he doesn’t do it for the small clients, but does it for the big ones, then it’s a commissiondriven decision,” Kelman says. So what’s the best practice? First off, says Kelman, the exchanges have to be done on a
“If a compliance officer or branch manager sees clients exiting one version of a fund and entering an almost mirror-like version of that same fund, then questions need to be asked.”
client-by-client basis. If a rep sees an opportunity to switch that really is driven by the belief the client will have more flexibility with a fund portfolio going forward, then he needs to discuss it with the client. The client needs to be told that the trailer commission will double. The client needs to be told about any tax consequences of redeeming his or her shares. And the rep owes it to the client to discuss whether or not there are other, better, options for the money tied up in those mutual fund shares, Kelman says. “The fact that he’s getting an extra halfpoint, I don’t think the client cares, but from a disclosure point of view the rep would be wise to document everything – this is what we’re doing, how and why we’re doing it, and these are what the implications are for you.” Han notes information about DSC to front-end-load switches appears on all prospectuses as well
as on the fund company’s website. They have considered changing procedures to add a form that would require the dealer to show the client had been told about the implications of the switch, but so far that procedural change hasn’t been made. That means AIM Trimark and other fund companies will continue to assume orders coming from their dealers are being delivered following appropriate discussions with the client. They’re expecting the dealers to do the due diligence. “If it comes to us as a good order transaction, we’ll process it,” says Han. “We’re not part of the relationship between the client and the advisor.” The MFDA’s notice warns there may be tax implications associated with the switches and clients need to be informed if they’ll incur capital gains. Depending on the fund, there may or may not be a problem. Many funds anticipated this problem and set things up so the exchange does not require an outright disposition of the fund shares. In such cases, no gains occurred since the shares were technically never sold. Dickson noted the IDA’s guidance does not apply to funds in which there are features embedded to prevent a full redemption from taking place when the products are switched. AER
Mutual Liability
Ontario gives investors right to sue
BY KATE MCCAFFERY
Mutual funds and their managers could face legal action under Ontario’s new civil liability regime, compliance experts say. Bill 149, which amends the Securities Act, comes into effect on Dec. 31, 2005. The legislation, proclaimed in August, gives stock market or secondary market investors the right to sue public companies that issue misleading financial reports, press releases and other disclosure documentation. Companies who issue misleading or incorrect statements open themselves up to lawsuits if investors can reasonably claim they relied on that information to make a decision about their holdings in the company. Analysts’ jobs might also become more difficult in the future since the rules not only apply to any oral statements made by company executives and investment managers, but to anyone else with the actual, implied or apparent authority to speak on behalf of the fund. Primary market investors, who
buy shares as part of an initial public offering, already have a statutory right to sue if the information presented in a prospectus is false or misleading, or if the company omits important information. More than 90% of all equity trading in Canada occurs in the secondary market, however, where investors generally buy shares from other investors. The rules will apply to investment funds as well, even though the language used in drafting the legislation is not well tailored to the products. Mutual funds are already sold by prospectus and by their very nature and structure, they also have relatively few “material facts” that would significantly affect their market price. Lawyers presenting at Investment Funds Institute of Canada’s annual conference in Toronto last month said a strict interpretation of the legislation would seem to suggest that the rules would not apply to most investment funds.
But in discussions with the province’s finance minister and the Ontario Securities Commission, an IFIC working group found that legislation was indeed intended to apply to mutual funds. In overseeing cases, judges are more likely to accept a broader view of the legislation, rather than a strict interpretation of the law. “They don’t like technical defences,” warns IFIC legal counsel Stacey Shein. To guard against the threat of
litigation mutual fund companies will need to beef up their already elaborate compliance policies. Don MacDonald, vice-president and legal counsel at Investors Group Financial Services, advised company executives gathered at the conference to review existing policies and create a disclosure policy. He added it would also be prudent to establish a disclosure committee that includes legal representation and employees senior enough to
know what material changes are taking place at the company. Perhaps most importantly, companies need to implement an awareness and training program to help employees recognize that potential liability arises whenever a document is released, like sales and marketing materials, or when a public statement is made. Disclosure policies, MacDonald points out, are not worth very much if people don’t know about them. AER
OAS UPDATE
Maximum old age security benefit rates as of Oct. 1, 2005 Type of old age security benefit Basic old age security pension Guranateed Income Supplement Single Spouse/common-law partner of - a non-pensioner - a pensioner - an allowance recipient The Allowance - regular - survivor
Source: Social Development Canada
Maximum monthly benefit rates October - December 2005 $479.83
Previous quarter July - September 2005 $476.97
$570.27
$566.87
$570.27 $371.46 $371.46
$566.87 $369.24 $369.24
$851.29 $939.84
$846.21 $934.24