NOTICE OF PROPOSED CHANGESTO PROPOSED RULE 81-503
AND COMPANION POLICY 81-503CP
SALES PRACTICES APPLICABLE TO THE SALE OF
MUTUAL FUND SECURITIES
NOTICE OF PROPOSED NATIONAL INSTRUMENT 81-105
AND COMPANION POLICY 81-105CP
MUTUAL FUND SALES PRACTICES
Substance and Purpose of Proposed National Instrument
On August 30, 1996, the Ontario Securities Commission (the "Ontario Commission") published proposed Rule 81-503 Sales Practices Applicable to the Sale ofMutual Fund Securities (the "Ontario Draft Rule") with proposed Companion Policy 81-503CP (the "Ontario Draft Policy").1 The Canadian SecuritiesAdministrators (the "CSA") have agreed to use the Ontario Draft Rule as the basis for a national instrument that will regulate substantially the same matters asthe Ontario Draft Rule.
This Notice relates to proposed National Instrument 81-105 Mutual Fund Sales Practices (the "National Instrument"), which, in Ontario, amends and replacesthe Ontario Draft Rule. This Notice also relates to proposed Companion Policy 81-105CP (the "Companion Policy") that accompanies the proposed NationalInstrument and amends and replaces in Ontario the Ontario Draft Policy. This Notice summarizes the proposed National Instrument and the Companion Policy,together with the changes made from the Ontario Draft Rule and the Ontario Draft Policy.
The proposed National Instrument and Companion Policy are initiatives of the CSA, and the proposed National Instrument is expected to be adopted as a rule ineach of British Columbia, Alberta, Ontario and Nova Scotia, as a Commission regulation in Saskatchewan, and as a policy in all other jurisdictions represented bythe CSA. The proposed Companion Policy is expected to be implemented as a policy in all of the jurisdictions represented by the CSA.
The proposed National Instrument and Companion Policy implement, in part, the recommendation of the CSA Task Force on Operational Efficiencies thatCanadian securities regulatory authorities increase the coordination of regulation, including standardization of requirements.
During the comment period in respect of the Ontario Draft Rule and the Ontario Draft Policy that expired on November 29, 1996, the Ontario Commissionreceived submissions on the Ontario Draft Rule and the Ontario Draft Policy from a broad range of commenters. Appendix A lists the commenters.
The Ontario Commission considered these comments with the other members of the CSA in conjunction with the development of the proposed NationalInstrument and Companion Policy and these instruments reflect the decisions of the CSA in this regard. Appendix B to this Notice summarizes in chart form theprincipal comments received in respect of the Ontario Draft Rule and the Ontario Draft Policy and the CSA's disposition of them. Appendix C to this Noticecontains a more detailed summary of those comments and the response of the CSA. Further background to, and explanation of, the changes made to theOntario Draft Rule and the Ontario Draft Policy are contained in the footnotes to the proposed National Instrument and the Companion Policy.
Drafting changes to the Ontario Draft Rule and the Ontario Draft Policy have also been made throughout the proposed National Instrument and CompanionPolicy and are noted, where material, in footnotes to the instruments and in this Notice.
The Ontario Commission outlined the regulatory history of the CSA's regulation of mutual fund sales practices in the Notice accompanying the publication of theOntario Draft Rule and Ontario Draft Policy for comment. The Ontario Commission noted that prior to the release of the report of Ontario CommissionerGlorianne Stromberg2 (the "Stromberg Report"), the CSA relied on competitive market forces to moderate sales practices in the mutual fund industry andmandated that full disclosure of sales incentives and practices be given to investors. Commissioner Stromberg reviewed the sales and business practices followedby industry participants in the distribution of mutual fund securities. She noted in her report that as a result of competitive pressures, "questionable salespractices and incentives have become commonplace in the industry".3
After discussions with The Investment Funds Institute of Canada ("IFIC") and with the Investment Funds Steering Group, an industry- regulatory advisory groupestablished by the Ontario Commission to review and comment on the Stromberg Report, the Ontario Commission decided in June 1996 to promulgate a rule togovern the sales and business practices dealt with by the draft recommendations for a Code of Sales Practices for the mutual fund industry released by IFIC inMarch 1996 (the "IFIC Code").4
Although the CSA have determined to make the proposed National Instrument, they agree with the Ontario Commission that optimally, sales practices followedby participants in the mutual fund industry should be regulated by a self-regulatory organization having jurisdiction over the distributors of securities, includingmutual fund securities. The CSA will continue to encourage the development of self-regulatory organizations to regulate distributors of securities.
The CSA note that the two existing CSA Notices that deal with some of the same subject matter as the proposed National Instrument will be revoked inconnection with the coming into force of the proposed National Instrument. Those notices are "Mutual Fund Sales Incentives" CSA #93/1, and "Mutual FundSales Incentives - Point of Sale Disclosure Statement" CSA #95/2.5
Purpose of the Proposed National Instrument
As was proposed by the Ontario Draft Rule, the proposed National Instrument regulates the sales and business practices followed both by managers and principaldistributors of publicly offered mutual funds, and by registered dealers and their sales representatives in connection with the distribution of securities of publiclyoffered mutual funds. The proposed National Instrument is designed to make mandatory, on an industry-wide and on a national basis, restrictions on certainsales and business practices followed by participants in the mutual fund industry in Canada.
The proposed National Instrument is based on, and is largely consistent with, the Ontario Draft Rule. As such, the proposed National Instrument has its originsin the IFIC Code and deals with the same sales and business practices that are covered by the IFIC Code. The proposed National Instrument (like itspredecessor, the Ontario Draft Rule) also reflects the by-laws and rules of the Investment Dealers Association of Canada (the "IDA") as they relate to salespractices in the mutual fund industry. Changes to the Ontario Draft Rule and the IFIC Code have been made both in response to comments received on theOntario Draft Rule and where they were deemed warranted in order to achieve legislative certainty and to give effect to the overall scheme and purpose of theproposed National Instrument.
The CSA seek to ensure a level playing field for all participants in the mutual fund industry in Canada through the proposed National Instrument. The proposedNational Instrument will require these participants to adhere to common rules in the distribution of publicly offered mutual funds, whether or not they aremembers of a self-regulatory organization and without regard to where such participants are located in Canada.
Although the proposed National Instrument applies only to the distribution of publicly offered mutual funds, the CSA agree with the Ontario Commission thatthe regulatory objectives of the proposed National Instrument have equal application to the distribution of all collective money management schemes in Canada.Ultimately, the distribution of all schemes should be subject to the same or equivalent rules and standards.
The CSA are of the view that regulatory reliance on competitive forces and disclosure alone has not been sufficient to govern the conflict between the interests ofthose involved in the distribution of mutual fund securities, including the various members of a mutual fund organization, and their respective duties towards theinvesting public. Accordingly, the CSA have concluded that the restrictions on the sales and business practices provided for in the proposed National Instrumentare necessary.
In formulating the proposed National Instrument, the CSA agreed with, and were guided by, the Ontario Commission's articulation in the Ontario Draft Policy ofcertain fundamental principles that the Ontario Commission considered should govern the conduct of participants in the mutual fund industry. The CSA hasretained the description of these principles in the proposed Companion Policy and consider them a necessary underpinning to the proposed National Instrument.
The Ontario Commission in its August 1996 Notice noted the concern that arises with the use of certain sales incentives or practices by industry participants inthe distribution of mutual fund securities; that is, that investment recommendations cannot be said to be made solely on the basis of an investor's investmentobjectives or circumstances, but rather are influenced by the incentives being paid to a dealer or sales representative. The CSA agree with this concern andaccordingly propose the proposed National Instrument.
Substance and Purpose of Proposed Companion Policy
The proposed Companion Policy emphasizes that the proposed National Instrument establishes only minimum standards of conduct for industry participants.The proposed Companion Policy is designed to provide a regulatory background and context for the proposed National Instrument and to outline the CSA'sgeneral regulatory purpose in making the proposed National Instrument. The proposed Companion Policy also provides guidance as to the CSA's interpretationof some provisions of the proposed National Instrument and brings certain matters to the attention of participants in the mutual fund industry.
Summary of Proposed National Instrument
Part 1. Part 1 sets out several key definitions used in the proposed National Instrument and provides that terms used in the proposed National Instrument thatare defined in National Policy Statement No. 39 - Mutual Funds ("NP39"), or any successor instrument to NP39, (being proposed National Instrument 81-102Mutual Funds ("NI 81-102")), have the meanings ascribed to them in that instrument or successor instrument. Part 1 also sets out the application of theproposed National Instrument.
Section 1.1. Section 1.1 defines several key terms used in the proposed National Instrument.
Changes from Ontario Draft Rule
The term "direct costs" is a new definition added to the proposed National Instrument to increase clarity. The principles underlying the definition of the termwere used in the Ontario Draft Rule. The definition is used in Part 5 of the proposed National Instrument and describes those costs incurred by participatingdealers that may be paid for by mutual fund organizations. Further explanation of this definition is provided in the Companion Policy.
The definition of "equity interest" has been amended from the definition contained in the Ontario Draft Rule by the increase in the percentage threshold from fivepercent to ten percent in order to conform with the thresholds applicable to other requirements contained in securities legislation, such as insider trading andearly warning system rules. The definition has also been amended to refer specifically to partnership units, in order to avoid uncertainty over whether partnershipunits are equity securities. The definition now applies the ten percent test to reporting issuers in any jurisdiction whose securities are listed on a Canadian stockexchange, rather than all reporting issuers.
The definition of "member of the organization" has been amended from the Ontario Draft Rule in three ways. First, mutual funds are no longer included in thedefinition, and are dealt with separately in Part 2 of the proposed National Instrument in order to clarify that mutual funds never are permitted to make paymentsor provide benefits to participating dealers. Second, paragraph (e) of the definition in the Ontario Draft Rule, which pertained to persons or companies acting onbehalf of other persons included in the definition, has been deleted in response to comments that the provision was too broad and could apply to persons actingon behalf of mutual funds in ways outside the scope of the proposed National Instrument. In connection with this deletion, the CSA are proposing section 2.3 ofthe proposed National Instrument, a prohibition against indirect actions that could not be taken directly; that provision is designed to effect the same purpose asformer paragraph (e), namely to ensure that third parties that are not members of a mutual fund organization could not be used in arrangements designed tosubvert the proposed National Instrument. Third, portfolio advisers have been added to the definition. The CSA are of the view that there is a risk that portfolioadvisers could provide benefits to participating dealers that could influence the advice given by those dealers to their clients. The CSA therefore wish to treatportfolio advisers in the same manner as other members of mutual fund organizations.
The definition of "representative" has been changed from the Ontario Draft Rule to clarify that personal holding companies of the persons referred to in thedefinition are to be considered "representatives" for the purposes of the proposed National Instrument.
Section 1.2. Section 1.2 operates to give terms defined in NP39, as well as in any successor instrument to NP39, the same meaning in the proposed NationalInstrument as they have in NP39 or the successor instrument. Footnotes to the proposed National Instrument outline the relevant defined terms.
Changes from the Ontario Draft Rule
This section has been altered to reflect the fact that the proposed National Instrument will likely be in effect before NI 81-102 and accordingly, reference is madeto the definitions contained in NP39 and, once it is replaced by NI 81-102, that successor instrument.
Section 1.3. Section 1.3 provides that the proposed National Instrument applies to a distribution of securities of a mutual fund that offers or has offeredsecurities under a prospectus or simplified prospectus so long as the mutual fund remains a reporting issuer, and to persons or companies in respect of activitiesrelating to the mutual fund. This language is identical to that included in NI 81-102, so that the proposed National Instrument and NI 81-102 will apply to thesame mutual funds and industry participants.
Part 2. Part 2 establishes the general scope of the proposed National Instrument and is based on the overall scope of the IFIC Code and is generally consistentwith the Ontario Draft Rule.
Section 2.1. Subsection 2.1(1) provides that no member of the organization of a mutual fund and no mutual fund may, in connection with a distribution ofsecurities of the mutual fund, pay money to a participating dealer or a representative of a participating dealer, provide a non-monetary benefit to a participatingdealer or to a representative of a participating dealer or pay for a cost or expense incurred or to be incurred by a participating dealer or a representative of aparticipating dealer. Subsection 2.1(2) provides the limited exceptions from the prohibitions contained in subsection 2.1(1). Subsection 2.1(2) permits a memberof the organization of a mutual fund to make a payment of money or provide a non-monetary benefit to a participating dealer, and to pay for or makereimbursement of a cost or expense incurred or to be incurred by a participating dealer or its representatives, if permitted by Parts 3 or 5 of the proposedNational Instrument. Subsection 2.1(2) also allows a member of the organization of a mutual fund to provide a non-monetary benefit to a representative of aparticipating dealer, if permitted by Part 5.
Under no circumstances may a payment of money, including a reimbursement of a cost or expense, be made by a member of the organization of a mutual funddirectly to a representative of a participating dealer in connection with the distribution of securities of the mutual fund. Also, under no circumstances may amutual fund itself, in connection with the distribution of its securities, make a payment of money to, provide a non-monetary benefit to, or pay for or makereimbursements of a cost or expense incurred by, a participating dealer or a representative of a participating dealer.
Subsection 2.1(3) prohibits the use of contests to determine the payment of money, the provision of non-monetary benefits and payments or reimbursements ofcosts or expenses by a member of a fund organization to a participating dealer and its representatives. The provision prohibits the making of any payment ofmoney, provision of benefit or reimbursement of cost or expense that is conditional upon the sale of a particular amount or value of securities of one or moremutual funds by a participating dealer or a representative, or a particular amount or value of securities of one or more mutual funds being held in accounts ofclients of a participating dealer or a representative.
This provision, which applied to some of the permitted payments contained in Part 5 of the Ontario Draft Rule, has been included in the proposed NationalInstrument to apply generally to all activities permitted by Parts 3 or 5 of the proposed National Instrument. Mutual fund organizations are not permitted to tiethe activities or payments permitted by Parts 3 and 5 to specific levels of performance by participating dealers; in addition, no representations in this regard maybe made, therefore preventing "sales contests" from being held by mutual fund organizations.
Changes from the Ontario Draft Rule
Mutual funds have been deleted from the definition of "member of the organization", so that it has been necessary to make specific reference to mutual funds insection 2.1 in order to clarify that mutual funds never may make payments of money to, provide non- monetary benefits to or pay for or reimburse costs ofparticipating dealers or their representatives.6 The CSA are aware that certain mutual funds, namely labour sponsored investment fund corporations, pay salescommissions, both "up-front" and trailing commissions, out of fund assets to participating dealers. The CSA, and in particular, the Ontario Commission (beingthe principal jurisdiction for most of the labour sponsored investment fund corporations distributed in Canada), do not propose to exempt these mutual fundsfrom this provision by way of the proposed National Instrument.
Subsections 2.1 (3) and (4) of the Ontario Draft Rule, which were intended to prevent certain persons or companies from doing indirectly what they could not dodirectly, have been deleted and replaced by a general prohibition on indirect actions contained in section 2.3 of the proposed National Instrument.
Subsection 2.1(3) is a new subsection designed to collect all the formerly separate prohibitions on sales contests into one general prohibition.
Section 2.2. Section 2.2 represents the converse of section 2.1 and restricts the ability of participating dealers and representatives to solicit and accept thepayments or benefits referred to in section 2.1. Paragraph 2.2(2)(a) allows a participating dealer to solicit and accept any payment, benefit or reimbursementfrom a member of the organization of a mutual fund that the member is permitted by Parts 3 or 5 to provide. Paragraph 2.2(2)(b) allows a representative toaccept any non-monetary benefit from a member of the organization of a mutual fund that the member is permitted by Part 5 to provide; however therepresentative is not permitted to solicit that benefit from a member.
Changes from the Ontario Draft Rule
Section 2.2 has been modified in order to state more directly and clearly the rules applicable to the solicitation and acceptance of payments, non-monetarybenefits and reimbursements of costs and expenses. The ability of participating dealers to solicit and accept permitted incentives has not changed. However, theproposed National Instrument clarifies that representatives may never solicit any incentives, although they may accept the non-monetary benefits permitted to begiven to representatives by fund organizations under Part 5 of the proposed National Instrument.
Section 2.3. Section 2.3 provides that no person or company shall arrange to effect indirectly any action that the person or company would be prohibited by theproposed National Instrument from taking directly.
Changes from the Ontario Draft Rule
This section is new and has been inserted for greater clarity. It replaces the detailed restrictions on indirect actions contained in section 2.1 of the Ontario DraftRule.
Section 2.4. Subsection 2.4(1) clarifies the application of the proposed National Instrument for a participating dealer that is also a member of the organization ofa mutual fund. The section provides that nothing in the proposed National Instrument prohibits a person or company that is both a member of the organizationof a mutual fund and a participating dealer of a mutual fund in a different mutual fund family from undertaking any activity, if
(a) the activity is undertaken in the person or company's capacity as a participating dealer of the mutual fund of which it is a participating dealer and not in itscapacity as a member of the organization of the mutual fund of which it is a member; and
(b) the participating dealer is not prohibited by the proposed National Instrument from undertaking that activity.
Subsection 2.4(2) is analogous to subsection 2.4(1), and clarifies that a representative of a participating dealer that is also a member of the organization of amutual fund is not prohibited by the proposed National Instrument from soliciting or accepting any payment, benefit or reimbursement from the participatingdealer, so long as the participating dealer in making the payment or providing the benefit is taking such action in its capacity as dealer, and not as a member ofthe organization of a mutual fund.
Changes from the Ontario Draft Rule
Section 2.4 is a new section. It responds to comments received by the Ontario Commission to the effect that a person or company that is both a member of theorganization of a mutual fund and a participating dealer of another mutual fund, and their representatives, could be inappropriately caught by rules applicable toboth types of entities. The intent of the CSA is that those persons or companies should be subject to the rules applicable to participating dealers, and not to therules applicable to members of the organization of mutual funds, when they are acting in their capacity as participating dealers in distributing unrelated mutualfunds. The proposed Companion Policy gives examples of the extent and the effect of this provision.
Part 3. Part 3 outlines the compensation that members of the organization of a mutual fund may pay to participating dealers in connection with the distributionof securities of the mutual fund. Other than by prohibiting bonus commissions through subparagraphs 3.1(c)(iii) and 3.2(1)(d)(iii), Part 3 does not regulate therate or amount of commission paid by members of the organization of a mutual fund in respect of the distribution of securities of the mutual fund, provided thatthe mutual fund's prospectus discloses the range of commissions paid. Part 3 is generally consistent with the Ontario Draft Rule.
The Ontario Commission requested comments in response to questions it posed relating to whether the Ontario Draft Rule should be expanded to regulatecertain common commission payment related practices. The comments received by the Ontario Commission in response to these questions, and the CSAresponse to such comments, are summarized in Appendix C to this Notice.
Section 3.1. Section 3.1 permits the payment of a commission in money if the obligation to pay the commission arises at the time of the sale of the mutual fundon the conditions indicated. Commissions permitted by section 3.1 include up front sales commissions paid by fund organizations and those paid underarrangements where the principal distributor of a mutual fund permits a participating dealer to retain the whole or a portion of commissions paid by thoseinvestors purchasing securities on a "front end load" basis. The primary conditions to such payments include requirements for prospectus disclosure as to therange of commissions that may be paid and the method of calculation used in determining the amounts of those commissions. Section 3.1 provides that the rateof commission cannot increase based on increases in participating dealers' sales or asset levels or for a particular period of the year in which the commission ispaid or earned.
Paragraph 3.1(c) continues the IFIC Code prohibition on the payment of bonus commissions, including increased rates of commissions, either duringpre-determined periods of time or if certain asset or sales levels are achieved. This paragraph, together with paragraph 3.2(d) are based on, and replace withoutsubstantive change, section 3.3 of the Ontario Draft Rule. The two most prevalent practices prohibited by this paragraph are, first, the payment of highercommissions, for example, during the RRSP season or the first few months of operation of a new mutual fund and, second, the establishment of differentcommission rates based on sales or asset levels.
Changes from the Ontario Draft Rule
Subsection 3.1(1) no longer requires specific prospectus identification of different base commissions paid to various participating dealers by a mutual fundorganization; instead the range of commissions payable must be disclosed. In connection with this change, subsection 3.1(2) of the Ontario Draft Rule has beendeleted. The presentation of section 3.1 has been changed, without change to the substance and purpose of the rule, to increase clarity.
In conjunction with the inclusion of paragraphs 3.1(c) and 3.2(d) in the proposed National Instrument, section 3.3 of the Ontario Draft Rule has been deleted.
Section 3.2. Section 3.2 governs the payment of trailing commissions, which are those commissions where the obligation to make the payment arises after a saleof securities. Section 3.2 permits the payment of trailing commissions subject to certain conditions. First, trailing commissions must be based on the aggregateamount or value of securities of the mutual fund held in accounts of clients of the participating dealer at the calculation date. Second, there must be prospectusdisclosure as to the range of trailing commissions that may be paid and the method of calculation and relevant times or times periods used in determining theamounts of those trailing commissions. Third, the rate of trailing commissions cannot increase based on increases in participating dealers' sales or asset levels orfor a particular period of the year in which the trailing commission is paid or earned. Section 3.2 also requires that trailing commissions earned by relevantparticipating dealers must be paid out to them at least annually.
Paragraph 3.2(d) continues the IFIC Code prohibition on the payment of bonus commissions, including increased rates of commissions, either duringpre-determined periods of time or if certain asset or sales levels are achieved. This paragraph, together with paragraph 3.1(c) are based on, and replace withoutsubstantive change, section 3.3 of the Ontario Draft Rule. The two most prevalent practices prohibited by this paragraph are, first, the payment of highercommissions, for example, during the RRSP season or the first few months of operation of a new mutual fund and, second, the establishment of differentcommission rates based on sales or asset levels.
Changes from the Ontario Draft Rule
As with section 3.1, section 3.2 no longer requires the specific identification in a mutual fund prospectus of different commission rates paid to variousparticipating dealers so long as the range of commission rates are disclosed. Subsection 3.2(3) of the Ontario Draft Rule has been deleted. The presentation ofsection 3.2 has been changed, without change to the substance and purpose of the rule, to increase clarity. The CSA have not continued the use of the term"continuing" commission; instead the proposed National Instrument uses the term "trailing" commission as the more commonly understood, and used,terminology.
The CSA has not provided for an ability for fund organizations to set minimum asset or sales thresholds before trailing commissions would be payable, asprovided for in the IFIC Code. Section 3.2 of the proposed National Instrument does not change section 3.2 of the Ontario Draft Rule in this regard.
The IFIC Code permits a member of the organization of a mutual fund to pay, and a participating dealer to accept, trailing commissions based on the assets in anindividual representative's client accounts, on a representative by representative basis. The IFIC Code further provides that where the assets in the individualrepresentative's client accounts do not exceed $100,000, no trailing commissions have to be paid.
The CSA, as was the Ontario Commission in proposing the Ontario Draft Rule, are of the view that the modifications to the IFIC Code made in the proposedNational Instrument are desirable to achieve the regulatory purpose of the proposed National Instrument. A consistent theme of the proposed NationalInstrument (and its predecessor, the Ontario Draft Rule) is that compensation paid, or other benefits provided, to participating dealers must not be contingentupon the participating dealer or its representatives achieving particular sales or asset thresholds. Accordingly, the proposed National Instrument does not permitminimum sales or asset thresholds to be established by mutual fund organizations. Reference is made to Appendix C of this Notice wherein this issue isaddressed in more detail. Section 5.2 of the proposed Companion Policy also addresses this issue.
However, the proposed National Instrument specifically allows members of fund organizations to establish policies permitting annual payments of trailingcommissions, instead of more frequent payments, where, for example, the aggregate value of securities of a mutual fund held in accounts of clients of aparticipating dealer is less than $100,000 on the relevant more frequent payment date. Subsection 3.2(2) is applicable in this regard. Mutual fund organizationswill, accordingly, be able to reduce their administrative costs in processing commission payment cheques.
In conjunction with the inclusion of paragraphs 3.1(c) and 3.2(d) in the proposed National Instrument, section 3.3 of the Ontario Draft Rule has been deleted.
Part 4. Part 4 carries forward the IFIC Code provisions that regulate the practices of participating dealers and principal distributors of mutual funds incompensating their representatives.
Part 4 does not regulate the compensation practices of principal distributors in connection with their representatives who are employed to sell only mutual fundswithin the principal distributor's mutual fund family. Neither the Ontario Draft Rule nor the IFIC Code addressed this matter. The Ontario Commissionrequested comment in respect of this matter; the responses received, and the CSA response to such responses, are summarized in Appendix C to this Notice.
Section 4.1. Section 4.1 prevents participating dealers from providing incentives to their representatives to recommend mutual funds of one family over another.Subsection 4.1(2) permits different payments to be made by participating dealers to their representatives for different mutual fund families, if the difference inpayments is a result of the different commissions received by the participating dealers from the mutual fund organization.
Section 4.2. Section 4.2 prohibits a principal distributor of proprietary funds that also acts as a participating dealer in the distribution of third party sponsoredmutual funds from paying incentives to its representatives that could cause the representatives to favour the proprietary funds over the third party funds.
Changes from the Ontario Draft Rule
Section 4.1 has been amended from the Ontario Draft Rule to permit a participating dealer to compensate its representatives in a manner that may provide anincentive for the representative to recommend mutual funds of one mutual family over mutual funds of another mutual fund family if the differential incompensation is the direct result of the compensation paid to the participating dealer by the relevant mutual fund organizations. For example, if Mutual FundOrganization A pays a 5 percent commission to participating dealers in respect of sales of its mutual funds and Mutual Fund Organization B pays a 4 percentcommission, participating dealers may flow such different commission rates through to their representatives.
Neither section 4.1 nor section 4.2 extends to regulate practices of participating dealers in providing compensation to their representatives that differs in respectof particular mutual funds, so long as the basic rules contained in these sections are complied with; the Ontario Draft Rule has been changed in this regard.
Part 5. Part 5 describes the marketing and educational expenses of a participating dealer and its representatives that may be paid for by a member of theorganization of a mutual fund. Except as permitted by Part 5, the payment of any marketing and educational costs of a participating dealer and itsrepresentatives or the holding of a conference for representatives of a participating dealer by a member of a fund organization would be prohibited under section2.1 of the proposed National Instrument, as either a payment of money, the provision of a non-monetary benefit or a payment or reimbursement of a cost orexpense incurred by a participating dealer.
In general, Part 5 permits payment of the marketing and educational expenses of a participating dealer and its representatives permitted by the IFIC Code and isconsistent with the Ontario Draft Rule. Certain modifications have been made to reflect CSA concerns and to address comments received in respect of theOntario Draft Rule. The CSA note that the rules provided in Part 5 have their origins in the IFIC Code. The CSA continued the Ontario Commission approachof regulating sales practices as much as possible in a fashion consistent with the IFIC Code. However, the CSA note that Commissioner Strombergrecommended a complete prohibition on the practice of cooperative marketing and a restrictive approach to the ability of fund companies to sponsor educationalconferences and seminars7. Had the CSA not made a decision to keep Part 5 consistent with the IFIC Code treatment of the applicable sales practices, the CSAmay have proposed different rules in this regard. The rules proposed in Part 5 represent the CSA's attempt to balance their concerns about the risk that thesesales practices will inappropriately influence the distribution process with their preference to make rules that conform as much as possible to the solutionsworked out by industry participants.
The proposed rules applicable to the sales practices covered by Part 5 should be read carefully by industry participants. Changes have been made from the IFICCode and the Ontario Draft Rule, for the most part to limit the scope of the permitted payments. The additional conditions proposed by the rules in Part 5 areproposed by the CSA to lessen the conflicts that are, in the view of the CSA, inherent in such payments.
Part 6 of the proposed Companion Policy contains interpretative guidance for industry participants in connection with Part 5 of the proposed National Instrumentand should be read with Part 5.
Section 5.1. Section 5.1 is based on the IFIC Code provisions dealing with cooperative marketing practices. A member of the organization of a mutual fundmay pay to a participating dealer some of the direct costs (as defined in the proposed National Instrument) incurred by the dealer relating to a salescommunication (as defined in NP39) or an investor conference or investor seminar prepared or presented by the participating dealer on certain conditions. First,the primary purpose of the sales communication or the investor conference or investor seminar must be to promote or provide educational informationconcerning the mutual fund, the mutual fund family of the mutual fund or mutual funds generally. Second, any investor conference or investor seminar must bepresented by the participating dealer to investors or potential investors of the mutual fund or family, or of mutual funds generally. Third, invoices or receipts forthe direct costs to be paid for by the mutual fund organization must be provided. Fourth, no more than 50 percent of the applicable direct costs incurred by aparticipating dealer for the sales communication or event can be paid by members of all fund organizations contributing to the payment of the costs. Finally,disclosure of all persons making such payments must be made in the sales communication or provided, in writing, to the investor conference or investor seminarattendees.
The term "direct costs" is defined in section 1.1 of the proposed National Instrument to be "reasonable, out-of-pocket costs and expenses directly attributable to"the production and presentation of a sales communication or the presentation and organization of a conference or seminar referred to in Part 5. The definitionexcludes any travel, accommodation or personal incidental expenses associated with the attendance of an individual at the conference or seminar.
Changes from the Ontario Draft Rule
Section 5.1 remains largely unchanged from section 5.1 of the Ontario Draft Rule. In order for payments to be made by a member of a mutual fund organizationunder this section, the "primary purpose" of the investor conference or investor seminar is required to be the promotion or provision of educational informationabout the mutual fund, mutual fund family or mutual funds generally. The term "primary purpose" replaces the concept of "relates substantially" that was used inthe Ontario Draft Rule.
The CSA note in respect of investor conferences and investor seminars that disclosure of all sponsors of such conferences as mandated by paragraph 5.1(e) of theproposed National Instrument is essential in order for attendees at such conferences to properly comprehend the potential bias that may exist in connection withthe material being presented at these conferences. The CSA commend the recommendations of the Investment Funds Steering Group in this regard made inresponse to the Stromberg Report recommendations that a code of standards and ethics be developed in respect of investor education programs8. TheInvestment Funds Steering Group noted "the fundamental concern with investor education programs that are part of a sales process...is for investor participantsin the program to be aware of this sales process. Any investor education program...must disclose the sponsors of the program so that investors are made awarethat the program is part of a sales process and can exercise proper judgment in acting upon the information supplied through the program".9
Section 5.2. Section 5.2 is based on the IFIC Code provisions governing conferences and other educational programmes organized and presented by mutualfund organizations for participating dealers. This section permits a member of a fund organization to provide a non-monetary benefit to a representative of aparticipating dealer by allowing him or her to attend a conference or seminar organized and presented by a member of the organization of the mutual fund,provided that the applicable conditions are met. First, the primary purpose of the conference or seminar must be the provision of educational information aboutfinancial planning, investing in securities, mutual fund industry matters, the mutual fund, the mutual fund family of the mutual fund or mutual funds generally.Second, the selection of the representatives of the participating dealer to attend the conference or seminar must be made exclusively by the participating dealer,uninfluenced by any member of the organization of the mutual fund. Third, the conference or seminar must be held in Canada or the continental United States ofAmerica. Fourth, no member of a mutual fund organization may pay any travel, accommodation or personal incidental expenses associated with the attendanceof the representative at the conference or seminar. Fifth, the costs relating to the organization and presentation of the conference or seminar must be reasonablehaving regard to the purpose of the conference or seminar.
Changes from the Ontario Draft Rule
Although the presentation of section 5.2 of the proposed National Instrument has changed somewhat from section 5.2 of the Ontario Draft Rule, its substanceand purpose remains largely unchanged. Section 5.2 of the proposed National Instrument does however explicitly provide that fund complexes wishing to holdeducational conferences and seminars for representatives of participating dealers must leave the decision as to which representatives will attend the conference orseminar to the applicable participating dealer. This provision is consistent with the CSA's position that mutual fund organizations should be dealing exclusivelywith participating dealers and not with individual representatives so as to permit participating dealers to maintain better supervisory control over theirrepresentatives and to lessen the conflicts between the duties owed to clients by representatives and the sales incentives provided by fund companies.
Personal incidental expenses have been added to section 5.2 as matters that members of the organization of a mutual fund may not pay for, in addition to thetravel and accommodation expenses that were dealt with in the Ontario Draft Rule.
The requirement that the events described in sections 5.2, 5.3, 5.4 and 5.5 of the proposed National Instrument be held in Canada or the continental UnitedStates is consistent with the requirements of the 1991 Code of Conduct - Sales Incentives prepared by IFIC10.
Section 5.3. Section 5.3 allows a member of a fund organization to pay the registration fees for representatives attending a conference, seminar or courseorganized and presented by a person or company other than a mutual fund organization or a participating dealer, provided that the applicable conditions are met.First, the primary purpose of the conference, seminar or course must be the provision of educational information about financial planning, investing in securities,mutual fund industry matters or mutual funds generally. Second, payments are only permissible if the participating dealer provides invoices or receiptsevidencing payment of the registration fees. Third, the selection of representatives to attend the conference, seminar or course must be made exclusively by theparticipating dealer. Finally, the conference, seminar or course must be held in Canada or in the continental United States of America.
Changes from the Ontario Draft Rule
For greater clarity, section 5.3 of the Ontario Draft Rule has been split into three smaller sections in the proposed National Instrument, each directed at a specifictype of event. Payment of registration fees for third party conferences, seminars or courses are now dealt with in section 5.3 of the proposed NationalInstrument. The rule in this regard remains largely unchanged from the Ontario Draft Rule, except that subparagraph 5.3(1)(a)(ii) of the Ontario Draft Rule hasbeen deleted. Subsection 2.1(3) of the proposed National Instrument deals with the CSA's concern that provision of benefits or reimbursement of expenses byfund organizations not be based on sales contests.
Industry association sponsored educational events are dealt with in section 5.4, while dealer sponsored educational events are governed by section 5.5.
Section 5.4. Section 5.4 permits a member of the organization of a mutual fund to pay, to IFIC or the IDA, direct costs incurred by IFIC or the IDA relating toa conference or seminar organized by IFIC or the IDA. The Ontario Draft Rule dealt with this matter under subparagraph 5.3(1)(b)(i).
The conditions to the payment of such costs are described in section 5.4. First, the primary purpose of the conference or seminar must be the provision ofeducational information about financial planning, investing in securities, mutual fund industry matters or mutual funds generally. Second, a mutual fundorganization may pay in aggregate not more than 10 percent of the total direct costs incurred by IFIC or the IDA for the organization and presentation of theevent. Third, the selection of representatives of a participating dealer to attend the event may only be made by the applicable invited participating dealer. Finally,the conference must be held in Canada or the continental United States.
Changes from the Ontario Draft Rule
The division of section 5.3 of the Ontario Draft Rule into three sections in the proposed National Instrument was made to ensure greater clarity in the applicablerules and the conditions to the payments. The reference to conferences organized by "similar" or "other industry associations" other than the two named insubparagraph 5.3(1)(b)(i) of the Ontario Draft Rule has been deleted. The CSA are of the view that mutual fund organizations should be permitted by theproposed National Instrument to pay costs associated with events organized and presented only by IFIC and the IDA. Specific relief may be sought inappropriate circumstances from the CSA for conferences or seminars presented by other similar organizations.
The conditions described above in respect of section 5.4 of the proposed National Instrument have been added to the proposed National Instrument and, otherthan the 10 percent payment limit and the requirement that the conference or seminar be educational in nature, were not in the Ontario Draft Rule. The CSA areof the view that the conditions described in section 5.4 of the proposed National Instrument are required to ensure that the involvement of mutual fundorganizations in industry association sponsored events not present potential conflicts of the type that the proposed National Instrument is designed to address.
The CSA are of the view that, at present, mutual fund organizations may appropriately pay for education-related costs incurred by trade associations inpresenting educational seminars and conferences for participating dealers and their representatives. The CSA do not agree that it is appropriate for mutual fundorganizations to pay for the non-education related costs of such conferences or seminars such as the travel, accommodation or personal incidental costs incurredby trade associations in connection with the attendance at the seminar or conference by participating dealers and their representatives; therefore mutual fundorganizations are restricted to paying only for "direct costs", which excludes travel, accommodation and personal incidental expenses.
The condition relating to the selection of representatives attending the conference has been added to the proposed National Instrument due to the CSA's view,articulated above, that fund companies should not be dealing directly with representatives and should be providing sales incentives to participating dealers, whowill, if appropriate, pass such benefits on to their representatives.
Section 5.4 no longer requires that persons attending the event be informed in writing of the identities of those paying for part of it, and indeed, the CSA are ofthe view that such information is inappropriate.
Section 5.5. Section 5.5 is derived from paragraph 5.3(1)(b) of the Ontario Draft Rule and the "10 percent/66 percent" limits conform with those provided for inthe IFIC Code. Section 5.5 of the proposed National Instrument allows a mutual fund organization to pay, to a participating dealer, direct costs incurred by theparticipating dealer relating to a conference or seminar that is organized and presented by the participating dealer for its representatives. The same conditionsdescribed above in connection with section 5.4 are contained in section 5.5, together with an additional condition that limits payment of such costs by all mutualfund organizations that are paying such costs to not more than 66 percent of the total direct costs incurred by the participating dealer.
Changes from the Ontario Draft Rule
The discussion of the changes from the Ontario Draft Rule in respect of section 5.4 of the proposed National Instrument is applicable to the changes made tosection 5.5 of the proposed National Instrument. The Ontario Draft Rule imposed the "10 percent/66 percent" limits and the requirements in respect ofeducational conferences or seminars; all other conditions set out in section 5.5 of the proposed National Instrument are new and are proposed for the reasonsoutlined above.
Section 5.6. Section 5.6 permits a member of a fund organization to deliver non-monetary benefits of a promotional nature and of minimal value torepresentatives of a participating dealer. The IFIC Code permits the provision of non-cash promotional items provided that these items are restricted to the"usual business promotional items (tickets, logo items, etc.) of nominal value". Section 5.6 also permits limited reasonable business promotional activities to beundertaken by a mutual fund organization with a representative that would otherwise be prohibited as non-monetary benefits under section 2.1 of the proposedNational Instrument. Neither the provision of benefits or the activities may be so extensive nor so frequent as to cause a reasonable person to question whetherthe provision of the benefits or activities improperly influence the investment advice given by the representative to his or her clients. In addition, in the case ofbusiness promotion activities, no member of a mutual fund organization may pay the travel, accommodation or personal incidental expenses associated with theattendance of the representative at the activities.
Changes from the Ontario Draft Rule
Sections 5.4 and 5.5 of the Ontario Draft Rule have been merged into section 5.6 of the proposed National Instrument. The general requirement that theprovision of promotional items or activities may not be so extensive nor so frequent as to raise concerns was applicable in the Ontario Draft Rule only topromotional activities; now it applies to both activities and items.
This section no longer limits the provision of non-cash promotional items to $150 per representative per annum; instead, the limitation described above replacesthat test. The proposed National Instrument no longer requires such promotional items to be delivered to the participating dealer for delivery to representatives.
The Ontario Draft Rule provided that promotional activities had to take place in the locale in which the representative resided. This restriction has been deletedin favour of a prohibition on fund organizations paying the travel, accommodation and personal incidental expenses incurred by the representative in order toengage in the particular business promotional activity.
Finally, the Ontario Draft Rule provided that the representatives of a participating dealer that would be the beneficiary of promotional activities not be selectedby the mutual fund organization on the basis of the amount of securities of the mutual fund sold by him or her. This provision has been removed from section 5.6of the proposed National Instrument and replaced by the general restriction against contests contained in subsection 2.1(3) of the proposed National Instrument.
Section 5.6 of the proposed National Instrument sets out the only limited circumstances where the CSA consider direct contact with a representative by fundcompanies not inappropriate.
Part 6. Part 6 is based on the IFIC Code provisions regulating the portfolio transactions to be entered into by a member of the organization of a mutual fund andits portfolio advisers and is largely consistent with the Ontario Draft Rule. It is designed to ensure that "best execution" practices are followed in makingbrokerage arrangements. Part 6 limits the connection between a participating dealer's distribution activities in respect of a mutual fund and its activities incarrying out portfolio transactions for the mutual fund. Part 6 does not prohibit a participating dealer from acting as a broker in connection with portfoliotransactions where that participating dealer has also distributed securities of that mutual fund. However, it ensures that conflicts between these activities areminimized. Subsection 6.1(4) prohibits arrangements whereby a member of a fund organization agrees to direct portfolio transactions to a participating dealer asan inducement or reward for that participating dealer selling securities of the mutual fund at some future time or having sold securities in the past, or retainingassets under administration with the fund organization. Subsection 6.1(5) represents the converse of subsection 6.1(4) and applies to participating dealers.
Section 6.2 prohibits a participating dealer from executing a portfolio transaction that has not been directed through a designated institutional representative.
Changes from the Ontario Draft Rule
Part 6 of the proposed National Instrument is largely unchanged from the Ontario Draft Rule, however, the proposed National Instrument does not require thatdesignated institutional representatives of participating dealers be restricted to institutional accounts. Reference should be made to section 7.1 of the proposedCompanion Policy in this regard.
Part 7. Part 7 deals with the remaining sales practices covered by the IFIC Code, such as commission rebates, the provision of financial assistance, makingcharitable donations and tied selling activities. Generally, Part 7 of the proposed National Instrument is consistent with Part 7 of the Ontario Draft Rule.
Changes from the Ontario Draft Rule
Section 7.5 of the Ontario Draft Rule, governing "no load funds", has been removed from the proposed National Instrument to avoid repeating provisionspresently contained in section 16.03 of NP39 and to be contained in NI 81-102 as its successor instrument. It is to be noted that the CSA is of the view, that forthe present time, section 16.03 of NP39 should remain unchanged. The Ontario Commission requested specific comment on the appropriateness of section 7.5of the Ontario Draft Rule in the context of "no-load" funds whose managers pay continuing commissions to dealers. The comments received by the OntarioCommission, together with the CSA response to such comments, are summarized in Appendix C to this Notice.
Section 7.1. Subsection 7.1(1) provides that a participating dealer or its representatives may pay all or part of redemption fees or commissions that may bepayable by an investor in connection with a transfer from one mutual fund to another mutual fund only if three conditions are satisfied. First, the participatingdealer or the representative, on behalf of the participating dealer, must provide the investor with written disclosure of both the redemption charges to which theinvestor will be subject in connection with the securities being acquired, and the tax consequences of the applicable redemption, together with a description of thecurrent redemption fees being paid by the participating dealer or the representative. Second, the participating dealer or representative must also obtain thewritten consent of the investor before proceeding with the redemption. Third, the participating dealer must not be a member of the organization of the mutualfund the securities of which are being acquired.
Subsection 7.1(3) prohibits a member of a mutual fund organization, other than a member that is also a participating dealer acting in compliance with subsection(1), from paying the redemption charges that may be payable by an investor redeeming securities of a mutual fund in another mutual fund family to invest in amutual fund within the organization's mutual fund family.
Changes from the Ontario Draft Rule
Subsections 7.1(1) and (3) now deal with situations involving a participating dealer that is also a member of the organization of a mutual fund.
Section 7.2. Section 7.2 prohibits a member of the organization of a mutual fund from providing financial assistance to a participating dealer or itsrepresentatives; conversely, no participating dealer or representative may solicit or accept this financial assistance. Subsection (3), however, permits financialassistance provided by financial institutions and affiliates.
Section 7.3. Section 7.3 prohibits a member of the organization of a mutual fund making a charitable donation if the tax benefit associated with that donationwould go to a participating dealer, an associate or affiliate of a participating dealer or a representative of a participating dealer.
Section 7.4. Section 7.4 deals with tied-selling practices. The section prohibits a person or company from requiring that another person or company invest insecurities of a particular mutual fund or mutual fund family as a condition, or on terms that appear to a reasonable person to be a condition, of supplying orcontinuing to supply products or services. The section also prohibits the converse; that is, requiring that a person or company open an account or use anyproduct or service as a condition, or on terms that appear to a reasonable person to be a condition, of entering into a mutual fund transaction.
Changes from the Ontario Draft Rule
The reference to terms that may appear to be a condition has been inserted into section 7.4 of the proposed National Instrument to address concerns thatarrangements relating to the purchase of mutual fund securities that are presented to a purchaser of products or services in a manner that appears to him or her tobe a condition would be as offensive to the prohibition against tied selling as an actual condition.
The restrictions against the offering of incentives relating to the purchase of mutual fund securities contained in paragraph 7.4(b) of the Ontario Draft Rule havebeen deleted. The CSA do not wish to prevent legitimate "relationship pricing", by which a financial institution provides financial incentives or advantages tothose clients with which the financial institution considers it has a more established relationship.
Part 8. Part 8 contains various disclosure requirements, based on those contained in the IFIC Code, and is derived from Part 9 of the Ontario Draft Rule.
Changes from the Ontario Draft Rule
Part 8 of the Ontario Draft Rule has been deleted. Section 8.1 of the Ontario Draft Rule was intended by the Ontario Commission to encourage self-policing byindustry participants as to compliance with the provisions of the Ontario Draft Rule by other participants and required mutual fund organizations to satisfythemselves that their mutual fund products were being sold through participating dealers who themselves complied with the Ontario Draft Rule. The OntarioCommission proposed this provision in the Ontario Draft Rule in substitution for the IFIC Code requirement that fund complexes sign annual compliancecertificates. The CSA do not propose to adopt the IFIC Code requirement for an annual compliance certificate, and instead expect industry participants tocomply with the proposed National Instrument and will be exploring ways in which the CSA can monitor and enforce compliance with the proposed NationalInstrument.
In connection with the deletion of Part 8 of the Ontario Draft Rule, paragraph 9.1(b) of the Ontario Draft Rule has not been carried forward into the proposedNational Instrument.
Section 8.1. Section 8.1 requires that the prospectus of a mutual fund contain complete disclosure of both the commissions paid, and the sales practices followedby the members of the organization of the mutual fund.
Section 8.2. Section 8.2 requires prospectus disclosure and separate written point of sale disclosure of any equity interests that may exist among a member ofthe organization of a mutual fund, a participating dealer, a representative of the participating dealer, or their associates. This disclosure is required to be given atthe time of an initial sale of a security to a purchaser, and also for any subsequent sale if there has been a change in the information already provided to theinvestor. The written consent of a purchaser must be obtained prior to a sale in circumstances in which an equity interest relationship requiring disclosure ispresent.
Changes from the Ontario Draft Rule
The proposed National Instrument requires disclosure of equity interests that associates of a participating dealer and associates of representatives of theparticipating dealer have in members of organizations of mutual funds.
The proposed National Instrument requires, not only disclosure of any applicable equity interest by a representative of a participating dealer, but also that therepresentative obtain the written consent of the purchaser to the sale of securities before completion of the sale.
The Ontario Commission requested comment on whether disclosure of equity interests was the appropriate regulatory approach or whether a prohibition onequity interests between fund complexes and participating dealers should be imposed. The comments received by the Ontario Commission, and the CSAresponse to such comments are summarized in Appendix C to this Notice.
Section 8.3. The effect of section 1.3 of the proposed National Instrument is that the applicable rules contained in the proposed National Instrument must befollowed by fund organizations and participating dealers in respect of all distributions of mutual fund securities. No distinction is made between thosetransactions carried out on an exempt basis and those made under a prospectus. Accordingly, section 8.3 is necessary to permit alternative disclosure ofparticulars required to be disclosed by the proposed National Instrument in circumstances where a mutual fund does not have a current prospectus. Section 8.3governs the disclosure requirements of the proposed National Instrument in the context of distributions that are carried out under a prospectus exemption andwhere the mutual fund in question does not have a current prospectus in which the requisite disclosure could be made. Section 8.3 requires that the applicabledisclosure be made in a separate written disclosure statement that is provided to the relevant client of the participating dealer at or before the time of the trade.
Part 9. Part 9 provides that the regulator or securities regulatory authority in a jurisdiction may grant an exemption from the proposed National Instrument. InOntario, only the securities regulatory authority (defined in the National Definitions Instrument11 as the Ontario Commission) may grant such an exemption.
Summary of Proposed Companion Policy
Part 1. Part 1 states that the purpose of the proposed Companion Policy is to state the views of the CSA on various matters relating to the proposed NationalInstrument.
Part 2. Part 2 of the proposed Companion Policy describes the background to the proposed National Instrument. It also outlines the regulatory purpose formaking the proposed National Instrument, incorporating much of what is contained under "Purpose of the Proposed National Instrument" in this Notice. ThisPart articulates the fundamental obligations owed by industry participants to investors that guided the CSA in formulating the proposed National Instrument andremains largely unchanged from the Ontario Draft Policy.
Part 3. Part 3 clarifies the scope of the term "representative", as used in the proposed National Instrument, including that the term includes personal holdingcompanies through which persons carry out activities on behalf of the participating dealer. Part 3 was not part of the Ontario Draft Policy.
Part 4. Part 4 of the proposed Companion Policy provides background and explanation for certain terms used in Part 2 of the proposed National Instrument.
Section 4.1. Section 4.1 sets out the CSA's view of the meaning of the phrase "in connection with the distribution of securities" of a mutual fund. It emphasizesthat this phrase includes, without limitation, any activity done in furtherance of the distribution of securities of mutual funds, including general promotional oreducational activities. The proposed Companion Policy emphasizes the CSA's view that this phrase should not be interpreted in a restrictive or narrow fashion.Section 4.1 is largely unchanged from the Ontario Draft Policy.
Section 4.2 Section 4.2 provides the CSA's view on the meaning of the phrase "non-monetary benefits". This phrase includes any goods, services or otherbenefits that could be provided to or received by a person or company that could be perceived by that person as being of benefit, advantage or value to him orher. Section 4.2 outlines some examples of non-monetary benefits as well as some examples of what the term would not include. Non-monetary benefits wouldinclude the provision of certain non-proprietary computer software to participating dealers. On the other hand, computer systems whose sole function is tofacilitate the electronic interface between participating dealers and members of fund organizations would not be considered to be non-monetary benefits.
Section 4.2 is largely consistent with the Ontario Draft Policy, except that the proposed Companion Policy expands on the proprietary computer software theCSA consider to be more akin to marketing materials than non-monetary benefits and as such would be appropriate to be delivered to dealers.
Section 4.3. Section 4.3 sets out the CSA's view on the meaning of the phrase "pay for or make reimbursement of a cost or expense incurred or to be incurredby a participating dealer or a representative of a participating dealer" in the context of Part 2 of the proposed National Instrument. Essentially, this phrase is tobe interpreted broadly to include both direct and indirect reimbursement.
Section 4.4. Section 4.4 discusses the general prohibition against using indirect means to circumvent the proposed National Instrument, as provided for insection 2.3 of the proposed National Instrument. The CSA are particularly concerned about arrangements making use of third parties for the purpose ofeffecting payments, providing benefits or making payments or reimbursements of costs that would not be allowed by the proposed National Instrument if sucharrangements were carried out directly by members of organizations or participating dealers or their representatives. Section 4.4 to the proposed CompanionPolicy was not provided for in the Ontario Draft Policy, since section 2.3 was not contained in the Ontario Draft Rule.
Section 4.5. Section 4.5 discusses section 2.4 of the proposed National Instrument, which is designed to relieve a participating dealer that is also a member ofthe organization of a mutual fund from the restrictions contained in the proposed National Instrument on members of the organization of a mutual fund, so longas the participating dealer is acting in its capacity as a dealer in connection with the distribution of unrelated mutual funds. Section 4.5 of the proposedCompanion Policy provides examples that are designed to demonstrate the application of section 2.4 of the proposed National Instrument.
Part 5. Part 5 of the proposed Companion Policy clarifies certain matters provided for in Part 3 of the proposed National Instrument. Section 5.1 clarifies thatthe prohibition on bonus commissions contained in subparagraphs 3.1(c)(iii) and 3.2(1)(d)(iii) of the proposed National Instrument does not prevent a mutualfund organization from changing its general commission rates applicable to its mutual funds at a particular point during a year. Section 5.2 emphasizes that theeffect of subsection 2.1(3) and section 3.2 of the proposed National Instrument is that fund organizations are not permitted to set minimum asset thresholds todetermine payment of trailing commissions.
Part 6. Part 6 outlines the CSA's views on the scope of permitted marketing and educational payments that can be made by fund organizations under theproposed National Instrument.
Section 6.1 discusses the definition of "direct costs" contained in the proposed National Instrument and sets out the CSA's expectations regarding the diligenceto be undertaken by industry participants in respect of direct costs that are permitted to be paid by fund organizations. The CSA emphasize that the phrase"out-of-pocket" expenses used in the definition of "direct costs" does not include internal salary and overhead costs associated with the efforts of theparticipating dealer in organizing such events or preparing the sales communications.
Section 6.2 emphasizes that section 5.1 of the proposed National Instrument permits only certain "cooperative" marketing and is not designed to enableparticipating dealers to recoup their general marketing costs from fund organizations. Examples of marketing by participating dealers that would not fall underthe ambit of cooperative marketing are given.
Section 6.3 provides further explanation as to the CSA's views on permissible mutual fund sponsored conferences or seminars, including the extent of the term"reasonable expenses" and whether or not guests can attend such conferences (at the expense of the mutual fund organization).
Section 6.4 provides an explanation of the extent of the term "registration fees" used in section 5.3 of the proposed National Instrument.
Section 6.5 provides examples of "non-monetary benefits of a promotional nature" and "reasonable business promotion activities" as referred to in section 5.6 ofthe proposed National Instrument.
Part 7. Section 7.1 contains the CSA's view on the designation of institutional representatives for the purposes of Part 6 of the proposed National Instrument.
Part 8. Part 8 of the proposed Companion Policy clarifies that section 8.3 of the proposed National Instrument relates to the distribution of mutual funds that aresubject to the proposed National Instrument, but that do not have a current prospectus.
Terms used in the proposed Companion Policy that are defined and interpreted in the proposed National Instrument or a definition instrument in force in thejurisdiction should be defined and interpreted in accordance with the proposed National Instrument or definition instrument, unless the context otherwiserequires.
Authority for Proposed National Instrument (Ontario)
In those jurisdictions in which the proposed National Instrument is to be adopted or made as a rule or regulation, the securities legislation in each of thosejurisdictions provides the securities regulatory authority with rule-making or regulation-making authority in respect of the subject matter of the proposedNational Instrument.
In Ontario, the following provisions of the Securities Act (Ontario) provide the Ontario Commission with authority to make the proposed National Instrument.Paragraph 143(1)2 gives the Ontario Commission authority to make rules prescribing requirements for registrants including requirements that are advisable forthe prevention or regulation of conflicts of interest. Paragraph 143(1)13 authorizes the Ontario Commission to make rules regulating trading or advising insecurities to prevent trading or advising that is, among other things, unfairly detrimental to investors. Paragraph 143(1)18 gives the Ontario Commissionauthority to make rules designating activities, including the use of documents or advertising, in which registrants or issuers are permitted to engage or areprohibited from engaging in connection with distributions. Paragraph 143(1)31 authorizes the Ontario Commission to make rules regulating mutual funds andthe distribution and trading of their securities.
In the August 1996 Notice accompanying the publication of the Ontario Draft Rule and the Ontario Draft Policy for comment, the Ontario Commission outlinedthe alternatives to the Ontario Draft Rule it considered. The available alternatives, and their status, have not changed and the Ontario Commission remains of theview that the only viable option at this time is to exercise its rule-making authority to make the proposed National Instrument.
In proposing the proposed National Instrument and Companion Policy, the CSA have not relied on any significant unpublished study, report, decision or otherwritten materials, other than certain of the comments made in the comment letters received by the Ontario Commission in connection with the Ontario DraftRule.
The proposed National Instrument and Companion Policy are related to each other.
Regulations to be Revoked or Amended
In Ontario, the adoption of the proposed National Instrument does not require any Regulation to be revoked or amended.
Anticipated Costs and Benefits
The Ontario Commission outlined the anticipated costs and benefits of the Ontario Draft Rule in its August 1996 Notice. The CSA are of the view that thedescription of the anticipated costs and benefits in that Notice is largely accurate and re-affirms the following paragraph as being applicable to the proposedNational Instrument.
The proposed Rule is designed to benefit mutual fund investors and industry participants equally, by restricting sales and business practices that could be seen tobe compromising the integrity of the mutual fund industry. It is anticipated that mutual fund investors will benefit both through enhanced disclosure of incentivespaid to participating dealers and through investment recommendations made, and services provided, by industry participants that have, and can be seen to have,their best interests at the forefront. Similarly, industry participants will benefit by the enhanced confidence that investors and prospective investors may have inthe overall integrity, professional responsibility and trust inherent in the mutual fund industry.
During the comment period in respect of the Ontario Draft Rule, the Ontario Commission received submissions to the effect that the Ontario Draft Rule, and inparticular certain provisions of the Ontario Draft Rule, would significantly increase the costs of doing business by mutual fund participants. Fund organizationsargued that they would experience higher costs due to the lack of an asset or sales threshold in respect of trailing commissions. Rules that circumscribe howfund organizations allocate payments for educational and marketing costs of dealers would increase costs to the fund organization. Participating dealerscommented that restrictive rules regarding their costs that could be paid for by fund companies would increase their costs.
The CSA have considered these comments, but has concluded, as did the Ontario Commission in respect of the Ontario Draft Rule, that the benefits of theproposed National Instrument outweigh any potential costs that may be associated with it. The Ontario Commission noted that the costs to the mutual fundindustry are difficult to quantify. The CSA agree with this statement and also with the statement that the proposed National Instrument may reduce the rangeand amount of compensation and non-cash benefits that have been paid or given to distributors of mutual fund securities in the past.
CommentsInterested parties are invited to make written submissionswith respect to the proposed National Instrument and proposedCompanion Policy. Submissions received by September 30, 1997will be considered.Submissions should be sent to all of the Canadian securitiesregulatory authorities listed below in care of the OntarioCommission, in duplicate, as indicated below:British Columbia Securities CommissionAlberta Securities CommissionSaskatchewan Securities CommissionThe Manitoba Securities CommissionOntario Securities CommissionOffice of the Administrator, New BrunswickRegistrar of Securities, Prince Edward IslandNova Scotia Securities CommissionSecurities Commission of NewfoundlandSecurities Registry, Government of the Northwest TerritoriesRegistrar of Securities, Government of the Yukon Territoryc/o Daniel P. Iggers, SecretaryOntario Securities Commission20 Queen Street WestSuite 800, Box 55Toronto, Ontario M5H 3S8Submissions should also be addressed to the Commission des valeursmobilières du Québec as follows:Jacques Labelle, General SecretaryCommission des valeurs mobilières du Québec800 Victoria SquareStock Exchange TowerP.O. Box 246, 17th FloorMontréal, Québec H4Z 1G3A diskette containing the submissions (in DOS or Windows format,preferably WordPerfect) should also be submitted. As securitieslegislation in certain provinces requires that a summary of thewritten comments received during the comment period be published,confidentiality of submissions received cannot be maintained.Questions may be referred to any of:Lata CascianoSenior Policy Advisor, Policy & LegislationBritish Columbia Securities Commission(604) 660-4785Ian KerrLegal CounselAlberta Securities Commission(403) 297-4225Rebecca CowderySpecial Counsel, Market OperationsOntario Securities Commission(416) 593-8129Pierre MartinLegal Counsel, Service de la reglementationCommission des valeurs mobilières du Québec(514) 873-5326Proposed National Instrument and Proposed Companion PolicyThe text of the proposed National Instrument and proposedCompanion Policy follow, together with footnotes that arenot part of the proposed National Instrument and proposed CompanionPolicy, but have been included to provide background and explanation.DATED: July 25, 1997
APPENDIX A - LIST OF COMMENTERS ON ONTARIO DRAFT RULE ANDONTARIO COMPANION POLICY1. Altamira Management Ltd.2. Bank of Montreal Investment Management Limited3. Berkshire Investment Group Inc.4. Bob L'Heureux Agencies5. Borden & Elliot (2 submissions)6. Capital Management Group, on behalf of:CMG Financial Corp., Worldsource Financial Services,Ross Dixon Financial Services and The Investment Centre Financial Corp.7. Canadian Bankers Association8. C.I. Mutual Funds Inc.9. The Consumers Council of Canada10. Ethical Funds Investment Services Inc.11. Fidelity Investments Canada Limited12. Fogler, Rubinoff (2 submissions)13. Fortress Equity Management Inc.14. Goodman & Company Ltd.15. Investment Dealers Association of Canada16. The Investment Funds Institute of Canada17. Investors Group Inc.18. Ms. Lily X. Day19. Ms. Sandra L. Kegie20. Mr. Joe Killoran (2 submissions)21. Mr. David Leigh22. Mr. R.L. Murray23. Niagara Credit Union24. Pension Commission of Ontario25. Peter Cundill & Associates Ltd.26. Planvest Pacific Financial Corporation27. Prisma Financial Planning28. Rice Financial Group Inc. (2 submissions)29. Sceptre Investment Counsel Limited30. Mr. Lawrence P. Schwartz31. Scotia Securities Inc.32. St. Willibrord Community Credit Union33. Templeton Management Limited34. Tory Tory DesLauriers & Binnington, on behalf of:A.G.F. Management Limited, BPI Capital Management Corporation,C.I. Mutual Funds Inc., Mackenzie Financial Corporation andTrimark Investment Management Inc.35. Trimark Investment Management Inc.
NOTE: The table summarizing the comments on Draft Rule and Ontario Draft Policy and CSA Disposition Mutual Fund Sales Practices waspublished in the July25, 1997 edition of the OSC Bulletin (20 OSCB 3832)
APPENDIX C - SUMMARY OF COMMENTS RECEIVED ON ONTARIO DRAFT RULE AND ONTARIO DRAFT POLICY AND RESPONSE OF THECANADIAN SECURITIES ADMINISTRATORS
In August 1996, the Ontario Securities Commission (the "Ontario Commission") released for public comment proposed Rule 81-503 (the "Ontario Draft Rule"),together with proposed Companion Policy 81-503CP (the "Ontario Draft Policy"). Both the Ontario Draft Rule and the Ontario Draft Policy are being replacedby proposed National Instrument 81-105 Mutual Fund Sales Practices (the "Instrument") and its proposed Companion Policy 81-105CP (the "Policy").
During the comment period on the Ontario Draft Rule and the Ontario Draft Policy, which expired on November 29, 1996, the Ontario Commission received 39submissions from 40 commenters. The commenters can be grouped as follows:
Mutual Fund Distributors and Financial Planners 15
Law Firms 2
Trade Associations 3
Mutual Fund Management Companies 11
Financial Institutions 2
The three trade associations listed, being The Investment Funds Institute of Canada ("IFIC"), the Investment Dealers Association of Canada (the "IDA") and theCanadian Bankers Association (the "CBA"), each made extensive submissions in respect of the Ontario Draft Rule and the Ontario Draft Policy on behalf of theirrespective members.
Copies of the comment letters may be viewed at the office of Micromedia, 20 Victoria Street, Toronto, Ontario (416) 312-5211 or (800) 387-2689.
The Canadian Securities Administrators ("CSA") have considered the comments received by the Ontario Commission in conjunction with their formulation of theInstrument and the Policy. The CSA thank all commenters for providing their comments on the Ontario Draft Rule and Ontario Draft Policy. The extensivenature of the comments received indicates the care and thought given by industry participants to the issues addressed by the Ontario Draft Rule and has beenvery helpful to the CSA in formulating the Instrument and the Policy.
The following is a summary of the comments received, together with the CSA's responses and, where applicable, the changes adopted by the CSA.
2. GENERAL COMMENTS
In general, commenters were supportive of the decision of the Ontario Commission to move to promulgate a rule based on the Recommendations for a Code ofSales Practices released by IFIC in March 1996 (the "IFIC Code"). Several commenters noted that the IFIC Code represented industry consensus as toappropriate limits that should be placed on sales and business practices applicable to the sale of mutual fund securities and as such the Ontario Commissionshould consider carefully the implications of changing the IFIC Code provisions. IFIC concluded its comments with the following statement:
In considering these submissions, IFIC urges that the OSC give due weight to the fact that the IFIC Code represents an industry consensus on what theappropriate standards should be, and that significant deviation from that consensus increases the risks that the implementation of a rule based on the Draft Ruleand the IFIC Code will not be successful.
The CSA have considered, as did the Ontario Commission before releasing the Ontario Draft Rule and Ontario Draft Policy, the implications of making changesto the IFIC Code in the Instrument. The CSA are of the view that the changes to the IFIC Code made in the Instrument are changes that are necessary toachieve the CSA's overall objectives in proposing the Instrument. In certain circumstances, particularly in connection with the rules contained in Part 5 of theInstrument, the changes to the IFIC Code are as a result of continued consultation by CSA staff with representatives of IFIC and the IDA and representrefinements to the IFIC Code necessary to clarify the appropriate limits.
Certain commenters, including IFIC, suggested that the approach to drafting the Ontario Draft Rule was quite different than the IFIC Code and that they weremore comfortable with the approach taken in the IFIC Code. Whereas the IFIC Code identified, and then restricted, specific sales practices and businesspractices IFIC considered objectionable, the Ontario Draft Rule, in the words of one commenter, "uses blanket - and often vague - restrictions and obligationswith limited exceptions as the manner in which it regulates sales practices". This commenter remarked that as a result, industry participants will be subject to a"significantly higher degree of uncertainty" as to the applicable rules. Another commenter asked that the Ontario Draft Rule be re-drafted where possible tosimplify its presentation.
The CSA recognize that the Instrument's approach to regulation differs from the IFIC Code. The Instrument begins by prohibiting all sales practices andincentives and goes on to describe certain sales practices and incentives the CSA are prepared at this time to permit on the conditions articulated in theInstrument. The CSA are of the view that, ultimately, the IFIC Code was directed at achieving much the same result. In any event, the CSA do not agree withthe approach to regulation suggested by these commenters, namely that regulation should articulate lists of restricted sales practices, which would permitindustry participants to follow a sales practice if it is not specifically mentioned in the restricted list. The Ontario Commission adopted the approach taken in theOntario Draft Rule and developed Part 2 of the Ontario Draft Policy precisely due to their concern that industry participants would indeed believe a questionablesales practice is permitted, unless it is specifically restricted by rules. The CSA agree with, and have retained, the approach taken by the Ontario Commission inthis regard.
The CSA also recognize the different drafting styles between the IFIC Code and the Instrument. A central objective of the CSA in drafting the Instrument is toachieve legislative certainty in articulating the mandatory rules. The CSA consider that the Instrument achieves this objective. The approach to rule-makingmust, of necessity, be less descriptive and explanatory than the approach taken by the CSA in the past in drafting policy statements. Despite that fact, the CSAare of the view that the words used in the Instrument and the Policy are capable of being easily understood with their ordinary meaning, particularly when thecentral concepts and views of the CSA articulated in the Policy are considered by the reader. In preparing the Instrument, the CSA made changes in draftingpresentation and style from the Ontario Draft Rule with a view to simplifying the presentation of the Instrument.
Other general comments made include:
(1) The Ontario Draft Rule should not be an Ontario-only rule. The CSA agree with this comment and accordingly propose the Instrument, which will beadopted as a rule in those provinces with rule-making powers and as a policy in the remaining provinces and territories.
(2) The final rule on mutual fund sales practices must be adequately enforced. Two commenters advocate the establishment of a formal independent "watchdog"organization that would include consumer representation. One commenter urged the CSA to set up a system whereby industry participants could reportimproprieties and illegal practices on an anonymous basis. Other commenters noted the importance of CSA compliance monitoring and enforcement action andindicated that if the CSA were unable to undertake this action, then the CSA should delegate its responsibility to a willing third party or self-regulatoryorganization. The CSA agree that compliance monitoring and appropriate enforcement action will be necessary and is considering how best to carry out thisobjective. The Ontario Commission has decided to move forward with a rule that would require all securities dealers and mutual fund dealers to becomemembers of a self-regulatory organization recognized by the Ontario Commission. The purpose is to replace direct regulation of these groups by the OntarioCommission by regulation of a self-regulatory organization supervised by the Ontario Commission.
(3) Sales practices cannot be regulated in a vacuum, that is, without addressing other important issues, such as outstanding disclosure issues, investor education,"know your client" rules and standards, industry ethical standards and corporate governance issues. The CSA acknowledge the importance of the identifiedmatters, but are of the view that the Instrument will be very significant in ensuring that investors' interests are at the forefront of actions of industry participants.As such, the CSA have placed a priority on finalizing the Instrument in priority to completing other regulatory projects that would address the other matterscommented on.
(4) The CSA should carefully consider whether any justification exists for statements made by the Ontario Commission and in the Stromberg Report to the effectthat the pre-existing regulatory strategy of reliance on disclosure and competitive market forces has not been sufficient to moderate questionable sales practices.The commenter making this comment asks whether the Ontario Commission has any evidence of harm to investors that resulted from the pre-existing regulatorystrategies. IFIC made a similar remark. IFIC urged the Ontario Commission to keep in mind that the effects of the Ontario Draft Rule on the market wereunstudied and that there was "no empirical evidence that these potential conflicts of interest are actually resulting in harm to the Canadian mutual fund investor".The CSA observes that the Ontario Commission was asked to proceed with the Ontario Draft Rule by IFIC and others in the industry and as such, the OntarioCommission acted responsibly in moving to fill a regulatory void and to meet a perceived regulatory need. The CSA, and the Ontario Commission, propose theInstrument out of their strong views that industry participants must act in the best interests of the investing public. The securities legislation of the rule-makingjurisdictions gives the relevant members of the CSA authority and jurisdiction to make the Instrument and as such, the CSA will not be making the Instrumentthrough an "arbitrary" exercise of such powers.
3. RESPONSES TO SPECIFIC QUESTIONS
In the August 1996 Notice accompanying the Ontario Draft Rule, the Ontario Commission requested specific comment on five issues. The comments requestedand the responses received are discussed below. The CSA's disposition of such responses is also indicated.
Issue 1 - Should the Ontario Draft Rule be expanded to prevent certain commission payment practices?
The Ontario Commission noted that there are problematic practices in the sales commission area that were not dealt with by the IFIC Code, where differentialcommissions paid could result in the creation of incentives that could cause participating dealers to recommend mutual funds that are not suitable for their clients.The Ontario Commission identified the following practices as potentially problematic:
(a) differential commissions paid by fund organizations according to the type of mutual fund or for one mutual fund over another; for example, differentcommissions for equity funds over income funds or for "star" funds or for speculative, high risk funds;
(b) differential commissions paid by fund organizations according to the purchase method chosen by investors; for example, different commissions for front endload sales over back end load sales or over "level" load sales; and
(c) higher commissions paid by fund companies to particular dealers than commissions paid generally to other dealers, even where there is clear and specificdisclosure of these arrangements.
All commenters in respect of these issues said that the Ontario Draft Rule should not be expanded to restrict or prohibit these practices, although the ConsumersCouncil of Canada commented that the general principle behind the Ontario Draft Rule should be that there are "no incentives to sell one fund over another".IFIC's comments in this regard are representative. It would be inappropriate for the CSA to re-enter the field of commission regulation, "especially without thebenefit of major economic investigations of the impact of same, as pricing is not set unilaterally, and is subject to the law of supply and demand". Anothercommenter remarked:
....to the extent that it is well accepted that different kinds of investments yield different returns, require different techniques to manage, and therefore can andshould bear different management fees, it is reasonable to consider commissions in the same light. Fees and commissions should reflect that an expected higherreturn is worth more to an investor and could bear higher costs. The marketplace will determine if this concept is supportable on a long term basis.
The Consumers Council of Canada, in citing their contrary view, said "sales of equity funds should not generate greater fees for the salesperson since the sameeffort goes into the sales process".
Ultimately the CSA have decided to not extend the Instrument at this time to regulate commissions to any greater extent than as proposed by Part 3 of theInstrument. The Instrument does not attempt to eliminate all of the inherent conflicts of interest associated with the industry-wide system of commission-basedcompensation. The CSA are of the view that the Instrument deals adequately with the more significant regulatory concerns present at this time surroundingcommission-based compensation, namely that sales contests and bonuses be curtailed, that adequate disclosure be given to investors and that compensation notbe based on the achievement of any asset or sales threshold.
A common sentiment expressed by commenters in respect of the third practice noted by the Ontario Commission is "in recognition of the fact that dealers are notequally efficient, or effective, the fund manager should have the right to value the services being paid for". The CSA agree with this statement and have notaltered the Ontario Draft Rule to restrict differential commissions being paid to different dealers, provided the range of commissions paid is disclosed toinvestors.
Issue 2 - Should the Ontario Draft Rule regulate internal compensation practices of dealers?
The Ontario Commission noted that except as set out in Part 4 of the Ontario Draft Rule, the Ontario Draft Rule does not (and the IFIC Code does not) dealwith the compensation paid by principal distributors to their representatives, that is, compensation paid by fund organizations to their sales forces employed tosell only funds within that fund organization's mutual fund family. With the exception of one commenter, who provided a detailed discussion on why internalcompensation practices vis a vis "tied sales forces" should be regulated, all commenters on this question suggested that the Ontario Draft Rule not be expandedto cover this issue. IFIC noted that an ordinary investor purchasing a product in an environment in which the only product offered is an in-house brand knows,just as the ordinary car purchaser knows, that their choice in that environment is limited.
The CSA do not propose to expand the ambit of the Instrument at this time to regulate internal compensation practices.
Issue 3 - Should Annual Maximum Dollar Limits on Promotional Gifts and Activities be Imposed?
Section 5.4 of the Ontario Draft Rule imposed a $150 limit on the value of promotional items that could be distributed to dealers by a fund company in a year.The Ontario Commission requested comment on the appropriateness of this limit and whether or not a similar dollar limit should be imposed for promotionalactivities.
Most of the commenters in respect of this issue suggested that sections 5.4 and 5.5 of the Ontario Draft Rule be merged in a fashion similar to that proposed bythe CSA in section 5.6 of the Instrument. Rather than imposing a dollar limit, the majority of commenters felt that paragraph (b) of section 5.5 should beextended to cover both promotional items and activities. The IDA felt the $150 per annum limit on promotional items was appropriate and suggested a$500-600 per annum limit on promotional activities conducted with any one representative. The CSA agree with the commenters urging a merger of the sectionsand have drafted section 5.6 of the Instrument accordingly.
Issue 4 - Should Funds Whose Managers pay Trailing Commissions be described as "no-load"?
The Ontario Commission discussed the statement contained in the IFIC Code that "...payment of a trailer commission out of the management fee [is] not [a]factor in determining whether a mutual fund is a "no load" fund" and asked whether this was appropriate having regard to the reality that a trailing commission isa "load".
With two exceptions, all commenters responding to this issue suggested the term "no-load" had an accepted industry meaning - that is - no commissions oracquisition costs are paid directly by investors. The term does not necessarily mean that the investor's representative receives no compensation for his or herservices from the fund company. The two commenters with contrary views were adamant that funds that pay commissions out of fund assets should not becalled "no load". The CSA note that the Instrument (as did the Ontario Draft Rule) prohibits mutual funds from paying commissions directly and agree that ifsuch were the case, these funds should not be called "no load". The relevant commenters were concerned that investors had disclosure that sales representativesreceived commissions from fund companies; the Instrument requires such disclosure.
The CSA have decided not to alter the commonly understood meaning of the term "no load" fund. In this regard, section 7.5 of the Ontario Draft Rule has notbeen carried forward into the Instrument, since section 16.03 of National Policy Statement No. 39 provides for an identical provision. Section 16.03 is beingcarried forward in the proposed National Instrument to replace NP39.
Issue 5 - Should Equity Interests be Prohibited?
The Ontario Commission noted that the IFIC Code did not prohibit equity investments by fund companies in dealers, but required prospectus disclosure. TheOntario Commission indicated that it was concerned about the conflicts inherent in equity interests and asked whether such interests should be prohibited.
With one exception, all commenters responding to this question answered in the negative. Disclosure was deemed to be sufficient, although, as noted below,commenters in respect of this issue generally felt that the requirement for a separate dealer generated point of sale disclosure statement, in addition to prospectusdisclosure was excessive. The dissenting commenter noted that it was fundamentally opposed to allowing a fund manager to make equity investments in anydealer, or affiliate of a dealer, who is selling the securities of the funds managed by the manager. The conflicts cannot be adequately addressed by disclosure.
The CSA are of the view that section 8.2 of the Instrument imposes sufficient and appropriate disclosure requirements to enable investors to make informeddecisions about their investment and the conflicts of interest to which their representative is subject. The CSA do not propose at this time to prohibit equityinterests of fund companies in dealers and dealers in fund companies.
4. COMMENTS ON PROVISIONS OF ONTARIO DRAFT RULE
Part 1 - Definitions, Interpretation and Application
Section 1.1 - definition of "equity interest"
The CBA suggested that the percentage threshold of five percent in the definition of "equity interest" be increased to ten percent to be consistent with otherapplicable securities legislative limits. The CSA have made this change.
Section 1.1 - definition of "member of the organization"
Several commenters expressed difficulty in understanding the impact of paragraph (e) of the definition of "member of the organization" and suggested that thedefinition was far too broad. The CSA have deleted paragraph (e) and replaced it with section 2.3 of the Instrument in order to deal more directly with theregulatory concern, that is, that no indirect actions be taken that could not be taken directly under the Instrument. Section 2.3 of the Instrument is intended toensure third parties that are not members of a mutual fund organization could not be used in arrangements designed to circumvent the Instrument. Section 2.3 ofthe Instrument also replaces other operative provisions throughout the Ontario Draft Rule that were designed to prevent indirect action.
Other commenters pointed out the effect of this definition would be to unduly restrict participating dealers who were affiliated with fund companies (caught viaparagraph (d) of the definition) from undertaking activities or receiving compensation that they would be permitted to do or receive if they were not affiliatedwith the fund companies. Section 2.4 of the Instrument has been introduced to alleviate these concerns.
One commenter noted that the term "member of the organization" was not intuitively easy to comprehend, and suggested it be changed to "mutual fundorganization" or "mutual fund complex". The name of the term has not been changed; the CSA are not persuaded that any of the proposed alternatives, or anyother possible alternative, is any more intuitive than "member of the organization".
Section 1.2 - Interpretation
Two commenters recommended that the Ontario Draft Rule be amended to define all relevant terms in the rule, rather than cross- referring to the meaning ofterms defined in other instruments. The CSA has not changed the Instrument in this regard, to duplicate terms defined in NP39 would make the Instrumentunwieldy and more difficult to read.
Section 1.3 - Application
Several commenters urged that the Instrument ensure a "level playing field" in respect of the distribution of all types of collective investment schemes, includingproducts such as labour sponsored investment funds, "wrap accounts" and segregated funds. The Instrument applies to the distribution of all publicly offeredmutual funds, which include labour sponsored investment fund corporations. It is beyond the scope of the Instrument to deal at this time with the distribution ofother types of "mutual fund-like" investment products. However, the CSA are engaged in discussions with the applicable insurance regulators of the provincesand territories with a view to considering the implementation of a regulatory regime applicable to the distribution of comparable insurance products.
Part 2 - General
Section 2.1 - Restrictions on Payments or Provision of Benefits
Several commenters suggested adding a definition of "non-monetary benefit", to be based on the discussion contained in the Ontario Draft Policy. The CSAhave not defined "non-monetary benefits" in the Instrument, since the term should be given its ordinary meaning in the Instrument. The discussion in the Policyis intended to provide interpretative guidance for users of the Instrument in respect of matters that would be considered to be non-monetary benefits within theordinary meaning of such term. The list of items contained in the Policy should not be considered "all-inclusive" and readers should not consider something tonot fall within the meaning of the term simply because it is not mentioned in the Policy.
All commenters in respect of section 2.1 supported the restrictions on payments to and the provision of benefits by fund companies directly to representativescontained in the Ontario Draft Rule.
Certain commenters requested that the Ontario Draft Rule be clarified to specifically permit fund companies to pay third parties compensation that otherwisewould be paid to dealers, if the applicable dealers so requested and directed such payments be made. The CSA have not changed the Instrument in this regard,as outlined below.
Several commenters expressed concern over the difficulty they had in understanding subsection 2.1(4) of the Ontario Draft Rule.
Partially in response to these comments, the CSA decided to delete subsections 2.1(3) and (4) of the Ontario Draft Rule and replace such sections with the moredirect rule of section 2.3, which restricts any indirect action that would not be permitted by the Instrument if such action were taken directly. Payments,provision of benefits and reimbursements to third parties will continue to be prohibited by the new section 2.3.
Section 2.2 - Restrictions on Receipt of Payments or Benefits
IFIC commented that subsection 2.2(1) could be read as technically prohibiting a participating dealer from negotiating a unique commission schedule with a fundcompany, although sections 3.1 and 3.2 allow the dealer to accept such commissions. The CSA do not agree with this interpretation of the subsection, however,with the redrafting of section 2.2, this technical concern may not exist any longer. Subsection 2.2(2) now clearly provides an exception to the rule againstsolicitation and acceptance - that is - dealers may solicit and accept any payment, benefit or reimbursement fund organizations are permitted to pay dealers underParts 3 and 5 of the Instrument. Part 3 does not require all commission rates paid to dealers to be exactly the same. .
The CSA have re-considered the clarity of subsections 2.2(2) and (3) of the Ontario Draft Rule with respect to the ability of representatives to solicit and acceptcompensation. The CSA propose the revisions contained in section 2.2 of the Instrument. The revisions clarify the CSA's views that representatives may notsolicit any form of compensation, although they may accept the limited benefits permitted to be given to them by fund organizations under Part 5.
Part 3 - Permitted Compensation
Section 3.1 - Commissions
A number of commenters suggested that the requirement for fund companies to disclose in fund prospectuses the specific commission rates paid to differentdealers was excessive and would require fund companies to disclose potentially sensitive competitive information. Instead the rule should be that fundprospectuses disclose the range of commission rates paid. The CSA have amended the Instrument to take account of this comment.
Other commenters asked that the Ontario Draft Rule be clarified to permit the payment of different rates of commissions for different classes or series ofsecurities of a mutual fund. The CSA consider that the Ontario Draft Rule does not need this clarification; such a practice is permitted, provided the fundprospectus contains appropriate disclosure. Accordingly, the Instrument has not been changed in this regard.
IFIC asked that subsection 3.1(3) of the Ontario Draft Rule be amended to include the words "or value" after the words "aggregate amount" and "to a greateramount". In connection with the redrafting of section 3.1 in order to simplify its presentation, subsection 3.1(3) has been deleted.
Section 3.2 - Trailing Commissions
The same comments regarding disclosure of a range of rates paid, rather than specific disclosure of the different rates paid to different dealers made in respect ofcommissions were made in respect of trailing commissions. The CSA made similar changes to section 3.2 as made to section 3.1.
A significant majority of the commenters on the Ontario Draft Rule commented on the lack of a $100,000 asset threshold in respect of payment of trailingcommissions as is permitted by the IFIC Code. IFIC and other commenters who are mutual fund management companies urged the Ontario Commission tore-consider the decision not to permit fund companies to impose a minimum asset threshold. The IDA and other commenters who are mutual fund distributors(and also a few commenters who are mutual fund managers) suggested that the Ontario Draft Rule should not be changed in this regard.
Those commenters in favour of the ability of fund companies to set minimum thresholds made the following arguments:
(a) Fund companies should be able to decide not to pay trailing commissions to dealers whose representatives sell only a minimal amount of their mutual funds.The $100,000 per representative threshold permitted by the IFIC Code is a relatively low threshold and means that representatives selling securities below thatamount are not big supporters of the relevant mutual fund family. Trailing commissions are intended as payment for the on-going service those representativesprovide to investors in funds managed by the relevant fund company. The Ontario Draft Rule would require fund companies to pay compensation to thosedealers whose representatives do not provide this service to any great extent, and accordingly, the rule is inappropriate.
(b) Any trailing commissions payable upon reaching a threshold of $100,000 are so small that they would be unlikely to influence advice given by representatives.IFIC noted that a trailing commission of 25 basis points on $100,000 of assets is $250 annually. At 75 basis points, it is $750 annually. IFIC concluded "at thisminimal level the true risk of a client being sold an inappropriate investment in order to ensure access to a trailer is virtually non existent". Commenters notedthat, as a result of the "grid system" of compensation paid to representatives by dealers, small trailing commissions paid to dealers would not necessarily bepassed on to the representatives, and as such, the person providing the service the fund companies value, would not receive any compensation.
(c) The administrative costs associated with commission payments for accounts below a $100,000 per representative threshold are significant in relation to thecompensation provided to dealers by these commissions.
(d) The absolute dollar cost of paying trailing commissions to all dealers in respect of all assets is "enormous" and will negatively impact fund managers and,indirectly, investors.
(e) Section 3.2 of the Ontario Draft Rule represents a re-entry of the Ontario Commission into the field of commission regulation, an area, IFIC notes, that"regulators have, almost universally, abandoned".
On the other hand, commenters opposed to changes to the Ontario Draft Rule in this regard noted, as did the IDA, that the decision of the Ontario Commissionnot to permit a minimum threshold, "reinforces the fundamental prohibition against paying out fees differentially according to an individual IA's sales or assetsheld of particular fund or family of funds". The IDA, with other commenters, noted that the concerns that the Ontario Draft Rule will increase administrativecosts of fund companies were "overstated" since most fund companies computerize trailing commissions owing and make single payments of trailingcommissions to dealers in respect of all applicable representatives. One commenter noted, accurately in the view of the CSA, that establishing a minimum hurdleto be exceeded sets sales targets which are "effectively a disguised form of bonus commission that is paid once a minimum threshold is reached".
Ultimately, after considering alternatives such as a minimum threshold based not on individual representatives' accounts, but on all client accounts of aparticipating dealer, the CSA have decided not to change the Ontario Draft Rule to permit a minimum threshold. The CSA are not persuaded to change theOntario Draft Rule by the arguments noted above. CSA are of the view that a minimum threshold as permitted by the IFIC Code would be fundamentally atodds with at least two central objectives of the CSA in making the Instrument.
(a) The Instrument is designed to minimize the conflicts of interest inherent in fund companies directly compensating representatives. The notion of permittingcompensation to be based on the individual performance of representatives, rather than on the overall performance of a participating dealer, is inconsistent withthis fundamental objective.
(b) The Instrument is also designed to minimize the potential that recommendations be made, and fund securities sold to investors, purely to enable arepresentative to reach a specified threshold - a minimum threshold of this nature functions like a bonus or a sales contest and therefore can potentially bias theadvice provided to investors.
Section 3.3 - Bonus Commissions
Certain commenters requested that section 3.3 of the Ontario Draft Rule be clarified to expressly permit a mutual fund to change its general commission ratesduring a financial year. The CSA consider that subparagraphs 3.1(c)(iii) and 3.2(1)(d)(iii) (the successor provisions to section 3.3 of the Ontario Draft Rule)permit mutual funds to make changes in general commission rates during a year (provided prospectus disclosure is amended). As such, the CSA did not changethe substance of section 3.3 of the Ontario Draft Rule, but instead chose to clarify this matter in section 5.1 of the Policy.
IFIC suggested that section 3.3 implies that a fund company is required to pay the same rate of commission for all mutual funds it offers to investors. The CSAdo not agree with this interpretation and have not made any change in this regard. The restriction on bonus commissions is directed at preventing differing ratesof commission during pre-determined periods.
Part 4 - Internal Dealer Compensation Practices
Section 4.1 - Participating Dealers' Practices
Certain commenters expressed concern that the Ontario Draft Rule prohibited dealers from compensating their representatives differently depending upon thetype of product or mutual fund sold. The CSA have amended section 4.1 in the Instrument to conform its scope to that contemplated in the IFIC Code; that is,to prevent incentives to representatives that discriminate among mutual fund families.
A significant number of commenters pointed out that section 4.1 of the Ontario Draft Rule could be reasonably interpreted to require participating dealers to paythe same rate of commission in absolute terms to each representative, regardless of the commissions actually paid to the participating dealer by the various fundcompanies. As such, the Ontario Draft Rule went beyond the scope of the IFIC Code.
The CSA have amended section 4.1 of the Instrument in response to these comments. Different mutual fund companies pay different levels of commissions toparticipating dealers and there is no compelling reason to prevent those differentials from flowing through to representatives. The fundamental rule should bethat payments to representatives must be based entirely on the compensation received from different fund companies, and not on a decision of the dealer to payrepresentatives more compensation if mutual funds in a particular fund family are sold.
Two commenters suggested that the Ontario Commission should make rules that regulate the internal "grid payout system" employed by dealers. Onecommenter suggested the rule should set out the maximum that can be paid out to representatives by dealers. The other commenter suggested that section 4.1 ofthe Ontario Draft Rule was only one-half correct and that the rule should be that dealers cannot compensate their representatives according to the existing gridsystems in common use by dealers. The CSA consider that rules of this nature would be beyond the present scope of the Instrument and would be overlyintrusive regulation of compensation structures.
Section 4.2 - Principal Distributors' Practices
Many of the same comments made regarding section 4.1 were made in respect of section 4.2. In particular, commenters noted that paragraph 4.2(b) wentbeyond the scope of the IFIC Code. The CSA agree with these comments and accordingly, have deleted this subsection from the Instrument.
One commenter suggested that section 4.2 be deleted entirely and a dealer be allowed to pay compensation to a representative that differentiates betweendifferent mutual fund families and between mutual funds in connection with which the dealer acts in different capacities provided that conflict of interest rules arein place and monitoring and supervision of sales takes place. The commenter noted that section 4.2 will "restrict the ability of companies to rationally plandistribution strategy and may inhibit the development of fund distribution channels". The CSA has not changed section 4.2 in this regard - the CSA continue tobelieve that the inherent conflicts of interest raised by a dealer selling proprietary funds as well as third party funds is best managed through a reasonablerestriction on that dealer providing incentives to a representative that may cause that representative to make inappropriate recommendations.
Part 5 - Marketing and Educational Practices
Numerous comments were received in connection with Part 5 of the Ontario Draft Rule. The comments highlighted for the CSA that users of the Instrumentwould benefit from more precise rules as to the permissible marketing and educational benefits that fund companies could provide. For this reason, this Part ofthe Instrument has been substantially reorganized, not only to address comments received, but also to increase clarity. The CSA did not however change thetypes of benefits that fund companies could provide from those set out in the IFIC Code.
Several commenters did not understand why each of the sections in the Part articulated different conditions to the relevant payments. The re-ordering andgreater precision in drafting Part 5 of the Instrument should clarify for these commenters that each of the sections of Part 5 covers a different event organized orsponsored by different industry participants and accordingly different rules apply.
One commenter expressed concern that the rules relating to marketing and educational practices were particularly vague and unduly restrictive. The rulesprovided for in Part 5 fail to recognize that business conducted between fund companies and dealers in the mutual fund industry is based upon personalrelationships and the confidence built up over the years as a result of personal contacts. Limitations on personal contact imposed by Part 5 will significantlyreduce the quality of advice being given to investors by representatives.
As noted in the Summary of the Instrument, the rules provided in Part 5 of the Instrument have their origins in the IFIC Code. The CSA continued the OntarioCommission approach of regulating sales practices as much as possible in a fashion consistent with the IFIC Code. In formulating the Instrument, the CSAcontinued to permit payment by fund organizations of these costs, but in some instances added additional conditions to such payments in order to lessen theconflicts inherent in such payments. The risk of biased advice to investors generated by the payment of marketing and educational costs of dealers by fundcompanies outweighs concerns that the rules will undermine personal contact between fund companies and representatives.
Section 5.1 - Cooperative Marketing Practices
Several commenters asked that fund companies be permitted to reimburse a participating dealer for its reasonable internal costs incurred in the creation of salescommunications or in the organization and presentation of an investor conference or investor seminar. These commenters proposed that these costs could belimited to 15 percent of the total costs incurred by the relevant dealers. IFIC suggested that the term "out-of-pocket" expenses needed clarification. The CSAare of the view that the term "out-of-pocket" expenses is capable of bearing its ordinary meaning and does not include internal overhead-type costs incurred bydealers in connection with these forms of marketing. The CSA do not agree that dealers should be able to receive reimbursement of internal costs from fundcompanies and accordingly have not amended section 5.1 of the Instrument in this regard.
IFIC noted that section 5.1 of the Ontario Draft Rule does not permit a fund company to attend a dealer organized investor conference or seminar at its ownexpense and that if it did so attend, the costs incurred by the fund company would have to be included in the total costs of organizing the conference or seminar.The CSA are of the view that the Instrument does not so prohibit a fund company from attending or participating nor does it require that the fund company'sexpenses in this regard be included in the costs of the conference or seminar.
A number of commenters pointed out that the breadth of the definition of "member of the organization" in the Ontario Draft Rule would unfairly restrict howmuch a participating dealer that is also a member of the organization of a mutual fund could pay for sales communications, investor conferences and investorseminars. Indeed, such dealers would be technically prohibited by the Ontario Draft Rule from even paying their own expenses. The Ontario Commission didnot intend for this result and accordingly the CSA have drafted section 2.4 of the Instrument to clarify this matter.
Another commenter pointed out that paragraph 5.1(d) of the Ontario Draft Rule puts the onus for ensuring compliance with the applicable payment limits onfund companies, rather than more appropriately on dealers. The CSA are of the view that both dealers, being the recipient of the payment (and the partysoliciting the payment) and fund companies, being the party making the payment, must satisfy themselves that any such payments are permissible under theInstrument. Accordingly, no change to this provision has been made.
Section 5.2 - Mutual Fund Sponsored Conferences
Several commenters indicated that the breadth of the definition of "member of the organization" gave rise to technical problems with the application of section5.2 of the Ontario Draft Rule to those dealers that are also members of the organization of mutual funds. As indicated above, section 2.4 of the Instrument isintended to alleviate those concerns.
The IDA noted that fund companies should be prohibited from paying personal incidental expenses of attendees at conferences and seminars. The CSA havemade this change to section 5.2 (and elsewhere in Part 5) of the Instrument.
Several financial planners and independent mutual fund dealer commenters indicated their general concern with the perceived restrictions contained in section 5.2of the Ontario Draft Rule. The commenters appeared to believe that the section prohibits mutual fund companies from holding educational conferences forrepresentatives. These concerns are unfounded. Section 5.2 of the Instrument, like section 5.2 of the Ontario Draft Rule, operates to require attendeerepresentatives to pay their own accommodation and travel expenses to attend such conferences, but does not prohibit fund companies from holding educationalconferences. These commenters also noted that financial institutions, insurance companies and other financial service providers are not subject to similarregulation in respect of non mutual fund products distributed or sold by agents employed by the relevant entity. As such the Ontario Draft Rule unfairlydiscriminates against independent financial planners and mutual fund dealers selling only mutual fund products. The CSA note that the Instrument is intended atthis time to regulate mutual fund sales practices; the regulation of the distribution of other products is beyond the scope of the Instrument at this time. Althoughas indicated elsewhere, the CSA are of the view that the principles governing the Instrument are equally applicable to the distribution of other collective moneymanagement schemes.
Section 5.3 - Third Party Conferences
As indicated above, the CSA decided to increase the clarity of the rules set out in this section of the Ontario Draft Rule, by dividing it into three sections, witheach section to cover the conditions applicable to a separate type of permissible payment by fund companies. The comments received in respect of this sectioncan be broken down according to the type of payment.
Payment of Registration Fees (provided for in section 5.3 of the Instrument)
IFIC requested the word "course" be included in this provision. This change has been made in section 5.3 of the Instrument.
A number of commenters argued that subparagraph 5.3(1)(a)(ii) of the Ontario Draft Rule be deleted as being a totally unreasonable and impractical provision.Fund companies must be able to base decisions as to benefits and compensation on some reasonable measure of significance of the dealer to the fund companies'business. The CSA have deleted this paragraph in response to these comments and have refined the regulatory objective in this regard, by including subsection2.1(3) in the Instrument, being the general rule against sales contests. The CSA note that the IDA was supportive of the concept behind subparagraph5.3(1)(a)(ii).
Industry and Dealer Sponsored Educational Conferences (provided for in sections 5.4 and 5.5 of the Instrument)
Commenters noted the same comments as were made in connection with section 5.1 namely, that dealers should be able to recoup internal costs of organizingconferences, the breadth of the definition of "member of the organization" gives rise to technical difficulties for those dealers who are also members oforganizations of mutual funds and that fund companies should be able to pay the expenses of their own personnel in attending these conferences without suchexpenses being included as part of the dealer's expenses. The CSA have the same response to these comments as given above.
Section 5.4 - Promotional Items
A number of commenters suggested that sections 5.4 and 5.5 should be merged into one section, with the overriding restriction on the provision of promotionalitems and activities to be that contained in paragraph 5.5(b). The CSA agree with this comment and have amended the Instrument as proposed in section 5.6.
Reference is made to the discussion above as to the Ontario Commission's request for comments on the appropriateness of dollar limits in respect of promotionalitems and promotional activities.
Commenters also noted the impracticality of the requirement in section 5.4 of the Ontario Draft Rule that promotional items be delivered to a participating dealerfor distribution to representatives. The CSA have changed section 5.6 of the Instrument in this regard and note that to this limited degree, it is not inappropriatefor fund companies to deal directly with representatives.
One commenter urged the Ontario Commission to restrict the provision of promotional items and promotional activities, noting that the such items and activitiescan be valuable (notwithstanding the dollar limit proposed in the Ontario Draft Rule) and the restrictions suggested by the Ontario Draft Rule were capable ofbeing easily abused by industry participants. The CSA believe that the regulatory approach set out in section 5.6 is appropriate at this time but will monitor salespractices in this regard.
Section 5.5 - Business Promotion Activities
Commenters suggested that paragraph 5.5(a) of the Ontario Draft Rule be amended to permit activities conducted outside of a representative's locale, providedthat the representative pays for his or her own travel and accommodation costs. The CSA have amended section 5.6 of the Instrument to so provide.
Several commenters objected to paragraph 5.5(c) of the Ontario Draft Rule on the basis that it was unrealistic and overreaching. The CSA have deletedparagraph 5.5(c) and instead have clarified the intention of the Ontario Commission in this regard, with the addition of subsection 2.1(3) of the Instrument.
Part 6 - Portfolio Transactions
Section 6.1 - Reciprocal Commissions and Portfolio Transactions and Section 6.2 - Obligations of Dealers Executing Portfolio Transactions
IFIC asked that the Ontario Commission confirm or clarify that section 6.1 was not intended to prohibit soft dollar arrangements. The CSA are satisfied thatthese provisions cannot be interpreted to catch soft dollar arrangements and have not amended the section.
Both IFIC and the IDA strongly urged the Ontario Commission to remove the requirement in sections 6.1 and 6.2 that portfolio transactions for mutual funds becarried out by designated institutional representatives of dealers, whose accounts are limited to institutional accounts. Both these associations indicated that theCanadian dealer community was such that a provision of this nature would severely limit the number of representatives who could carry out such trades. TheIDA indicated that only a very small percentage of IDA members have institutional departments and even for those who do, most of the qualified representativeshandle some degree of retail accounts. The IDA pointed out that this provision effectively prohibits all of its members from receiving reciprocal business. TheCSA have amended sections 6.1 and 6.2 of the Instrument to account for these comments. However, the CSA continue to be concerned about the possibleabuse of these sections and accordingly have expressed their views in this regard in section 7.1 of the Policy.
IFIC suggested that section 6.1 of the Ontario Draft Rule be amended to contemplate permission for fund companies and dealers to carry out "necessarycommunications" concerning portfolio transactions. The CSA have not amended section 6.1 of the Instrument in this regard. Section 6.1 prohibits fundcompanies from "influencing" how brokerage commissions are allocated by dealers or directing portfolio transactions to inappropriate representatives of dealers.It also prohibits fund companies from advising inappropriate representatives of dealers of portfolio transactions. Any other form of communication madebetween a fund company and a dealer is not covered by section 6.1 and therefore could be made, subject to other provisions of the Instrument.
Part 7 - Other Sales Practices
Section 7.1 - Commission Rebates
IFIC and another commenter asked that the obligation to obtain a client's written consent before an applicable redemption of securities as required by subsection7.1(1) be deleted. They noted that clients tend to resist having to provide written consent to transactions. The CSA have not deleted this requirement; writtenconsent is essential in ensuring that a client understands the implications of the applicable redemption transaction.
A number of commenters expressed concern about the scope of the prohibition contained in subsection 7.1(2) in conjunction with the breadth of the definition of"member of the organization". Subsection 7.1(2) when combined with the definition, means that a dealer who is a member of the organization of a mutual fundcannot provide clients with rebates as other dealers are permitted to do under subsection 7.1(1). Paragraph 7.1(1)(b) of the Instrument addresses this issue andclarifies that a participating dealer that is also a member of the organization of a mutual fund may make commission rebates to clients as permitted by subsection7.1(1) so long as the redemption is carried out in conjunction with a purchase of securities of an unrelated mutual fund.
Section 7.2 - Financial Assistance
The CBA suggested that the prohibition on financial assistance contained in section 7.2 of the Ontario Draft Rule was potentially very broad and attributed thisto the fact that the term "financial assistance" was not defined. The CSA have not defined "financial assistance" in the Instrument. This term should be given itsordinary meaning at law.
Section 7.3 - Tied Selling
A large number of comments were directed at paragraph 7.4(b) of the Ontario Draft Rule, which purported to regulate tied selling. Most commenters took theposition that paragraph 7.4(b) effectively prohibited legitimate "relationship pricing", being a practice by which a financial institution provides financial incentivesor advantages to those customers it considers its best clients. IFIC's comments in this regard are to the effect that provided no investor is required to make aninvestment in a particular mutual fund or fund family in order to receive another product or service, then there is no policy reason why the investor should notreceive a benefit offered. Investors want and expect the benefits of relationship pricing.
Other commenters expressed concern about the ability of financial institutions to use their capability to make loans and provide services to, in effect, coerceinvestors to invest in or use, their sponsored products. One commenter suggested that the Ontario Commission "draw a line in the sand" as to when relationshippricing becomes improper tied selling.
The CSA accept legitimate "relationship pricing" and have accordingly deleted paragraph 7.4(b) of the Ontario Draft Rule. However, the CSA remain concernedabout the potential for coercion in connection with the provision of services related to the sale of mutual fund securities. Accordingly, the CSA have added tosection 7.4 of the Instrument a reference to terms that could, to a reasonable person, appear to be a condition; the provision now provides that no person orcompany shall as a condition or on terms that appear to a reasonable person to be a condition of supplying or continuing to supply products or services require aperson or company to invest in a mutual fund.
Part 8 - Compliance with Rule by Participating Dealer
Section 8.1 - Compliance with Rule by Participating Dealer
A large number of commenters were of the opinion that Part 8 of the Ontario Draft Rule, which imposed monitoring obligations on fund companies to ensuretheir product was being distributed in compliance with the rule, was excessively onerous and completely impractical. Most commenters recommended deletingthe entire section, while others suggested alternatives such as annual compliance certificates filed with the Ontario Commission. In general, commenters notedthe inappropriateness of what they believed was an improper delegation of the Ontario Commission's responsibility to ensure compliance with, and enforcementof, its rules. The CSA have deleted Part 8 and paragraph 9.1(b) of the Ontario Draft Rule. The CSA will be reviewing methods available to ensure that theInstrument, once effective, is complied with and will undertake whatever enforcement action is deemed necessary as required.
Part 9 - Prospectus and Point of Sale Disclosure
Section 9.1 - Disclosure of Sales Practices
A few commenters expressed concern as to the disclosure requirements set out in paragraph 9.1(a), believing that the subsection requires disclosure of thecompensation practices of participating dealers. One commenter asked that the meaning of "sales practices" used in this subsection be clarified. The CSA havenot amended section 8.1 of the Instrument and are of the view that this section requires disclosure of compensation paid by the applicable fund company anddoes not require that a fund company disclose the internal compensation practices of participating dealers. The CSA are of the view that the term "salespractices" is clear.
In conjunction with comments made in respect of Part 8 of the Ontario Draft Rule, commenters objected to paragraph 9.1(b) of the Ontario Draft Rule on thebasis that it required fund companies to bear extraordinary statutory liability for potential misrepresentations. As indicated above, the CSA have deletedparagraph 9.1(b) from the Instrument.
IFIC asked that the Instrument contain transitional provisions so that fund companies would not be immediately required to amend prospectuses. The CSA havenot provided for transitional provisions as the disclosure required by section 8 of the Instrument is important disclosure and is in large part now being provided infund prospectuses. The CSA are also of the view that a transitional period is not justified owing to the length of time that industry participants have had noticeof the CSA's concerns with respect to sales practices and incentives, including the adequacy of their disclosure. In any event, the IFIC Code (released in March1996) recommended appropriate disclosure be included in fund prospectuses; by the anticipated effective date of the Instrument, industry participants will havehad ample time to amend fund prospectus disclosure accordingly.
Section 9.2 - Disclosure of Equity Interests
As discussed above, the CSA have retained the disclosure requirements in respect of equity interests as provided for in the Ontario Draft Rule. The CSA havedecided that prohibition of equity interests is not the appropriate regulatory response at this time.
IFIC suggested that disclosure of equity interests should only be required where the relevant company (whether a fund company or a dealer) is a publicly tradedreporting issuer and the other company (whether a dealer or a fund company) owns a control position in the first company. The CSA have, as discussed above,amended the definition of equity interest, but have not otherwise amended the Instrument to account for IFIC's comment.
IFIC also recommended that the Instrument contain a transition period, so that the mandated disclosure would only be provided at the time of the nextprospectus renewal after the effective date of the Instrument. For the reasons described above, the CSA have not provided for a transition period in theInstrument with respect to disclosure requirements.
IFIC, the CBA and other commenters asked that subsection 9.2(2) of the Ontario Draft Rule be deleted, as an unrealistic and impractical provision. They askedwhy a separate point of sale document was necessary, given that this disclosure would be made in the fund prospectus. One commenter was concerned that thisprovision effectively repealed the exemption contained in s.225 of the Regulation to the Securities Act (Ontario). Another commenter urged that therequirement to disclose equity interests in fund prospectuses be eliminated in favour of the point of sale disclosure document required by subsection 9.2(2) of theOntario Draft Rule.
The CSA are of the view that a separate point of sale disclosure document, together with the prior written consent of investors is extremely important to ensurethat investors appreciate the significant conflicts of interest to which his or her representative is subject in these circumstances. However, the CSA haveamended section 8.2 of the Instrument to require that this point of sale disclosure document be delivered at the time of the initial sale of a fund and on anysubsequent sale of securities, only if the information contained in a previous point of sale disclosure statement has changed. The Instrument continues to requirefund prospectus disclosure on the basis that this disclosure is important and ensures full, true and plain disclosure of all material facts concerning a mutual fund.
Section 9.3 - Disclosure Requirements If No Prospectus or Simplified Prospectus
IFIC and another commenter recommended deleting section 9.3 of the Ontario Draft Rule. Both commenters disagreed with the notion of treating exemptmutual fund transactions any differently from other exempt transactions. The CSA have retained this section as section 8.3 of the Instrument. The potential forconflict of interests associated with the sales practices used in exempt mutual fund transactions is sufficiently serious and in reality no different from publictransactions (that is, those carried out under a prospectus) that the requirement for the disclosure provided for in this section remains appropriate.
5. COMMENTS ON PROVISIONS OF THE ONTARIO DRAFT POLICY
Part 1 - General
One commenter raised serious concerns about the use by the Ontario Commission of a companion policy statement to accompany the Ontario Draft Rule. Thecommenter noted that "the introduction of a companion policy in these circumstances is ... the first step to utilizing theoretically non-binding statements of viewsor policy to regulate the securities industry". The commenter urged the Ontario Commission to include its "views" in the Ontario Draft Rule so that changes tothese "views" will be subject to the safeguards of the rule-making process.
The CSA notes that the advent of the rule-making era did not do away with the ability of securities regulators to outline their views in policy statements. Therule-making procedure dictated by applicable securities legislation requires that policy statements be subject to a public comment period. The power for theOntario Commission to make policy statements is contained in section 143.8 of the Securities Act (Ontario). The Policy is necessary to supplement themandatory rules set out in the Instrument - it is intended as a guide to the user of the Instrument to assist the user in understanding the implications of the rulesset out in the Instrument.
Section 3.2 - Non-Monetary Benefits
Several commenters suggested revisions to the list of matters the Ontario Commission indicated were, in its view, non-monetary benefits, such as financialplanning computer software, general educational and training support. The CSA have modified somewhat the list contained in the Ontario Draft Policy to reflectits views that proprietary financial planning software that is more akin to marketing materials would not generally be considered non-monetary benefits.
Section 4.1 - Marketing and Educational Practices
IFIC and another commenter suggested that the Ontario Draft Policy be amended to permit fund companies to supply gifts and entertainment at fund sponsoredconferences provided such gifts and entertainment were provided in compliance with sections 5.4 and 5.5 of the Ontario Draft Rule. The CSA have made thischange in the Policy.
These commenters also suggested that guests of attendee representatives should be allowed to attend mutual fund sponsored conferences, provided suchindividuals pay their own expenses. The CSA have not so amended the Policy.