Securities Law & Instruments

 

COMPANION POLICY 81-105CP
TO NATIONAL INSTRUMENT 81-105 - MUTUAL FUND SALES
PRACTICES

TABLE OF CONTENTS
PART 1 PURPOSE
1.1 Purpose
PART 2 GENERAL DISCUSSION OF THE INSTRUMENT
2.1 Background
2.2 General Purpose of the Instrument
PART 3 DEFINITION OF "REPRESENTATIVE"
3.1 Definition of "representative"
PART 4 DISCUSSION OF CERTAIN ASPECTS OF PART 2 OF
THE INSTRUMENT

4.1 The phrase "in connection with the distribution
of securities"
4.2 Non-Monetary Benefits
4.3 The phrase "pay for or make reimbursement of a
cost or expense incurred or to be incurred by a participating
dealer or a representative of a participating dealer"
4.4 Prohibition of Indirect Means
4.5 Exception for Some Participating Dealers and
Representatives
PART 5 COMMISSIONS
5.1 Bonus Commissions
5.2 Trailing Commission Thresholds
PART 6 MARKETING AND EDUCATIONAL PRACTICES
6.1 Definition of "direct costs"
6.2 Cooperative Marketing Practices
6.3 Mutual Fund Sponsored Conferences
6.4 Third Party Sponsored Educational Events
6.5 Promotional Items and Business Promotion Activities
PART 7 RECIPROCAL COMMISSIONS AND PORTFOLIO TRANSACTIONS
7.1 Reciprocal Commissions and Portfolio Transactions
PART 8 DISCLOSURE REQUIREMENTS
8.1 Disclosure Requirements
PART 9 EXEMPTIONS
9.1 Exemptions

 

PART 1 PURPOSE

1.1 Purpose - The purpose of this Policy is to state the views of the Canadian securities regulatory authorities on various matters relating to National Instrument81-105 Mutual Fund Sales Practices (the "Instrument"), including

(a) a discussion of the general approach taken by the Canadian securities regulatory authorities in, and the general regulatory purpose for, the Instrument;

(b) the interpretation of various terms used in the Instrument; and

(c) examples of some of the matters described in the Instrument.

PART 2 GENERAL DISCUSSION OF THE INSTRUMENT

2.1 Background

(1) The Instrument has been adopted by the Canadian securities regulatory authorities as a response to the concern of many participants in the mutual fundindustry that the pre-existing regulatory strategy of reliance on prospectus disclosure of sales practices, coupled with the discipline imposed by competitivemarket forces, were not sufficient to discourage sales practices and compensation arrangements that gave rise to questions as to whether participating dealersand their representatives were being induced to sell mutual fund securities on the basis of the incentives they were receiving as opposed to what was suitable forand in the best interests of their clients.

(2) The Instrument follows the review of the investment fund industry undertaken by Ontario Securities Commission ("OSC") Commissioner GlorianneStromberg at the request of the OSC in February 1994. Her report "Regulatory Strategies for the Mid-'90s - Recommendations for Regulating Investment Fundsin Canada", was prepared for the Canadian Securities Administrators ("CSA") and released in January 1995.

(3) Commissioner Stromberg noted in her report that as a result of competitive pressures "questionable sales practices and incentives have become commonplacein the industry". She concluded that the regulatory strategy referred to in subsection (1) above would be an appropriate regulatory strategy if certainrecommended fundamental changes were made to the regulation of sales practices.1

(4) In response to Commissioner Stromberg's report, IFIC, after extensive industry consultation, released its recommendations for a Code of Sales Practices forthe Mutual Fund Industry dated March 29, 1996 (the "IFIC Code").2 The IFIC Code stated in its preamble:

"The Draft Code is designed to establish the industry standard of conduct and to reflect its concern for investor protection. The sales practices suggested in theDraft Code are designed to align the interests of the principal parties to the transaction, i.e. the investor, fund manager and, where applicable, third party funddistributor firm and salesperson, and to encourage long term relationships among them. If implemented, the Draft Code would prohibit many sales practiceswhich could result in conflicts of interest between the interests of an investor and those of the distributor firm, its salespersons and a fund manager. IFIC believesthat it is important, in the case of sales practices permitted under the Draft Code, that there be full disclosure of the sales practice in order that an investor is fullyinformed of the circumstances surrounding investment in mutual funds".

(5) In the absence of a self-regulatory organization which could adopt the IFIC Code as a regulation applicable to all distributors of securities of mutual funds,IFIC recommended that the provisions of the IFIC Code be reflected in rules of the OSC made under the Act. This request was endorsed by the InvestmentFunds Steering Group.3

(6) The Instrument is based on, and in Ontario, is an amended version of, the proposed Ontario rule regarding mutual fund sales practices (the "Ontario DraftRule") published for comment in Ontario on August 30, 1996 at (1996), 19 OSCB 4734. The Ontario Draft Rule reflected the approach taken in the IFIC Codeand also reflected certain of the by-laws and rules of the IDA. This Instrument reflects the discussions of the Canadian securities regulatory authorities ofcomments received in Ontario in respect of the Ontario Draft Rule. The Canadian securities regulatory authorities have made the Instrument in order to makemandatory, on an industry-wide basis across Canada, restrictions on certain sales and business practices followed by participants in the mutual fund industry.

2.2 General Purpose of the Instrument

(1) The purpose of the Instrument is to ensure that the interests of investors remain uppermost in the actions of participants in the mutual fund industry by settingminimum standards of conduct to be followed by industry participants in their activities in distributing mutual fund securities. The minimum standards of conductestablished by the Instrument are designed to minimize the conflicts between the legitimate commercial goals of industry participants and the fundamentalobligations outlined in subsection (2) that are owed by industry participants towards investors.

(2) The Instrument prohibits certain sales practices and compensation arrangements that have developed and that the Canadian securities regulatory authoritiesconsider undermine, compromise or conflict with the following fundamental obligations of industry participants to their investor clients:

(a) investment recommendations should be made by a representative of a participating dealer to an investor based on the investor's investment objectives andcircumstances and must be suitable for that investor;

(b) a participating dealer and a representative of a participating dealer are acting as agents on behalf of their client, an investor, and as such have a primaryobligation to act in the best interests of the client;

(c) where an investor is relying on a participating dealer and a representative of a participating dealer to provide him or her with independent expertise and adviceregarding options for mutual fund or other investments, the participating dealer and the representative of the participating dealer have a fiduciary obligation notto compromise the provision of this expertise and advice;

(d) a participating dealer, as a registrant under securities legislation, is required to exercise adequate and appropriate supervision of its representatives who aredealing with clients to ensure compliance with all statutory and other legal obligations;

(e) members of the organization of a mutual fund providing management services to a mutual fund have an obligation to act honestly, in good faith and in thebest interests of the mutual fund and its securityholders; and

(f) full, true and plain disclosure of all material facts concerning a mutual fund, including the compensation paid to participating dealers and their representativesand other sales practices followed in connection with the distribution of mutual fund securities, is essential to ensure that investors understand the nature of theinvestments they are making and the impact of fees and charges on them.

(3) The Canadian securities regulatory authorities are aware that other sales practices or compensation arrangements could arise that also undermine orcompromise the focus of industry participants in complying with the fundamental obligations outlined in subsection (2). The Canadian securities regulatoryauthorities expect participants in the mutual fund industry to be and remain faithful to their fundamental obligations to the investing public, and not to allowpractices or arrangements to develop that threaten this high standard of conduct. In this context, the restrictions on sales practices articulated by the Instrumentshould be seen as the minimum standards that should be followed by industry participants in order to fulfil their fundamental obligations.

PART 3 DEFINITION OF "REPRESENTATIVE"

3.1 Definition of "representative"

(1) The definition of the term "representative" contained in section 1.1 of the Instrument includes a person who is registered in the category of partner, director,officer or salesperson of a participating dealer, even though the relationship of the person with the participating dealer may be one of independent contractor.The definition of the term "representative" also includes employees of a participating dealer, even if those employees are not registered with the securitiesregulatory authority.

(2) Paragraph (b) of the definition of "representative" includes personal holding companies of the persons referred to in paragraph (a) of the definition. TheCanadian securities regulatory authorities have included this paragraph to ensure that the provisions of the Instrument apply both to the persons who carry onactivities through personal holding companies and to the holding companies themselves.

PART 4 DISCUSSION OF CERTAIN ASPECTS OF PART 2 OF THE INSTRUMENT

4.1 The phrase "in connection with the distribution of securities" - The prohibitions and restrictions contained in sections 2.1 and 2.2 of the Instrument relate toactions taken "in connection with the distribution of securities" of a mutual fund. The Canadian securities regulatory authorities are of the view that this phraseincludes, without limitation, any activity done in furtherance of the sale, distribution or marketing of securities of mutual funds. This would include promotionalactivities relating to the investment in securities or mutual funds generally, or educational activities concerning financial, investment or retirement planning thatcould involve a discussion of the advantages and disadvantages of mutual fund investments. Any compensation or non-monetary benefits given to solidify orpromote a relationship between a member of the organization of a mutual fund and a participating dealer and its representatives would fall within the scope ofthese sections. The phrase should not be interpreted restrictively or narrowly.

4.2 Non-Monetary Benefits

(1) Part 2 of the Instrument contains restrictions and prohibitions on the provision of, among other things, non- monetary benefits to participating dealers andtheir representatives.

(2) The Canadian securities regulatory authorities are of the view that the term "non-monetary benefits" includes any goods, services or other benefits that couldbe provided to or received by a person or company and that could be perceived by that person as being of benefit, advantage or value to him, her or it. Thematters that are included in the term include, without limitation

(a) domestic or foreign trips, food, beverages and accommodation, regardless of whether these benefits are provided in connection with attendance at aconference or other event sponsored by a member of the organization of a mutual fund;

(b) entertainment, including the provision of tickets to concerts, theatre or sporting events, or the ability to participate in events such as golf tournaments;

(c) gifts and non-cash gratuities;

(d) invitations to educational seminars or conferences organized by members of the organization of a mutual fund;

(e) attendance at educational seminars, conferences or courses; and

(f) computer hardware, including networking hardware and general business software systems.

(3) The term "non-monetary benefits" does not include the normal goods and services that are provided by mutual fund organizations to participating dealers tofacilitate the marketing of securities of the mutual fund, such as brochures, educational material, supplies of prospectuses or simplified prospectuses and financialstatements.

 

(4) Some mutual fund organizations provide participating dealers with computer software that is designed to assist in determining which of the mutual funds ofthe organization are most appropriate for a client of the participating dealer, having regard to the investment objectives and financial condition of the client. TheCanadian securities regulatory authorities are of the view that the provision of this type of proprietary software is not a non-monetary benefit to the participatingdealer and is in the nature of marketing materials as referred to in subsection (3).

(5) However, the Canadian securities regulatory authorities consider that the provision of financial planning software of a more general nature, whetherproprietary to the mutual fund organization or not, would likely constitute a non-monetary benefit. In addition, other non-proprietary software that is providedto the participating dealer would generally be considered to be a non-monetary benefit.

(6) The provision by a member of the organization of a mutual fund to a participating dealer of computer software, the only purpose of which is to facilitate theelectronic interface between the participating dealer and the members of the organization of the mutual fund, is not considered to be included in the term "non-monetary benefits".

4.3 The phrase "pay for or make reimbursement of a cost or expense incurred or to be incurred by a participating dealer or a representative of a participatingdealer" - Section 2.1 of the Instrument contains restrictions and prohibitions on the ability of a mutual fund and a member of the organization of a mutual fund to"pay for or make reimbursement of a cost or expense incurred or to be incurred by a participating dealer or a representative of a participating dealer". Section2.2 contains corresponding restrictions and prohibitions on the ability of a participating dealer and its representatives to solicit or accept such payments. TheCanadian securities regulatory authorities are of the view that this phrase includes direct or indirect reimbursement of costs or expenses, any payment thatcompensates a participating dealer or representative for such costs or expenses or any other method whereby the member of the organization of the mutual funddirectly or indirectly bears the costs or expenses incurred.

4.4 Prohibition of Indirect Means

(1) Section 2.3 of the Instrument contains a prohibition against a person or company arranging to effect indirectly any action that the person or company wouldbe prohibited by the Instrument from taking directly.

(2) This provision is designed to prevent members of organizations of mutual funds from structuring arrangements with participating dealers or representatives ofparticipating dealers in ways that would technically avoid non-compliance with the Instrument, but would subvert the intent of the Instrument.

(3) Of particular concern to the Canadian securities regulatory authorities are arrangements in which third parties who are technically unrelated to members oforganizations of mutual funds or participating dealers are used as conduits for the payment or receipt of funds or benefits or reimbursement of costs that couldnot be made directly under the Instrument. These arrangements, which could be structured so that a third party vehicle could make payments or provide benefitson behalf of a mutual fund organization that the organization itself could not make, or so that a third party vehicle could receive funds or benefits on behalf of aparticipating dealer that the dealer could not receive directly, would, in the view of the Canadian securities regulatory authorities, be prohibited by section 2.3 ofthe Instrument.

4.5 Exception for Some Participating Dealers and Representatives

(1) Section 2.4 of the Instrument provides that nothing in the Instrument prohibits a person or company that is both a member of the organization of a mutualfund 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) a participating dealer is not prohibited by the Instrument from undertaking that activity.

(2) That section is designed to respond to the fact that many registrants that are participating dealers will also be members of organizations of mutual funds; forexample, a dealer that is owned by a bank will likely be an affiliate of the manager or principal distributor of a mutual fund sponsored by that bank and thus be amember of the organization of that mutual fund.

(3) The Canadian securities regulatory authorities intend that a participating dealer that is also a member of the organization of a mutual fund will have thefreedom to operate as a participating dealer without concern over technically breaching the restrictions on members of the organizations of mutual fundscontained in the Instrument. Some examples of how section 2.4 of the Instrument would be relevant to certain actions, assuming that the conditions of section2.4 were satisfied, are as follows:

(a) a participating dealer that is also a member of the organization of a mutual fund would not be constrained in how it compensates its own representatives oremployees by the provisions of Part 2 of the Instrument;

(b) a participating dealer that is also a member of the organization of a mutual fund would not be limited by the operation of section 5.1 of the Instrument inpresenting an investor conference by the fact that the dealer may also be a member of the organization of a mutual fund;

(c) section 5.2 of the Instrument would not prevent a participating dealer that is also a member of the organization of a mutual fund from paying the travel,accommodation and personal incidental expenses for its own representatives to attend conferences sponsored by a mutual fund organization; and

(d) section 5.5 of the Instrument would not operate to subject a participating dealer to the limitations contained in that section if the dealer was sponsoring aconference for its own representatives; the dealer would be able to pay for its own costs even though technically, the dealer was a member of the organization ofa mutual fund.

(4) Similarly, by reason of subsection 2.4(2), the Instrument will not affect the ability of a representative of a participating dealer that is a member of theorganization of a mutual fund to receive compensation otherwise permitted by the Instrument from the participating dealer.

(5) The Canadian securities regulatory authorities note the possible application of section 2.3 of the Instrument to a participating dealer if the relationshipbetween a mutual fund organization and a participating dealer that was a member of the organization was used in an attempt to avoid the Instrument.

PART 5 COMMISSIONS

5.1 Bonus Commissions - Subparagraphs 3.1(c)(iii) and 3.2(1)(d)(iii) of the Instrument prevent the payment of "bonus commissions", in which the rates ofcommissions paid or earned during a particular period of the year are higher than the rates of commissions paid or earned for any other time. This provisionshould not be read to prevent a mutual fund from changing its general commission rates at some time during a year. It is noted that in such circumstances, themutual fund should amend its prospectus or simplified prospectus to disclose the change in general commission rates applicable to sales of its securities.

5.2 Trailing Commission Thresholds

(1) The Canadian securities regulatory authorities note that the IFIC Code permits a mutual fund organization to pay, and a participating dealer to accept, trailingcommissions based on the assets in an individual representative's client accounts, on a representative by representative basis. The IFIC Code further providesthat a mutual fund organization could establish a payment policy whereby no trailing commission would be paid to a participating dealer in respect of a particularrepresentative if the assets in the representative's client accounts did not exceed $100,000.

(2) The Canadian securities regulatory authorities consider that the effect of the rules established by subsection 2.1(3) and section 3.2 of the Instrument meanthat mutual fund organizations can no longer establish the minimum asset thresholds referred to in the IFIC Code. These sections require that the percentagethat a trailing commission represents of the aggregate value of securities of a mutual fund held in accounts of clients of a participating dealer must be the samefor that participating dealer, regardless of the aggregate value of securities of the mutual fund in accounts of clients of the participating dealer at any time or theaggregate level of sales of securities of the mutual fund by the participating dealer.

PART 6 MARKETING AND EDUCATIONAL PRACTICES

6.1 Definition of "direct costs"

(1) The phrase "out-of-pocket" costs and expenses, used in the definition of "direct costs" contained in section 1.1 of the Instrument, does not include internalsalary and overhead costs associated with the efforts of the participating dealer relating to the applicable sales communication or event. The definition of "directcosts" specifically excludes any costs incurred by a participating dealer for travel, accommodation or personal incidental expenses associated with the attendanceof individuals at applicable events. The Canadian securities regulatory authorities are of the view that those types of expenses form part of the cost of doingbusiness for the participating dealer and may not be borne by mutual fund organizations.

(2) Part 5 of the Instrument permits a member of the organization of a mutual fund to pay direct costs incurred by a participating dealer relating to certain salescommunications or events on the conditions indicated, which include, in some circumstances, a condition that the participating dealer provide invoices or receiptsfor the costs to be paid by the member. The Canadian securities regulatory authorities expect members of organizations of mutual funds to exercise reasonablediligence to ensure that the direct costs indicated on invoices or receipts received from participating dealers represent direct costs that are reasonable in thecircumstances. The Canadian securities regulatory authorities also expect participating dealers to exercise reasonable diligence to ensure that the direct costsindicated on invoices or receipts delivered to members of organizations of mutual funds represent direct costs incurred by the participating dealer.

6.2 Cooperative Marketing Practices - Section 5.1 of the Instrument is designed to permit some cooperative marketing between mutual fund organizations andparticipating dealers, within the parameters set out in that section. The Canadian securities regulatory authorities are aware that participating dealers conductcertain marketing on behalf of mutual fund organizations and accordingly have permitted a limited sharing of the costs of sales communications and investorconferences and seminars that are organized and presented by participating dealers on the conditions contained in section 5.1. Section 5.1, however, does notpermit a participating dealer to receive compensation or reimbursement from a mutual fund organization for its general marketing expenses, such as, for example,costs associated with client appreciation events or general client mailings or sales communications that relate generally to the business or operations of theparticipating dealer. Those costs may not be borne by mutual fund organizations.

6.3 Mutual Fund Sponsored Conferences

(1) Section 5.2 of the Instrument requires that the costs relating to the organization and presentation of a conference or seminar described in that section bereasonable, having regard to the purpose of the conference or seminar. The Canadian securities regulatory authorities are of the view that "reasonable" costs inthis context could include the provision of food and beverages for attendees at the conference or seminar, the provision of conference or seminar materials andthe payment or waiver of registration fees at the conference or seminar. The term "reasonable" costs would not include gifts or entertainment provided toattendees other than as permitted by section 5.6 of the Instrument.

(2) Section 5.2 of the Instrument does not permit a member of the organization of a mutual fund to invite a guest of a representative of a participating dealer toattend a conference or seminar referred to in that section.

6.4 Third Party Sponsored Educational Events - Section 5.3 of the Instrument permits a member of the organization of a mutual fund to pay the registration feesof a representative of a participating dealer for a third party sponsored educational event referred to in that section. The term "registration fees" should be readwith its ordinary meaning and should not be read to include travel, accommodation or other incidental costs associated with the attendance of the representativeat the event.

6.5 Promotional Items and Business Promotion Activities

(1) Section 5.6 of the Instrument permits the provision of "non-monetary benefits of a promotional nature" of minimal value. Examples of this type of benefitinclude reminder advertising such as pens, calendars, t- shirts, hats, coffee mugs, paperweights and golf balls.

(2) Section 5.6 of the Instrument permits a member of the organization of a mutual fund family to engage in reasonable business promotion activities. Examplesof such activities include occasional meals or drinks, tickets to sporting events, concerts or the theatre or the ability to participate in events such as golftournaments and other comparable entertainment.

PART 7 RECIPROCAL COMMISSIONS AND PORTFOLIO TRANSACTIONS

7.1 Reciprocal Commissions and Portfolio Transactions - Part 6 of the Instrument is designed to ensure that "best execution" practices are followed in makingbrokerage arrangements for mutual funds. It limits the connection between a participating dealer's distribution activities in respect of a mutual fund and itsactivities in carrying out portfolio transactions for the mutual fund. In this regard, subsection 6.1(2) and section 6.2 of the Instrument require that portfoliotransactions for a mutual fund are to be carried out only through a representative of a participating dealer who has been designated as an institutionalrepresentative by that participating dealer. The Canadian securities regulatory authorities expect that industry participants will not attempt to circumvent theintent of the Instrument by designating persons as institutional representatives to undertake portfolio transactions for mutual fund organizations if those personshave little or no other dealings with institutional accounts.

PART 8 DISCLOSURE REQUIREMENTS

8.1 Disclosure Requirements - Section 8.3 of the Instrument sets out the disclosure requirements for distributions of securities of a mutual fund subject to theInstrument that are made under an exemption from the prospectus requirements of the securities legislation and in circumstances in which the mutual fund doesnot have a current prospectus or simplified prospectus available to be delivered to the purchaser of the securities of the mutual fund.

PART 9 EXEMPTIONS

9.1 Exemptions

(1) The procedure to obtain, in more than one jurisdiction, an exemption from the Instrument is as follows:

(a) the applicant should file an application in writing simultaneously in all jurisdictions in which it requires an exemption;

(b) the application should indicate the name of the principal jurisdiction selected by the applicant for the purpose of dealing with the application and, if applicable,any related prospectus filing and of each other jurisdiction where the application and, if applicable, a related prospectus is being filed;

(c) the Canadian securities regulatory authority of the principal jurisdiction or the regulator in the principal jurisdiction will, on behalf of the applicant, contactthe Canadian securities regulatory authorities or regulators in the other jurisdictions in which the application has been made for their comments concerning theapplication and will forward all comments to the issuer; and

(d) the applicant should respond in writing to all comments to the Canadian securities regulatory authority in the principal jurisdiction, which will forward theresponse to the Canadian securities regulatory authorities in the other jurisdictions and again coordinate comments.

(2) In order to enable the Canadian securities regulatory authorities to deal with applications on a timely basis, issuers are encouraged to file applicationssimultaneously in all jurisdictions in which they require an approval or an exemption.