IFB Summit: Compliance pays off

The future is filled with documentation, according to the Mutual Fund Dealers Association. In a presentation at the Independent Financial Brokers’ Spring Summit, Ken Woodard and Ian Strulovitch confirmed that the MFDA would continue to push the practice of documentation.

The mention of high-profile cases, such as Portus and the infamous Ian Thow under the Berkshire banner, provided Strulovitch, enforcement policy counsel at the MFDA, an opportunity to showcase a number of investigations that had been conducted and concluded by the MFDA. It also offered the two MFDA representatives an opportunity to confirm the importance of current and upcoming compliance regulation.

“There are 150 people working at the MFDA,” explained Woodard, director, membership services. “The experience ranges from lawyers to chartered accountants to other professional[s]. The professionalism is very high.” He explained that while the self-regulatory organization is aware of the increased paperwork required of the advisors and the dealers, he believes that this degree of scrutiny of documentation is, in fact, necessary.

“Our rules are principle-based,” explains Woodard. “We make them that way so there is flexibility in the industry, but there are times when we run into a situation where people are bending the rules. That’s when we issue a notice to ensure that we are clear on how the rule should be read and applied.”

One such situation recently prompted the release of Notice MF-0065 on Churning.

“This is the first time we came up with penalty guidelines that will apply to excessive trading or overtrading,” said Woodard. This was prompted by the number of MFDA examinations that were turning up multiple trades within client accounts that appeared to be creating no benefit other than commissions for the advisor.

“One investigation found that a sample of 10 accounts from an [advisor] revealed 40 DSC transactions in a one-month period. These transactions generated $100,000 in commissions and no benefits for the clients.”

It’s these types of “unscrupulous” actions the MFDA is trying to curtail, said Woodard. He is quick to clarify, however, that the MFDA is not trying to prevent legitimate DSC-to-DSC trades, multiple transactions in a client’s account or non-redemption transfers, but it is trying to stop “the bad people out there,” says Woodard.

Under MF-0065, dealers and branch managers are required to review advisor client accounts and flag any trade that appears excessive, is a result of a redemption of a fund only to repurchase the same fund (“often parking the funds in a money market account,” said Woodard) or is a movement of money between funds in the same fund family and is recorded as a redemption rather than a transfer.

“Churning is very difficult to detect on a daily basis,” explained Woodard. “But through the requirement of branch managers having to file monthly compliance reports, we are able to observe monthly patterns that show whether or not churning is taking place.”

As such, Woodard and his colleagues believe the compliance requirements are, indeed, protecting clients. He is quick to state, again, that the MFDA is not attempting to prevent or deny advisors from making trades.

“What we are saying is that you need to document everything,” said Woodard. “The trade should only be performed for a valid and documented reason — not to simply generate a commission. That means every advisor is required to discuss and disclose the appropriate information.” This includes telling a client that a trade will trigger a redemption and that the client must hold the fund longer in order not to be penalized, said Woodard. It also includes providing specific details to a client about the amount of commission an advisor will earn on that trade.

In essence, then, a client’s signature is no longer enough, explained Woodard. The trade needs to be in accordance with the suitability based on the client’s risk assessment and portfolio. “Evidence of disclosure — through documentation of communication — should be part of an advisor’s best practice.”

Along those lines, Woodard and Strulovitch also confirmed that a signature on a blank form — any blank form — would trigger an investigation by the MFDA enforcement division.

“We do not believe [having clients presign forms], even as a matter of convenience for clients who travel or are frequently out of town, is an appropriate practice,” said Woodard. “All it takes is one presigned form in a client file, and the matter will be referred to enforcement.”

For advisors who deal with snowbirds or travelling clientele, Woodard and Strulovitch suggested setting up a limited trading authority agreement. However, they caution all advisors to re-examine the acceptable forms of electronic communication and trade requests as outlined in the Ontario Securities Act.

Advisors at the 2008 IFB Spring Summit were also reminded of Notice MF-0067: Stealth Advising.

“If you have a referral relationship with another [non-registered] professional, we suggest you take a good, hard look and make sure that it is you, the advisor, who is providing the investment advice and conducting any related investment activities,” said Woodard.

Finally, Woodard explained that a recent notice, MF-0070: Misleading Communication Regarding Leveraging, was just released by the MFDA in May 2008, in response to a number of recent advertisements regarding reverse mortgages and post-retirement leveraging.

“The MFDA felt that the advertisements that suggested that leveraging was appropriate for all clients or had promises that the mortgage was tax deductible or that promised unrealistic returns were not appropriate,” explained Woodard. The litmus test was whether or not these advertisements offered statements regarding the downside risk or provided risk disclosure.

“If there are no statements of downside risk, we consider that [type of communication] inappropriate,” Woodard said. “The client should be aware of the full gamut of potential downside risks.”

While the MFDA does not require advisors to stop offering these products to or discussing these products with their clients, it is trying to assure that clients in their later years — assumed at 60 or older in the MFDA documentation — are well aware of the risks before entering into this type of investment or leverage vehicle

“With these products, suitability is essential,” explained Strulovitch. “Actual signature on disclosure is meaningless without the [litmus test of] suitability.” He continued by saying that while the MFDA was not prohibiting advisors from offering these products, the current “method being used to get clients in the door was not appropriate.”

The result of these current MFDA notices and of prior regulation is that advisors and their dealers need to be aware that certain business practices will result in “situations where, on the surface, there is no obvious benefit to the client. As a result, you will hear from your compliance department, and we expect to see discussions and documentation of those discussions,” said Woodard. In the end, “it’s up to members to make this a process rather than a hassle.”

Originally published on Advisor.ca on May 27, 2008