Do-it-yourself regulation

In a world where consumers are always looking for opportunities to cut out middlemen and gatekeepers, finance is no exception.

Do-it-yourself regulation
Illustration: Matthew Billington

In a world where consumers are always looking for opportunities to cut out middlemen and gatekeepers, finance is no exception. The rise of do-it-yourself online investing is raising new questions for regulators and lawyers serving clients in wealth management say regulators need to get with the times.

In a thriving economy with a soaring stock market, Canada’s traditional retail investment products seem just fine to investors, says Kevin Rusli, a partner at Blake Cassels & Graydon LLP. But the economy is slowing down. After a three-per-cent growth in 2017, Canada’s GDP lagged last year  with an expansion of only 1.8 per cent. When growth begins to slow and a recession seems near, Canadians will increasingly scrutinize their management fees, and in Canada, retail investment products are among the most expensive in the world, he says. Middle-income investors will tend to venture away from financial advisors and mutual funds in these circumstances to something less expensive — such as do-it-yourself investing products like robo-advisors or exchange traded funds.

“People are realizing that the asset management industry may no longer be enough for long-term sustainable growth,” Rusli says.

ETFs outpaced mutual funds in sales last year and are the fastest-growing area of Blake’s asset management practice, he says. Robo-advisors such as Wealthsimple, Questrade, Justwealth Financial Inc. and WealthBar are also ascending.

“Particularly, in the last few years of the market since 2008, [investors have] experienced high costs, they’re paying a lot for their investments and they’re not making very much money,” says Rebecca Cowdery, a partner at Borden Ladner Gervais LLP, who practises corporate, commercial and securities law with a focus on the investment management industry. “And I think they feel that there is too much of the investment industry making money off investors, yet investors are not making very much money themselves.”

In a regulatory environment that values investor protection and transparency, Rusli says, these affordable, autonomy-empowering products mesh with the spirit of the regulation. But Cowdery, who spent nine years as a senior investment funds regulator with the Ontario Securities Commission, says the regulators need to catch up to the modern world. For many investors, websites and apps have displaced the traditional relationship between a registered financial advisor and their client, but the regulatory regime is still built according to the blueprints of that one-on-one dynamic, she says.

“So, the challenge for us as lawyers and for the businesses themselves and the regulators, to a certain extent, is how to tailor the regulation to fit the specific product,” she says.

Cowdery says these new products, which allow a customer to quickly open an account, answer questions determining their investment objectives and risk tolerance before the site fits them with the right portfolio, is a positive achievement for investors. But as robo-advisors emerged, regulators were concerned with the lack of any human relationship between investor and advisor — how can the firm know the client and make suitable investments if they’ve never met? — and the commissions had a “very cautious and conservative” approach, which is still the norm, Cowdery says.

“The regulatory system still expects full ‘know-your-client’ suitability analysis,” she says.

The regulators initially considered requiring robo-advisors to call everyone who opened an account to go over the answers they gave — which Cowdery says would be a waste of time. Ensuring the questions properly appraised the customers’ intentions and having a registered portfolio manager go over all the accounts on the back end turned out to be enough, she says.

However, there’s a “whole slew” of other requirements, which haven’t been adjusted to fit the shape of robo-advising, and the key for lawyers is to show they’re in compliance with regulations that were written for “one-on-one” advisor-client relationships, Cowdery says.

Robo-advisors are “required to collect a robust client onboarding process” either through face-to-face communication or an online questionnaire approved by the Canadian Securities Administrators, says Mary Lou Frazer, senior public affairs specialist at the Ontario Securities Commission.

“They’re not telling Wealthsimple you don’t have to comply with this, that and the other thing. You do have to comply with everything,” Cowdery says.

Mark Wright, director of communications and stakeholder relations at the Ombudsman for Banking Services and Investments, says that, although they are still new and fewer complaints tend to be made during a positive market environment, the OBSI has received few complaints about robo-advisors.

“We’re talking one or two cases a year at this point,” he says.

While he was chairman of the OSC from 1993 to 1997, Edward Waitzer says, regulators were grappling with the technological transformation of industry at that time, too. But, in 2019, Waitzer, a partner and head of the corporate governance group at Stikeman Elliott LLP, says it is artificial intelligence that is “fundamentally changing” investment decisions, financial product marketing and distribution channels. This calls for forward-thinking legislators and regulators, as there needs to be protections that ensure customer interests are a priority that is built into the algorithms. He adds that a lot of the existing regulation may not be necessary in an AI world.

“The real regulatory challenge is how do you get politicians and regulators to think longer term, to think forward and longer term in a world where the political calculus — unfortunately supported by the media — is very short term,” he says.

On the wider regulatory front, there have recently been several key developments in the regulation of wealth management, says Harold Geller, an associate in the financial loss advisory group at MBC Law PC. One aspect of Geller’s practice is representing plaintiffs who are suing stockbrokers, mutual fund representatives, insurance agents and financial planners.

Canada’s financial industry is regulated by provincial commissions. Unlike most countries in the developed world, Canada has traditionally classified a federal regulator such as the U.S. Securities and Exchange Commission as unconstitutional. This may change, after the November 2018 Supreme Court of Canada decision Reference re Pan‑Canadian Securities Regulation. The decision sets the stage for a pan-Canadian regulator overseen by a council of ministers representing provincial and territorial governments.

But despite the view by proponents that a national regulator will be a more robust and concentrated force against financial criminals, Geller worries it may be a step back for investor protection if the provincial governments are able to harmonize their objectives to create it in the first place.

“Between different participants, it’s hard to see how that’s going to move forward,” he says, adding that the move to a country-wide regulatory scheme could downgrade consumer protection. The cost for industry of manufacturing investment products may go down, but the risk to consumers appears to have gone up because there may be “watering down” of standards in some provinces, he says.

“And it also appears that any changes in the future are going to be held ransom to political issues that may not be as associated with the securities industry. That’s because the final decision-makers will be the council of ministers, all political elected officials,” he says.

If agreement cannot be achieved among the provincial players in the pan-Canadian regulator — for example, they have disagreed over consumer initiatives in the past — “nothing can change,” he says.

Waitzer has been involved in the initiative to establish a pan-Canadian regulator since the 1970s and says public officials are unlikely to make a federal regulator happen given the necessary expense of political capital it would require. If it did happen, the “theoretical benefit,” he says, is not just harmonization of provincial frameworks but the integration of financial regulation with other major policy concerns.

“It kind of makes sense to be dealing with the whole financial sector together, rather than carving out securities from banking and insurance,” he says. “It kind of makes sense dealing with them as a national problem, because these are national issues.”

Because most Canadians are not investing to grow a fortune but are saving for retirement, for a home and for their kids to go to university, financial regulation should be connected to education policy, health policy and social security, he says.

Another recent regulatory development is a February ruling by the Supreme Court of Canada, which means lawyers now should be especially careful when they refer clients to financial advisors. In Salomon v. Matte‑Thompson, Kenneth Salomon, a lawyer, referred his client to and gave an enthusiastic endorsement of financial advisor Themis Papadopoulos and his unregistered firm Triglobal Capital Management Inc. Papadopoulos disappeared with $5 million of the client’s money and Salomon and his firm, Sternthal Katznelson Montigny LLP, found themselves sued for breaching his duty to advise his client and placing himself in a conflict of interest. Salomon won the trial, but the Quebec Court of Appeal and then an eight-to-one Supreme Court found the lawyer to be liable for the losses.

In Ontario, there are divergent objectives between a deregulation-intent provincial government and the securities commission. In September 2018, the Canadian Securities Administrators, an umbrella group of provincial regulators including the OSC, announced its intention to ban certain embedded fees in mutual funds, which the regulators said have an inherent conflict of interest and “give rise to investor protection concerns.” The CSA released the proposals for a 90-day comment period to gain feedback, but the day it was announced, Ontario Finance Minister and Chair of Cabinet Victor Fedeli publicly stated the government did not support these changes.

In a statement delivered by his press secretary, Robert Gibson, Fedeli said he is “an advocate for choice for investors,” meaning he wants a “fair and open capital market system.” He said the embedded commissions “enabled Ontario families and investors to save towards retirement and other financial goals.”

The OSC has been pushing for the rules suggested by the CSA since when he was chairman, says Waitzer, adding that it is not a Liberal or Conservative issue but a difficult one for any government. “You have highly concentrated industry interest on one side and so-called retail investors on the other side, who don’t have a strong voice,” he says.

What was surprising was not the government’s opposition, he says, but the fact it announced this opposition on the day the comment period began, “which defeats the purpose of the comment process.”

“Given the present deregulation, buyer beware, businesses-first approach of the present Ontario government, further watering down of consumer protections are likely and no progress toward transparency or fairness is anticipated,” Geller says.

The regulatory situation in Ontario is “almost a little bit schizophrenic,” Cowdery says. On the one hand, the OSC had initiated a project called “client-focused reforms” — an investor-protection, regulatory initiative that would have been “quite costly” to industry, she says. But pivoting to the opposite direction, it more recently launched what the OSC calls an “unprecedented consultation” aimed at cutting the “regulatory burden.”

Frazer says the consultation is for “identifying new actions we can take to save time and money for market participants, while maintaining investor protections.” And having already received 65 comment letters from “industry associations, market participants and investors,” the OSC hopes to “eliminate requirements that are outdated or unduly burdensome.”

“We’re in a bit of a state right now of regulatory uncertainty. . . . It’s an interesting time to be a lawyer in this in this field,” she says.

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