2.3 Client Focused Reforms (CFR) and Conflict Management

2.3 Client Focused Reforms (CFR) and Conflict Management

Implemented jointly by the Canadian Securities Administrators (CSA) and CIRO in two phases throughout 2021, the Client Focused Reforms (CFR) substantially amended National Instrument 31-103. The reforms established higher standards across four core operational areas: Conflicts of Interest, Relationship Disclosure Information (RDI), Know Your Client (KYC) / Know Your Product (KYP), and Suitability determinations.

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1. The Conflict of Interest Management Framework

Under amended NI 31-103 (Division 2, Section 13.4), a conflict of interest exists whenever:

• The interests of a client and the interests of the registrant (the firm or individual dealing representative) are inconsistent or divergent.
• The registrant may be influenced to put their own interests—or the firm's interests—ahead of the client's interests.
• There is a reasonable perception that a reasonable client would consider the conflict important when deciding whether to do business with the registrant.

The Three-Step Compliance Protocol

Registrants must adhere to a mandatory three-step conflict management workflow:

                          CFR Conflict Management Workflow
                                         │
     ┌───────────────────────────────────┼───────────────────────────────────┐
     ▼                                   ▼                                   ▼
1. IDENTIFY                         2. RESOLVE                          3. AVOID
Identify existing & foreseeable     Address in the BEST INTEREST        Avoid conflicts that cannot
material conflicts of interest      of the client                       be resolved in client's favor

1. Identify: Firms and registered representatives must take reasonable steps to identify existing material conflicts and those that are reasonably foreseeable.
2. Resolve: All material conflicts must be addressed in the best interest of the client. This means prioritizing the client's financial outcome over the compensation, profit, or convenience of the firm or representative.
3. Avoid: If a material conflict cannot be resolved in the best interest of the client, the firm and representative must avoid the conflict entirely.

The Demise of "Disclosure-Only" Compliance

Prior to the CFR amendments, dealer firms frequently managed conflicts simply by drafting lengthy disclosure paragraphs in account agreements. Regulators determined that retail investors rarely understood these disclosures and that disclosure alone failed to mitigate the harmful effects of conflicted advice. Under CFR:

• Disclosure is NOT a substitute for conflict mitigation: Registrants cannot satisfy their legal obligations by simply disclosing a conflict to a client.
• When disclosure is provided, it must be delivered in plain language, in writing, before or at the time of the transaction, clearly explaining the nature of the conflict, the potential risks to the client, and how the firm has addressed the conflict in the client's best interest.

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2. Banned and Conflicted Sales Practices

CFR and companion amendments to National Instrument 81-105 Mutual Fund Sales Practices codify bright-line bans on commercial practices that compromise objective client advice:

Prohibited and Restricted Practices

1. Fund-Company Sales Incentives (NI 81-105): NI 81-105 limits what fund companies and their affiliates may give participating dealers and their representatives. Sales contests, trips and other benefits tied to selling particular funds are not permitted. Only permitted forms of compensation, cooperative marketing and conference support, and non-monetary benefits of minimal value, are allowed.
2. Internal Incentives and Compensation Grids (CFR conflicts rules): CFR does not list every banned pay practice. It requires firms to identify compensation that rewards selling particular products or hitting volume targets, address those conflicts in the client's best interest, and avoid any conflict they cannot address that way. Disclosure alone is not enough (MFD Rule 2.1.4; NI 31-103 s.13.4). CSA guidance flags product-specific bonuses, volume targets near period-ends and higher payouts for proprietary products as practices that are very difficult to justify.
3. Proprietary Product Favoritism: A firm that offers both proprietary funds (managed by an affiliate) and third-party funds must address the resulting conflict. It must disclose its proprietary focus in its relationship disclosure, and its suitability determinations must consider a reasonable range of alternatives and the impact of costs.
4. Deferred Sales Charges (DSC): Effective June 1, 2022, NI 81-105 amendments prohibited fund organizations from paying upfront sales commissions to dealers, which ended new DSC and low-load purchases. Units bought earlier continue on their original redemption schedules. The same amendments banned trailing commissions to order-execution-only dealers.

Heavily Scrutinized Branch Practices

• Referral Arrangements (MFD Rule 2.4.2; NI 31-103 ss.13.7-13.10):
  • The terms must be set out in a written agreement between the Member and the other party before any client is referred.
  • The Member must record all referral fees; a representative may not take unrecorded referral payments.
  • Before the receiving party opens an account or provides services, the client must receive written disclosure: the parties, the purpose and material terms, any conflicts, the method of calculating the fee (and the amount, where possible), and each registrant's category and permitted activities.
  • The Member must take reasonable steps to confirm that the person receiving a referral is qualified and, where required, registered to provide the services. Changes to the arrangement must be disclosed before the next fee is paid or received.
• Gifts and Business Entertainment (NI 81-105):
  • Fund companies may give dealing representatives only non-monetary benefits of a promotional nature and minimal value, and only infrequently (NI 81-105). Dealers set their own specific dollar limits and logging requirements in their policies.
  • Business entertainment (meals, sporting events, golf outings) is permitted only if it has a genuine, documented business purpose, is infrequent, and is not lavish or extravagant.
  • Representatives cannot attend educational conferences where fund sponsors subsidize personal leisure activities, golf rounds, or family travel expenses.
• Outside Business Activities (OBAs):
  • Approved persons must disclose all outside business activities, employment, corporate directorships, and volunteer roles to their dealer member for supervisory approval prior to commencing the activity.
  • Positions of Influence: Outside activities that put a representative in a position of influence (e.g., church treasurer, nursing home administrator, physician, religious leader) count as outside activities under MFD Rule 1.3. They require disclosure and prior written approval, and the firm must address the conflict. Controls often include restricting or prohibiting dealings with the people the representative influences.

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3. The Know Your Product (KYP) Due Diligence Framework

CFR elevated Know Your Product (KYP) from an implicit supervisory principle into an explicit, enforceable statutory requirement under NI 31-103 Section 13.2.1. KYP operates as a mandatory two-tier responsibility:

                      The Two-Tier KYP Due Diligence Framework
                                         │
     ┌───────────────────────────────────┴───────────────────────────────────┐
     ▼                                                                       ▼
Tier 1: Firm-Level KYP                                       Tier 2: Representative-Level KYP
- Conducts deep product due diligence                        - Understands product mechanics & risks
- Evaluates structure, risks, complexity, & MER              - Evaluates total cost impact on net return
- Approves securities for the firm's product shelf           - Compares against reasonable alternatives on shelf
- Ongoing monitoring for material changes                    - Only recommends firm-approved securities

Tier 1: Firm-Level KYP Due Diligence

Dealer members must maintain a formal, written product due diligence process before adding any mutual fund or security to their approved product list ("the shelf"):

• Analysis Criteria: The firm must examine the security's legal structure, underlying asset classes, investment strategy, liquidity, historical performance, volatility, and total fees (Management Expense Ratio - MER, Trading Expense Ratio - TER, and management fees).
• Shelf Diversity: Dealers must assess whether their shelf provides a sufficient diversity of low-cost, competitive products suitable for their client demographic.
• Ongoing Monitoring: The firm must continuously monitor approved products for material changes—such as portfolio manager resignations, style drift, regulatory actions, or unexpected increases in risk ratings.

Tier 2: Representative-Level KYP

Individual mutual fund dealing representatives must satisfy rigorous product proficiency requirements:

• Understanding Features & Costs: The representative must master the structure, returns, underlying holdings, and risk factors of every recommended security. Crucially, the representative must understand the impact of all direct and indirect costs (e.g., front-end loads, MERs, short-term redemption fees) on long-term client returns.
• Shelf Comparison Mandate: When recommending a security, the representative must consider a reasonable range of alternative products available on the firm's shelf (including comparable lower-cost funds or different share classes, such as fee-based Series F vs. commission-based Series A) to confirm that the recommendation puts the client's interests first.
• Prohibition on Off-Shelf Recommendations: Mutual fund dealing representatives are strictly prohibited from recommending or facilitating purchases of securities that have not been vetted and formally approved on the dealer member's product shelf.

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4. CRTC Telemarketing Rules and the National Do Not Call List (DNCL)

In addition to securities-specific regulations, branch prospecting activities are subject to federal telemarketing rules administered by the Canadian Radio-television and Telecommunications Commission (CRTC) under the Telecommunications Act.

Core Telemarketing Obligations for Branch Staff

Any representative conducting unsolicited telephone calls to solicit new mutual fund clients must comply with the Unsolicited Telecommunications Rules (UTR):

1. Registration and Subscription: Mutual fund dealers and branches that telemarket must register with the National DNCL Operator and subscribe to the National Do Not Call List (DNCL), paying the applicable fees.
2. Mandatory 31-Day List Scrubbing: Dealers and representatives must download the updated National DNCL and scrub their prospective calling lists at least once every 31 calendar days before initiating outbound calls.
3. Internal Branch Do Not Call List:
   • Every branch must maintain an internal, branch-specific Do Not Call List.
   • If a consumer verbally requests not to be called again during a telemarketing call, the representative must immediately record the consumer's name and telephone number.
   • The request must be added to the dealer's internal list within 14 calendar days and remains effective for a minimum of three years.
4. Permitted Calling Hours:
   • Outbound telemarketing calls are legally restricted to:
     • Monday to Friday: 9:00 AM to 9:30 PM (local time of the recipient).
     • Saturday and Sunday: 10:00 AM to 6:00 PM (local time of the recipient).
5. Mandatory Identification Disclosures:
   • Immediately at the beginning of the call, the representative must clearly state:
     • The full legal name of the representative.
     • The full legal name of the dealer member firm on whose behalf the call is made.
     • The commercial purpose of the call.
     • A local or toll-free telephone number where the dealer can be reached.

The Existing Business Relationship (EBR) Exemption

Under the CRTC rules, representatives are exempt from the National DNCL prohibition if they have an Existing Business Relationship (EBR) with the consumer:

• The consumer currently holds an open account or has conducted a financial transaction with the dealer within the past 18 months.
• The consumer submitted an inquiry or application to the dealer within the preceding 6 months.