Proposed CSA Reforms and the Effect on Our Culture of Compliance

In June 2018, the Canadian Securities Administrators published proposed amendments to National Instrument 31-103 and Companion Policy 31-103CP. I have chosen to analyze three major components of those proposed reforms:

  • Know your product (KYP);
  • Suitability, and;
  • Conflicts of Interest

These proposals are client-focused reforms that put the interest of the client before any other consideration relevant to the client-registrant relationship. Some of these proposed amendments would impose new requirements, while others would codify best practices set out in existing CSA and SRO guidance. The combination of the codification of best practices and the introduction of new requirements will result in a new, higher standard of conduct for all registrants.[1]

Client-Focused Reforms

In order for registrants and registered firms to deal honestly and fairly with clients, these amendments are designed to apply to each stage of the client-registrant relationship. The KYC and KYP amendments form the foundation for other provisions: KYC is intended to provide clarity about the regulators expectations of what information must be collected about a client; KYP outlines what constitutes a thorough understanding of products and full transparency of product attributes in client communication. In addition, the provisions address how conflicts of interest should be dealt with in the best interest of the client, including restrictions on referral arrangements and prohibitions against misleading marketing and advertising. In the conflicts of interest and suitability amendments, registrants would have to resolve all existing and reasonably foreseeable conflicts of interest by putting the clients interest first. These include conflicts resulting from compensation arrangements and incentive practices.

Developing and Maintaining a Culture of Compliance

There seem to be numerous differences in the culture of compliance among firms, especially in how it is implemented in small dealers compared to larger bank-owned institutions in Canada. I have found that bank-owned dealers compliance professionals are disinclined to support new product development, whereas compliance departments at smaller dealers work more collaboratively with the business in new product design and marketing. The banks tick-the-box approach to compliance creates a rigid evaluation system based on existing product structures. So, new products are unlikely to fit the established criteria. This creates lost opportunities for the bank client. One possible reason for this rigidity is that the banks have a powerful distribution channel, which means they do not have to be innovative to compete. Smaller dealers, on the other hand, must develop a strong value proposition, which requires innovation to compete against the banks.

Innovation has its upside as well as its downside. Langevoort states that companies with higher incidence of executive cheaters were also more creative and inventive. Psychologists have uncovered solid experimental evidence linking cognitive creativity and unethical behaviour. Those engaged in promoting better compliance have to be good students of the social science, not nave intuitionists.[2] You have to know what drives business managers and various actors. As much as we need to know your client/product, we need to know the firm and its actors to successfully implement a suitable compliance regime.

A socially optimal compliance program can be defined as what a rational, profit-maximizing firm would establish if it faced an expected sanction equal to the social cost of the violation.

According to Langevoort, the common structural framework for compliance includes:

  • a commitment from senior leadership to the task, setting a right tone at the top;
  • delegation of authority to officials with distinct compliance responsibilities and the resources to do their task;
  • firm-wide education and training about both the substance and process of compliance;
  • informational mechanisms to alert as to suspicious activity (e.g., whistleblowing procedures);
  • audit and surveillance tactics to detect compliance failures or risks;
  • Internal investigation, response, discipline and remediation to learn and adjust when failures occur. [3]

Under the Organizational Sentencing Guidelines (OSG) in 2004, attention to ethics and culture was made an explicit compliance goal: Firms are expected to promote an organizational culture that encourages ethical conduct and a commitment to compliance with the law.

Most human beings cheat less than they could, but more than they should. Orthodox economists are wrong to say that people generally just maximize self-interest by trading off the risks and benefits of opportunism. People generally have a desire for a positive identity and a good reputation. The compliance instinct is to err on the side of caution. On matters relating to the suitability and adequacy of risk disclosure in the sale of complicated financial products to customers, informed consent is something of the norm. In most circumstances, neither lawyers nor compliance personnel become intimately involved in the sales process, although the latter will certainly see the results within the surveillance system. Has there been informed consent? My sense is that salespeople are cognitively and culturally motivated to answer yes, and in normal circumstances, legal staff will usually leave those fact-specific inferences alone unless and until there is push-back.[4]

Another strong argument that Langevoort brings up is, if people in sales have come to place great faith in written disclosures to customers – so that aggressive sales tactics are fair after disclosure – then someone has to expose the illusion: disclosure does not dependably put customers on guard and can often enable opportunism. It is wildly known that clients do not pay much attention to written disclosures.

In the US, we have witnessed more deferred prosecutions with conditions to implement procedures and changes to the culture of the organization. Canada uses provincial tribunals to order sanctions and/or impose conditions under the respective securities acts. Negotiated settlements have required some firms to bring in compliance consultants as a condition for continuing to operate as a registrant.

Doubtless, key individuals in some firms will engage in self-interested behaviour to support competitiveness, which makes it difficult for a values-based approach to take root. So, directions from regulators must be clear and unambiguous; otherwise, it may defeat the purpose of regulation. However, regulators must also ask themselves whether laws are implemented for the right reasons or for political purposes. Wrong reasons will create additional headaches and obstacles for firms and encourage firms to be creative in circumventing regulations.

Creativity and innovation require risk taking and pushing boundaries, which Langevoort says could lead to unethical decision making.[5] While this may be true, innovation is essential in serving the interests of the end-client; a static business model will not yield client benefits as client needs change. In some organizations, compliance is perceived as too heavy- handed, impeding the sales/front line instead of working with it to ensure the firm as a whole is compliant, while achieving the end goals of the business. The cultures of compliance at large bank-owned firms may be perceived to be rigid, but that may be more attributable to a business model that does not require innovation to compete, rather than a put the client first mentality. A case in point is the sale of proprietary bank products: Is it conceivable that a proprietary product is in the best of interest of the client in the vast majority of cases? There have been at least two OSC enforcement cases in the recent past that have imposed fines on banks for incentives that preference the sale of proprietary mutual funds.[6] A recent article in the Wall Street Journal stated that in mid-December, Securities and Exchange Commission Chairman Jay Clayton told the U.S. Senate Banking Committee that investors dont want brokers or financial advisers to have hidden incentives or incentives that are clearly inconsistent with making a recommendation that is in the interest of their clients. Many brokers, banks and financial advisers take revenue-sharing payments – legal kickbacks that mutual fund companies pay to reward sales of particular funds. [7]

The desire to avoid ending up on the front pages of the paper is not a sufficient basis on which to build a culture of compliance. The key to creating a culture of compliance that works in protecting the integrity of the capital markets is developing a strong working relationship with the regulators. The tone from the top must establish a right thing to do approach as opposed to a climate of fear. Leadership plays an important role in being able to implement and follow ethical policies and procedures throughout the firm.

Further, regulators should not be perceived by the industry as only serving a policing and enforcing function. Langevoort cautions that prosecutors lack the expertise and incentives to create meaningful reforms that reduce the risk of recidivism, thereby imposing unnecessary costs or – if these terms are in lieu of some stronger sanction – diminishing deterrence. He also mentions that after reforms are imposed, prosecutors lack the time, resources or desire to revisit the firm to see whether the reforms made any difference. They have too much else to do and have moved on. The strong suggestion is that enforcers back away from imposing compliance-related reforms.

Bad outcomes are typically associated with bad culture. Regulators tend to be motivated to introduce new reforms in these circumstances. Perception matters when introducing new reforms. New regulations may be interpreted as intrusive signs of mistrust by those who had nothing to do with past misbehaviour. A culture of compliance needs to be based on shared values across the industry in the interest of the general public. Otherwise, the goal for firms becomes avoiding detection in a competitive market where regulation is an obstacle.[8]

The Proposed Reforms and Canadas Position on the LME/CME Continuum

In Liberal Market Economies, firms coordinate their activities primarily via hierarchies and competitive market arrangements. In Coordinated Market Economies, firms depend more heavily on non-market relationships to coordinate their endeavors with other actors and to construct their core competencies.[9] Canada is located close to the Liberal Market Economy (LME) on the continuum, although some attributes of Coordinated Market Economy (CME) are seen in closely held securities such as Bombardier, Barrick Gold and Magna, and in our supply management system.

I do not believe that the proposed CSA reforms, if implemented, change anything about where Canada lies on the LME v CME continuum outlined by Hall and Soskice. Some of Canadas key characteristics when it comes to securities regulation are: continuous disclosure rules; securities laws for social engineering (gender balanced boards, etc.); take-over bid rules and procedures which do not facilitate the take-over of control by the bidders, instead they protect the sellers; and the prohibition against insider trading. I do not anticipate that these proposed reforms will have a major impact on our disclosure policies or access to capital. These proposed reforms mostly codify best practices; therefore, I see no immediate impact in moving Canada closer to the CME continuum.



[1] CSA, Client Focused Reforms, Proposed Amendments to National Instrument 31-103 and Companion Policy 31-103CP

[2] Donald C. Langevoort,Cultures of Compliance,54 American Criminal Law Review. 54.4 933-977 (2017)

[3] Ibid.

[4] Ibid.

[5] Donald C. Langevoort,Cultures of Compliance,54 American Criminal Law Review. 54.4 933-977 (2017)

[7] Jason Zweig, Have I Got a Fund For You! Why Brokers Push Some Investments Wall Street Journal, January 4, 2019.

[8] Donald C. Langevoort,Cultures of Compliance,54 American Criminal Law Review. 54.4 933-977 (2017)

[9] Peter Hall and David Soskice,Varieties of Capitalism: The Institutional Foundations of Comparative Advantage,Oxford University Press, 2001 – Introduction.