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Canadian Securities Regulators Adopt Rules Against the Use of Deferred Sales Charges, OSC Places Restrictions

February 24, 2020

On February 20, 2020, the securities regulatory authorities of all the provinces and territories of Canada, except Ontario (Participating Authorities), announced the adoption of rules banning deferred sales charges (DSC) on mutual funds, which will take effect on June 1, 2022. The rules prohibit investment fund companies from paying upfront sales commissions to investment dealers, which incentivize the use of DSCs by dealers. Separately, the Ontario Securities Commission (OSC) published for comment a proposed rule that would place restrictions on the use of DSCs, instead of a blanket prohibition.
A DSC is a fee charged to a mutual fund investor if the investor redeems or sells their investment within a set amount of time, typically five to seven years from the date of purchase for traditional DSC options. Under the DSC model, the investor does not pay an initial sale charge for the purchase of mutual fund securities, but the dealer may receive an upfront commission from the manager of the mutual fund.
The DSC model has been in the regulators’ focus specifically due to the view that it leads to a conflict of interest for dealers and results in a “lock-in” effect, meaning that it deters investors from redeeming during the redemption fee period. On the other hand, proponents of the DSC model argue that the DSC option gives small investors access to financial advice which they otherwise wouldn’t be able to obtain due to the size of their portfolio. In 2018, the Canadian Securities Administrators (CSA) published for comment amendments to National Instrument 81-105 Mutual Fund Sales Practices that would, among other things, ban DSC options. On December 19, 2019, following a comment and consultation period, the CSA announced amendments to implement the DSC ban; the OSC, however, announced that it will not be implementing a DSC ban, but would instead explore alternative approaches for addressing concerns arising from the use of the DSC option.
The rules announced by the Participating Authorities will provide a transition period of almost two and a half years to allow dealers to adjust their business models. During this time, dealers will be allowed to sell mutual funds containing DSCs and the redemption fee schedules on those investments will be unaffected. The Participating Authorities will also grant relief to dealers from conflict of interest requirements that will take effect December 31, 2020, to allow the use of DSCs during the transition period.
The proposed rule announced by the OSC is intended to limit the circumstances in which DSCs may be sold, and to give clients greater flexibility to redeem these investments without penalties in certain circumstances. Specifically, the proposed rules would, among other things, (i) ban DSC sales to investors over the age of 60 or who have an investment time horizon shorter than the DSC schedule; (ii) limit the use of the DSC option to clients with account size below C$50,000; (iii) allow investors to redeem 10 per cent of the value of their investment annually without paying charges; (iv) shorten the DSC schedule to three years; (v) prohibit investors from borrowing money to purchase DSC funds; and (vi) provide a financial hardship exemption—such as involuntary loss of full time employment, permanent disability and critical illness—which would allow clients to redeem their investment without paying redemption fees in such circumstances. The OSC rule proposals are out for comment until May 21, 2020, and the OSC anticipates that the proposed rule would apply from June 1, 2022, the same date on which the DSC ban would come into effect in the other jurisdictions.
Even though Ontario is Canada’s most populous province, it is unclear how investment fund managers and dealers will respond as a result of the DSC ban in the other jurisdictions. In addition, the industry in general has been moving away from and several large investment fund managers have voluntarily discontinued the use of the DSC option, meaning that the life and prevalence of the DSC option may be limited, even in Ontario.
For further information, please contact:
Stacy McLean             416-863-4325
Norbert Knutel           416-863-4013
Jessie Dewdney          416-863-2299
or any other member of our Capital Markets group.