Regulatory Effectiveness

Will the MFDA back up its threats?

I think it’s fair to say, the financial industry is at an interesting crossroad. In the MFDA’s January bulletin, member firms were notified that MFDA staff is starting a second round of compliance examinations. In this second examination, the MFDA will be reviewing the various deficiencies they uncovered in their initial examinations at member firms. In the conclusion of the notice, the MFDA noted: ‘any deficiencies that were noted in the first examination that have not been rectified will be considered for referral to the Enforcement Department of the MFDA.’ The question is: what deficiencies will actually be referred, and how will the Enforcement Department handle the referrals?

The deficiencies found in the first examination were extensive, and in some cases, down right embarrassing. The MFDA found evidence of everything from churning and discretionary trading (issues that were immediately referred to the Enforcement Department of the MFDA), to simple but obviously critical issues like:

• Trade blotters not being reviewed regularly
• No evidence of follow up on issues discovered on the trade blotter
• Not maintaining a log of client complaints and/or not responding to client complaints
• No branch compliance reviews being conducted

After reviewing the ‘common deficiencies’ discovered by the MFDA, someone from outside the financial industry might reasonably ask, ‘since mutual fund dealers were monitored by the various securities commissions prior to the invention of the MFDA, how could these types of basic supervision issues be common?’

They are common, because prior to the MFDA, dealers were so rarely disciplined for such infractions. It’s hard for a dealer today to take these threats seriously. Although cheep, user-friendly technology exists to wipe out almost all of the more mundane day-to-day suitability and review problems pointed out by the MFDA, compliance departments have a tough time justifying the costs (or even the effort) to management, when the perceived threat is so low.

This lack of dealer motivation is not just an MFDA inherited problem. According to a BCSC’s 2002 audit of the IDA, ‘since taking sole responsibility for member regulation at IDA firms in 2000 (prior to 2000 the jurisdiction was shared by the CDNX, formerly the VSE), not only was the volume of proceedings not commensurate with the IDA’s new regulatory role, at the time of the report, the IDA had taken no action against firms in the previous 24 months.’ Even today, a review of discipline statistics on the IDA website shows an appallingly low number of investigations.

I’m not aware of the IDA releasing numbers from any audits they perform at member firms, but having personally been through a BCSC audit prior to the MFDA as well as an IDA sales audit, I can tell you the number of unsuitable investment cases randomly discovered by auditors makes the tiny number of complaints that actually get documented by COMSET look ridiculous. Why are the numbers reported to COMSET so low? Almost certainly because of the cost and effort required by investors to hire legal council to try and chase down losses. If you go into the IDA’s statistic page again, you’ll see another possible reason: the number of cases of investors that win arbitration are also frightenly low. In such an environment it is easy to see why dealers take these reviews somewhat lightly.

The IDA’s attitude appears to have changed little since 2002 in regards to suitability and supervision complaints. For example, someone not familiar with the financial industry might wrongly assume the IDA would consider fining a dealer for improper supervision when an audit detects a large percentage of randomly reviewed accounts containing unsuitable investments. Instead, the IDA issues a written notice to the dealer to ‘correct the deficiencies’.

Hey, I’m the first to admit, it’s a lot easier to deal with the handful of investor’s who lose their shirts each year to some crook than it is to try and stamp out all of the unsuitable investment problems before they happen. I’m sure it’s a lot easier to type up a deficiency report and walk away from the mess than it is to demand immediate action, but aren’t regulators in business to guard against such messes happening in the first place?

To be fair, I should point out both the MFDA and IDA are fining and banning obvious crooks in slam-dunk cases in which the advisor has simply stolen money from clients. But to be effective as protectors of the average investor, both regulators need to be far more proactive than regulators have been in the past. Regulators need to start fining incompetent advisors, and complacent dealers instead of just waiting for the investor complaints to roll in.

So, as I said before, we appear to be at a crossroad: what will the MFDA Enforcement Department do with the referrals it receives following this second round of reviews? Will the MFDA follow up on its threats and start issuing serious fines to make compliance with their policies and rules worthwhile from a business point of view? Will the increased pressure for positive headlines spur the IDA into doing more to protect the average investor? The MFDA notices look promising, as do the initial round of fines issued for serious rule infractions. But without follow-up, the threatening looking ‘bite’ will fizzle into an annoying small-dog ‘bark’ that can again be safely ignored by dealers.