Advisor at Risk

Ellen Bessner

Ellen Bessner is a well known, leading litigator with commercial litigation firm Babin Bessner Spry LLP. Her more than 20 years of experience includes defending investment and insurance industry participants, including dealers and individuals at all levels of courts.

Don’t be lulled into a false sense of security that clients are not breaching laws or regulations that could lead to regulatory proceedings and litigation

By Ellen Bessner |

How far do advisors have to go to ensure that clients are not trading on insider information — particularly if they call with an unsolicited trade of a stock that is unknown to them?

We all know that the know-your-client (KYC) form includes a question concerning whether the client is an insider. However,  completing a KYC form is not done with each trade; so, what happens if things change and the client becomes an insider and seeks to use the advisor to execute trades based on insider information? Does the advisor have any additional duty to make inquiries?

According to the Investment Industry Regulatory Organization of Canada (IIROC), the answer is a resounding, "Yes" — as advisors are seen as gatekeepers. (See [2009] IIROC No. 43). Let's take a closer look at the cited example: Mr. Smith calls his advisor and instructs him to open accounts for his two adult children and further instructs the advisor to deposit a substantial amount of stock of a single public company into each of the adult children's accounts. The advisor does not meet the adult children and does no research on the stock because Mr. Smith is an important client that the advisor has served for years — and the advisor trusts him. Over a period of time, Mr. Smith instructs the advisor to execute trades in the adult children's accounts and the advisor executes them without asking questions or doing any research.

IIROC then investigates the advisor because Mr. Smith is an insider and the executed trades were meant to drive up the price of the stock. Had the advisor fulfilled his KYC and know-your-product obligations, he would have known that Mr. Smith was an insider as he was the CEO of the company in this case. Furthermore, this information was available publicly as it was on both the company's website as well as on the System for Electronic Document Analysis and Retrieval (SEDAR).

The hearing panel in this case found that the advisor failed to know his client and because of his failure to identify red flags with respect to the trades executed, as these were "peculiar, suspicious or appeared to be consistent with market manipulation, deception or other improper market-related activity." As a result, the advisor was fined $10,000.

So, not only did the advisor fail in his duty to know Mr. Smith and his two adult children, as well as identify the red flags, he also didn't know the product. If he had done some research on the product, it would have been revealed that Mr. Smith was an insider.

It would be remiss not to add that even if Mr. Smith had a power of attorney for his two adult children, the advisor would have breached his KYC obligations because he must meet every client to ensure trades are suitable. However, it could have been worse. If the adult children had lost money on the stock, the advisor would be unable to prove that the stock was suitable for these clients, as he had no evidence of having known them. That would mean that the advisor would have regulatory infractions as well as exposure to litigation.

Advisors are gatekeepers; so, regardless of how good a client may seem to be, advisors cannot allow themselves to be lulled into a false sense of security that clients are not breaching laws or regulations that could lead to regulatory proceedings and litigation against the advisor.

Related Content