As inappropriate leveraging strategies attract the attention of regulators, advisors and their firms are being urged to exercise greater care in determining client suitability and to more clearly disclose the risks.

Compliance examinations of securities dealers conducted by the Investment Industry Regulatory Organization of Canada (IIROC) have turned up a growing number of cases where clients did not fully understand the costs and risks of borrowing. IIROC has responded with a proposed list of best practices for ensuring proper suitability and maintaining adequate supervision with respect to leverage.

“We are finding more instances of inappropriate use of leverage and although it is not a significant trend, it is an important issue when it comes to investor protection,” says Rosemary Chan, senior vice president of compliance with IIROC. “The rules are clear in terms of the amount of leverage available in margin accounts, but firms need to have a more robust framework in place to supervise accounts.”

Whereas margin accounts advanced by the member firm are easily visible to firm supervisors, loans obtained through third parties such as banks are considered off-book, and are more difficult to monitor. Chan says firms must have adequate systems to flag off-book leverage and ensure appropriate strategies.

The difficulties in monitoring these kinds of loans increases when the off-book loan has not been recommended by the advisor, but the client has obtained a line of credit independently, possibly by putting their home up as collateral.

“Advisors need to ask more questions to fully understand the client’s circumstances and ensure suitability requirements are being met,” Chan says. “Some clients may borrow on their own initiative. Advisors should be asking questions about where money is coming from, and not ignoring red flags.”

The Canadian Foundation for Advancement of Investor Rights (FAIR) is concerned that the current rules do not provide adequate investor protection with respect to the use of leverage. FAIR has urged the Canadian Securities Administrators (CSA) to “institute a presumption that leverage is unsuitable for retail investors,” thus placing the onus on the salesperson and firm recommending the leverage to prove that it is suitable for the client.

FAIR also recommends a certification requirement that would oblige advisors to certify that they have explained the risks associated with leverage to the client and certify their belief that the client understands these risks. Another recommendation of FAIR is that independent legal advice be obtained when a home is to be used as security for leveraged investing.

“Many people are being talked into borrowing substantial amounts of money to buy mutual funds and in some cases are mortgaging their house or taking a home equity line of credit,” says Ermanno Pascutto, executive director at FAIR. “A systemic incentive appears to be in place for advisors to recommend leverage to clients in situations where it’s clearly unsuitable.”

Pascutto suggests that advisors and mutual fund dealers offering access to loan programs may be looking to encourage leverage as a means to increase sales in difficult times. He is encouraging regulatory bodies such as the CSA and Ontario Securities Commission (OSC) to prioritize leverage as a key area of concern.

“We have warned regulators to get ahead of the problem and fire a shot across the bow before it gets worse,” Pascutto says. “Many people are being seriously harmed by inappropriate leverage. The onus should be on the financial advisor to prove that leverage is suitable for the client.”

Chan says leveraging strategies may be attractive to some individuals and are “totally appropriate” in some cases, but clients must be able to understand the implications of leveraging if their investments lose value, as well as their obligations to service the debt in a fluctuating interest rate and stock market environment.

This is the second article in a three-part series on leveraging to invest. Tomorrow: the best ways to borrow.