Advisors and the art of self-defence

The trick, Wirth says, is accepting that reality and practising preventive medicine so that when an issue does arise, you are both prepared and protected.

“At some point in your career,” Wirth says, “you will have to deal with these issues, whether through a civil lawsuit or a regulatory investigation. You will have to face a client complaint in some format and be prepared to respond to it, even if there is no merit.”

Although portfolio returns are starting to improve for many clients, the number of complaints against advisors continues to rise. The Investment Industry Regulatory Organization of Canada (IIROC) reported 1,484 complaints in 2012-13, up by 8.7% from 2011-12 and the highest number since 2009-10, when there were 1,482 complaints.

Regulatory bodies tend to receive different types of complaints. The top complaints for advisors regulated by IIROC are: unauthorized and discretionary trading; unsuitable investment recommendations; and misrepresentation.

The top complaints received by the Mutual Fund Dealers Association of Canada (MFDA) were: signing blank forms; leverage-related suitability; investments-related suitability; misrepresentation; commissions and fees; outside business activities; and discretionary trading.

In terms of dispute resolution at the Ombudsman for Banking Services and Investments (OBSI), the pattern repeats itself. The top complaints were: suitability of investments; fee disclosure; suitability of margin; transaction errors; and unauthorized trading.

When it comes to expertise, litigation risk boils down to three key areas: know your client (KYC), know your product (KYP) and knowing what is suitable for a particular client.

All of these are intertwined, says Harold Geller, a partner at Ottawa law firm McBride Bond Christian LLP who acts for investors and advisors in liability cases: “It’s the ‘know your client’ and ‘know your product’ failures that lead to suitability failures.”

However, the key element in any battle arising out of a client complaint is the issue of credibility. These disputes typically become a “he said/she said” slugfest, pitting advisor against client. So, the first line of defence is to document your client interactions as much as possible on key matters such as the client’s investment profile, recommendations and trades. You should be especially vigilant about trades, given that one of the main complaints investors tend to raise is unauthorized trading. Which party is believed can be the difference between exoneration and paying a large judgment – or having your licence suspended.

“If you are really busy, there is a temptation to cut corners,” says Wirth – by failing to document conversations properly or use technology to add notes to client files. But documenting client interactions becomes a habit, he adds, when you do it consistently as part of your daily process.

The more evidence you can present to support your version of events, the stronger your case will be, says John Fabello, a partner at Torys LLP in Toronto: “Notes are everything.”

Those notes should include followup letters to clients that outline what was discussed, what warnings or disclosures were made and what investing decisions were taken. Be specific, such as the amount and dollar values of proposed investments. It’s even better if you can get your clients to initial their instructions to you, especially if it involves a risky investment or something out of the ordinary.

Next: Steps you can take to limit your exposure
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Steps you can take to limit your exposure

Regarding specific areas, the KYC obligation is one of the most important. For KYC, there are a number of steps that you can take to limit your exposure.

First, there are good reasons for the standard forms issued by dealers. When you leave something blank or fail to fill these forms out properly, or if you get clients to sign blank forms that you fill in later (a regulatory no-no), it provides clients with ammunition in the event of a dispute.

“Make sure all your paperwork required by both the regulators and your employer is in top shape,” Wirth says. “It means that you have to take the time to open a matter properly and go and meet with clients.”

Doing so also makes “good business sense,” he adds, and develops deeper relationships with your clients.

Regularly update this paperwork. A client profile filled out 10 years ago is far too old. As circumstances change, the paperwork needs to reflect those changes, says Eric Dolden, a partner at Dolden Wallace Folick LLP in Vancouver who defends investment advisors when they are sued under their errors and omissions insurance coverage. One mistake Dolden sees constantly: “Financial advisors are not changing [a KYC profile] and updating it periodically to reflect the client’s knowledge.”

When assessing a client’s appetite for risk, Geller says, don’t simply lump clients in the same boat based on age or other, overly general markers – not all seniors are alike, for example – and don’t be tempted to substitute your own opinion. Says Geller: “You need to do a critical analysis and challenge the client.”

In Geller’s experience, investment firms often have inadequate forms and surveys for assessing client risk at the intake stage.

Do a genuine investigation. Don’t simply ask your client if he or she has a high, medium or low appetite for risk. Drill down and go behind the question. If the client claims a high tolerance for risk and wants to have 100% of assets in equities, push that client regarding how much of the capital he or she is prepared to lose.

Using concrete numbers rather than percentages to make your point can be quite instructive, for both you and your client. Asking your clients if they are comfortable with 20% of their money being invested in high-risk securities is different than asking if they are comfortable losing $20,000 of their $100,000 portfolio.

It is equally important to understand fully the features of the product that you are recommending. The investing world is full of landmines, and KYP requirements have never been so complex.

Advisors, says Wirth, “have to take the time to understand what they are putting people into. You cannot rely on knowledge from the past. Things are changing quickly.”

So, you need to take the time to read disclosure documents and fully comprehend the downside of any financial product that you recommend, information that usually is buried deep in the fine print.

Legal red flags should go up, Fabello adds, when “selling anything out of the ordinary, or anything that’s a little bit out of the ordinary.”

This includes hedge funds, leveraged exchange-traded funds (ETFs) and options. Says Fabello: “Don’t even consider selling a product unless you can, in your own words, describe how it works and disclose what the downside risks are fully and plainly.”

At a minimum, you should be able to say you’ve read the accompanying disclosure documents if asked under oath.

Explain to your clients how you are being compensated for investments and why you are recommending them. Tell clients about the warts, too – not just the upside. Document the contents of those conversations in followup letters to clients. If they do invest, lose money and then sue, claiming you didn’t tell them about the risks, you can produce that letter suggesting otherwise.

That’s why documenting client conversations – and then confirming them in writing with clients, along with what was decided – is so important. Geller notes that memories are faulty and, if you don’t document your conversations, “you are in a terrible position if something goes wrong.”

Regarding suitability obligations, the more information you can produce in a lawsuit, the better. Above all, make sure that whatever financial product you are recommending is properly aligned with the client’s investment policy statement and investing profile.

There are some particular investment vehicles to steer clear of in most cases. Beware of leveraged products, which can throw a serious wrench into your portfolio modelling. OBSI notes in its 2012 annual report that suitability complaints about leveraged ETFs are on the rise and among the key products OBSI is investigating.

In suitability matters, be particularly wary of clients who want to buy an investment that falls outside your recommendations, says Dolden. Confirm in writing with these clients that they specifically requested that you purchase the investment (be specific about the investment – e.g., 1,000 shares of XYZ Corp.). Confirm that you warned these clients that this investment was risky and not suited to them, reiterate your concerns and again caution them regarding the wisdom of the investment and recommend against it – but note that you will carry out their instructions as requested.

Next: A litigation avoidance checklist
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A litigation avoidance checklist

Here are some key practices that can help you steer clear of both the courts and regulators:

Retaining records. Lawsuits can arise years after an event, so it’s important to keep records for extended periods. Harold Geller suggests making electronic copies and keeping everything regarding each client until they and their beneficiaries die. Make sure you observe privacy laws and keep this information secure.

Take care that technology doesn’t surpass you; if it does, it could mean you can’t access your information because the format has changed.

Pay attention to warning signs. John Fabello notes that the regulators have set out their priorities, which should raise red flags for financial advisors. For example, the Investment Industry Regulatory Organization of Canada’s (IIROC) 2013 enforcement report notes: “The protection of seniors and vulnerable investors, as well as an enhanced focus on suitability, are key strategic priorities.” (One-third of IIROC disciplinary proceedings begun in 2011 and 2012 involved investors aged 60 or older.)

Monitor other regulators to stay aware of their priorities.

Avoid using margin. If a client insists on using margin, make sure you protect yourself by properly documenting and following up with the client regarding the dangers of leverage. And specifically explain, using monetary examples, how margin works and what happens when an investment declines in value. If you are sued, you will have a better chance of rebutting allegations that the risks were not communicated to the client.

Deal with problems immediately. If a client is upset about a trade, deal with it promptly. Ensure you find out if the client really wants you to cut the losses by selling. In the matters of negligence and breach of contract – two of the main causes of legal action that advisors face – the injured party has the duty to try to mitigate their damages. If a client sits on a loser against your recommendation, and its value continues to drop, then that client could be found partly responsible for the losses.

Avoid outside business activities. Geller deals with cases in which advisors see compliance as an “obstacle,” and think there are “better opportunities for clients outside the dealer.”

Don’t mix your outside investment activities with clients.

The second instalment in a three-part series on the risks of being sued – and how to protect yourself.

In the March issue: What to do if you are sued.

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