The first instalment in a three-part series on the risks of being sued – and how to protect yourself.
Landing in court is a nightmare no financial advisor wants to experience. Now, it appears that the chances of you doing so are rising significantly, due to a range of fundamental changes in the financial advisory landscape, from rising professional standards to increasingly activist regulators and investors.
Of particular concern is a proposal to impose a new “best interests” test on advisors who deal with retail clients, which would probably lead to more lawsuits against advisors, says John Fabello, a partner at Torys LLP.
“If the ‘best interest’ standard goes through,” he says, “there will be litigation on that issue, not so much because it is necessarily going to create a different standard but because the court will need to figure out what the heck it means. Clients seem very quick to complain these days.”
In a closely related development, enforcement actions by regulators are rising and can have devastating consequences on your career, Fabello notes. More than 70% of recent regulatory actions have resulted in a licence suspension.
“The regulatory side, unlike the court side, has the ability to pull your licence – and it’s doing that with greater frequency,” Fabello warns. “When [regulators] do it, you are going to have to sit on the sidelines for longer.”
There are three main topics that tend to trip up advisors when it comes to running afoul of the courts and regulatory bodies: know your product (KYP), know your client (KYC) and suitability.
In terms of KYP, advisors often get caught on the fine print. Eric Dolden, a litigation partner with Dolden Wallace Folick LLP in Vancouver, recalls that prior to the recent recession, banks were packaging annuities products, which advisors were relying on, that guaranteed clients a monthly payment and a cash payout at the end of the term. However, buried deep in the disclosure document was a provision allowing the banks to freeze the product and pay out the cash value if the market crashed. That scenario happened in 2008, leaving clients short of their expectations and creating a flood of claims.
“The technical wording in prospectuses is so complicated,” Dolden warns. “The ‘know your product’ rules require advisors to understand the essential attributes and what the risk factors are, and you have to tell your clients what the risk factors are.”
As for suitability and KYC issues, they often go hand in hand. “A lot of this is common sense,” says Harold Geller, a lawyer in Ottawa who represents both financial advisors and investors in liability cases. For example, telling an 85-year-old to take a long position in a stock that’s expected to pay out handsomely in 10 years will raise red flags.
Of course, litigation is nothing new in the financial advisory business, with surges in lawsuits occurring after downturns and recessions; what’s changing is the complexity, frequency and costs.
“There’s always an uptick in the number of filed lawsuits in the immediate aftermath of a recession,” notes Dolden, who represents errors and omissions (E&O) insurers.
Although being sued for professional reasons may seem unlikely to you, the costs, if it does happen, can be high. A simple lawsuit costs a minimum of $50,000 to take to trial. If you have E&O insurance, it’s the insurer who usually is running the show. The insurer may decide to end the litigation by settling a matter, even if you believe that you are blameless. You still might have the option to continue fighting the suit; however, the risks and costs must then be borne by you.
Settlements can have other ramifications: even if there is no adverse court ruling, you may be liable to your company for the costs of the settlement under the terms of professional indemnity clauses in your contract with your employer. You should also ensure that you are carrying the right amount of E&O insurance that carries into retirement – so-called “tail” insurance. Negligence claims from clients can come back to haunt you while you are sipping drinks on the beach.
Given these kinds of consequences, it’s not surprising that much controversy has arisen over the proposals for a new “best interests” rule to govern the relationship between advisors and their clients. The Canadian Securities Administrators’ (CSA) consultation paper No. 33-403, released in December 2013, reveals deep rifts in the financial services sector over whether or not to adopt a best interests standard for imparting advice to retail clients. The paper notes that a new standard would increase uncertainty for advisors while the practical effects are debated and litigated.
The current standard requires you to act “honestly and in good faith” when dealing with your clients; many in the financial services sector believe this is sufficient to protect both clients and their advisors. Critics of the proposed standard are concerned that it will be confusing and make it more difficult for advisors to fulfil their professional obligations.
They also argue that robust and flexible investor protections are already in place – and that creating this standard could backfire and lead to high investment costs and fewer advisors catering to smaller accounts.
In contrast, supporters of such a standard say the proposed rule, which is akin to creating a fiduciary duty, is necessary to “level the playing field” between knowledgeable advisors and their less knowledgeable clients. Such a duty would, in effect, require you to place the interests of clients ahead of your own.
Next: The growing compexity of claims
The growing compexity of claims
Creating even more uncertainty is the growing complexity of claims against advisors, leading to longer and more costly litigation. In the past, claims against advisors generally fell into three basic categories: breach of contract, negligence and breach of fiduciary duty.
Now, says Laura Paglia, a litigation partner with Borden Ladner Gervais LLP in Toronto, advisors face a “laundry list of allegations,” ranging from the basic three to newer violations, including breach of regulatory obligations and misrepresentation. Says Paglia: “It’s a kitchen sink.”
Not only that, but plaintiff lawyers know the chances of getting a settlement or favourable judgment in a civil case increase if the advisor is found to have breached a regulatory requirement. So, a regulatory complaint often will be made against you in anticipation of the lawsuit.
Paglia, who drafted the responses of the Investment Industry Association of Canada (IIROC) and the Mutual Fund Dealers Association of Canada to the CSA’s paper, says her concern is that a “best interests standard” would create a “new assumption” – that “all relationships with advisors are fiduciary in nature.”
That’s not the case under common law, she notes. The courts look at advisors across a spectrum. At one end are order-takers; at the other are discretionary money managers. If you have discretion on your clients’ accounts, you may be subject to fiduciary duties; if you’re simply an order-taker, you’re not. For those in between, the courts look at a range of factors in determining if you were offside in your recommendations or treatment of your client.
In addition to other issues, such as reduced client service, a statutory fiduciary duty could lead to bigger damages because a fiduciary must account for ill-gotten profits, Paglia says, even if the client suffers no harm.
Then, there are the growing risks presented by informal systems of conflict resolution, known as alternative dispute resolution (ADR), systems set up to handle complaints at the dealer and industry levels. For example, the Toronto-based Ombudsman for Banking Services and Investments (OBSI) hears cases valued at up to $350,000, with no costs to investors. IIROC’s arbitration system hears cases worth up to $500,000 and requires investors to pay a fee.
IIROC’s program has been a bust, with only 12 cases opened in 2012 and four in 2013. Fabello says that’s because the OBSI system is free for investors, whereas clients have to pay an arbitration fee to access IIROC and usually require a lawyer: “[IIROC] requires [investors] to put skin in the legal game.”
According to OBSI’s most recent annual report (for 2012), it opened 446 new cases that year – more than one a day. (The 2013 annual report is expected to be released later this month.) That figure was up from 405 cases in 2011, but down from 599 in 2009.
Of the 381 investment cases OBSI dealt with in 2012, the ombudservice recommended remuneration in 42% (161 cases), for a total of $3.6 million. The average award was $22,613; the highest was $193,943. A typical investigation takes 326 days to resolve.
The top five issues reported include: suitability – by far the largest complaint, as it was the main issue in 146 cases; fee disclosure, the main issue in 44 cases; leverage, the main issue in 33 cases; transaction errors, the main issue in 30 cases; and unauthorized transactions/churning, the main issue in 22 cases.
But, Paglia says, ADR doesn’t have the same safeguards as the courts, in which evidence is obtained under oath and tested in cross-examination. “Credibility is a huge factor,” in a court case, she says. “A judge has to determine who is telling the truth and whose story sounds more credible.”
The courts also will look at mitigating factors, such as contributory negligence on behalf of the investor. In contrast, Fabello says, OBSI refuses to acknowledge clients’ responsibility for their losses.
Another “sticking point,” adds Fabello, is OBSI’s methodology for calculating lost opportunity, which often “bears no resemblance to what the clients say they actually wanted.”
In the mid-February issue: How advisors can avoid litigation
Next: Leading cases give some guidance to the future
Leading cases give some guidance to the future
There is no shortage of court rulings testing the boundaries of financial advisor negligence. A sampling:
Ridel v. Cassin
This must-read case, which is heading to the Ontario Court of Appeal, is a classic “he said/they said” battle between an advisor and his firm. This is a textbook case on what not to do as a client, advisor or firm supervisor; and it dates back to the collapse of the high-tech bubble in 2000. The court found the advisor “traded recklessly” and failed to meet his KYC obligations by ignoring the clients’ risks, and that his firm is vicariously liable.
Young Estate v. RBC Dominion Securities [DS] and Houghton
Unlike “Cassin,” this is a textbook case on what an advisor did right. In this 2008 case, the plaintiffs sued their investment advisor and DS after suffering losses in their non-discretionary trading accounts, including a margin account, which held a high concentration in Nortel Networks Corp. shares. The ruling is notable for the 22 principles the court gleaned from other cases concerning investment advice.
Canaccord Capital v. Roscoe
This June 2013 case from the Ontario Court of Appeal dealt with an indemnity claim against an advisor. Canaccord settled a claim in 2009 without the advisor’s involvement, then sought indemnification from him under his employment contract. The advisor denied liability. In 2011, Canaccord sued for indemnity. An appeal court found in the advisor’s favour, based on a missed limitation period.
Abrams v. Sprott Securities
This 2003 Ontario case says the standard of care that applies to an inexperienced investor is considerably higher than the standard that exists between a broker and a seasoned investor.
Hunt v. TD Securities
This 2003 Ontario Court of Appeal decision found that for a relationship to be enforced as being fiduciary, there must be something more than a simple undertaking by one party to provide information and execute orders for the other.
Davis v. Orion Securities
This 2006 Ontario case discussed suitability, including five factors that advisors need to consider: a client’s age; income and net worth; investment knowledge; investment objectives; and risk tolerance. The court ruled: “On a best efforts basis, the broker will ascertain all relevant information from the client, such as his awareness of risk and return; the time horizon for his investments; and his net worth.”
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