As of mid-2012, we’ve observed some recurring features in the wave of claims against financial advisors and their firms. The roots of most current claims arose between 2003 and 2007, when markets were mostly buoyant and many advisors based their advice on the proposition that rising tides lift all boats. As a result, many advisors had counselled clients to invest in equities that advisors promoted as solid but which history has proven to be otherwise.
In general, there are two types of current claims arising from that period. First, many people borrowed to invest. In a rising market, returns exceeded interest on the loans, creating what looked like instant profits. But in a declining market, leveraged investing virtually wiped out some portfolios.
In the second type, portfolio managers and advisors advised or encouraged bets on a narrow range of securities, such as penny stocks, warrants or single economic sectors that were more volatile than blue-chip investments. With resources prices rising more quickly than the overall market, this technique succeeded for a time.
But by late 2008, it was obvious that both the rising stock prices and the rampant resources price increases were long gone. The rapid drop in market values from mid-2007 to early 2009 made many investors uncomfortable. Behavioural finance experts predict that the herd will buy high (as in 2005-07) and sell low (as in 2008-09). That is what has happened.
By late 2009, it became obvious that these two particular strategies would never recover their pre-crash positions. An 85% loss followed by a 100% gain still nets out at a 55% loss. That compares with the broad general markets in North America, which had recovered to within shouting distance of their June 2007 levels (dividends included). The contrast with leveraged portfolios and most sector-specific strategies was stark.
Claims arising from this period, at their heart, are similar to other periods when retail investors were hit by volatile markets, such as the tech bubble in 1998-2000. That is, the advice was unsuitable for investors unfamiliar with risk. Was it appropriate for a person nearing retirement to invest 100% (sometimes more, with leverage) in equities? In penny stocks? In resources firms with weak balance sheets?
Financial advisors have either the experience or the training to realize that there have been many occasions since 1970 when markets have dropped precipitously – and stayed down for long periods. The stretch from 1969 to 1980 was bleak, and some parts were even bleaker than our present circumstances. Market drops are a part of the story, and investors must take that possibility into account when planning their affairs. Advisors know this and must advise their clients accordingly.
So, the claims that we are seeing now have this in common: people who could not afford to lose substantial sums invested too much money into the common shares of risky companies. Often, they invested money they did not own to buy securities they did not need to meet objectives they did not have. Such investors were undiversified and did not keep at least some funds in bank accounts and GICs.
Some advisors may tell an unhappy client that this was all the fault of the client or of the market. These advisors might suggest that the client was greedy, or that the client did not tell the advisor of the need for early withdrawal. But, really, this is why the client hired the advisor – to give advice appropriate to that client. If the advisor told the client to keep safe investments in reserve, then this is what clients ought to do. If such advice was not given, then whose fault is that: the paid expert or the uninformed, paying client?
So, what are the regulators doing about it? Recent decisions by the Investment Industry Regulatory Organization of Canada (Re Gareau, 2011) and the Mutual Fund Dealers Association of Canada (Re Investia and Re Fundex, 2012) suggest that the regulators will be more diligent in requiring firms to show that recommendations were suitable for clients. Production of a form in which the client acknowledges good knowledge and high risk tolerance does not, by itself, meet this standard. The firm cannot pass the suitability duty onto the client. Regulators have gone so far as to order firms to conduct new “know your client” reviews with clients. However, it remains unclear what will happen should client holdings prove to be unsuitable.
Advisors and their firms should ensure that all clients receive only recommendations that, upon careful review and in compliance with industry standards, are suitable for each individual client.
Harold Geller and John Hollander are senior associates in the law firm of Doucet McBride LLP. This commentary is not intended to be legal advice.
© 2012 Investment Executive. All rights reserved.