At the core of the relationship between financial advisors and their clients is the assessment of the client’s financial situation by the advisor – an investigation intended to match the client’s financial goals with the planning and financial products recommended by the advisor. In other words, what financial choices are suitable for the client, given his or her particular situation?
It sounds straightforward. But, as most advisors know, the “know your client” process can be fraught with peril if it is not conducted and documented thoroughly. Witness the rising number of lawsuits against advisors and their firms to recover financial losses. These lawsuits almost always focus on the suitability issue, with even the most sophisticated plaintiffs alleging that they were advised to make financial decisions that were unsuitable for them, leading to catastrophic losses.
So, it’s very much in the interest of advisors and their firms to ensure that they are fully aware of their obligations in this regard. Indeed, the Mutual Fund Dealers Association of Canada and the Investment Industry Regulatory Organization of Canada have established “know your client,” “know your product” and “suitability” as the bedrock of the client/advisor relationship.
In our experience, problems often arise because some advisors may not have informed themselves as fully as they should have about their clients’ situations (KYC), the features and details of the investments they have recommended (KYP) and how those two investigations should be applied to the client’s situation (suitability).
But even if all of these steps have been taken, the advisor is still at high risk for a ruling of liability if he or she has failed to document the suitability process fully. This type of failure leaves advisors and their firms struggling to prove what is their most common defense – that the client made properly informed choices.
Indeed, it is typical for defendant advisors and firms in civil claims and disciplinary hearings to place the blame for client losses on their clients. These defendants often point to the “sophistication” of the client and the apparent understanding by the client as proof that the client was fully aware of his or her investment choices. The client’s sophistication in employment, business experience or education is often mistaken for investment knowledge. So is the client’s history of giving approval of recommendations.
So, who is responsible? And for what?
Clearly, the advisor and the dealer jointly bear the responsibility to recommend an appropriate match between the product and the client. Despite widespread investment industry misunderstanding to the contrary, suitability analysis is never the responsibility of the client. IIROC Rule 1300.1(q) requires that both dealer and advisor, “when recommending to a customer the purchase, sale, exchange or holding of any security, shall use due diligence to ensure that the recommendation is suitable for such customer.” MFDA Rule 2.2.1 is similar. Nowhere is this obligation for ensuring suitability imposed on the client – even in the case of unsolicited orders.
This debate effectively ended in Canada when the Alberta Securities Commission declared (in Re Lamoureux, 2002) that the responsibility for ensuring suitability rests solely on advisors and dealers: “The obligation to ensure that recommendations are suitable or appropriate for the client rests solely with the registrant. This responsibility cannot be substituted, avoided or transferred to the client, even by obtaining from the client an acknowledgment that they are aware of the negative material factors or risks associated with the particular investment.” This decision has been adopted extensively, including in the decision of the Ontario Securities Commission in Re Daubney, 2008, and that of IIROC in Re Gareau, 2011.
Advisors and their firms have every right to protect themselves from a liability finding by clearly establishing that they have met the suitability standard. The best way to do that is to be thorough in carrying out the suitability obligation and by fully documenting that process. It is this process, not the result, that advisors must answer for. Indeed, it can be argued that the intentional denial of a regulatory obligation, such as the suitability obligation, is itself a breach of both the regulation and the civil duty of care owed to the client.
When looking for evidence to support the conduct of the advisor, firms are well advised to avoid blaming the client, as is the current trend. Advisors and dealers promote their skills and assessment processes to their clients. When an advisor error is alleged, the advisors and dealers should do one of two things: either they should show how they complied with suitability standards or they should own up to their responsibilities. Failing that, further regulatory and judicial sanctions against the advisor and his or her firm are necessary to serve as a general deterrent against these types of failures. IE
Harold Geller and John Hollander are senior associates with Doucet McBride LLP. This commentary is not intended as legal advice.
© 2012 Investment Executive. All rights reserved.
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