Accusations of inappropriate portfolio management by investment advisors and the firms they represent tend to increase during market downturns as investors watch their losses grow and account balances decline. Investors may conclude that their advisor was not acting in the investor’s best interests and attempt to recover their losses through litigation.

Allegations are often made by investors claiming that their portfolios were not suitable. Had the funds been invested in an appropriate portfolio, investors often claim, the losses would not have occurred, or would have been substantially reduced. Claims concerning diversion of investment funds, mingling of investors’ funds, churning an investment account to generate increased commissions, or failure to execute trades or follow investor instructions may also arise. Allegations may also be made against the brokerage claiming failure to properly supervise the advisor, or failure to implement adequate internal control procedures and protocols to identify potential account problems.

Regardless of the specific allegations, counsel for the plaintiff-investor typically engages a damages expert to quantify the losses the investor allegedly incurred as a result of the advisor’s actions. Lawyers for the defendant (the investment advisor and/or the brokerage firm) will also engage a damages expert to provide comments on the plaintiff’s expert’s report and to provide an independent calculation of damages, if any. Although both experts may calculate damages using the same methodology, their conclusions may differ significantly depending on the underlying assumptions employed.

Some of the issues that must be considered by the damages expert follow:

> Actual Results. Damages are calculated as the difference between what should have happened, the “notional” scenario, and what actually happened. The first step is to understand what actually happened. Investment gains and losses are typically not calculated and disclosed on a monthly basis. As a result, the expert needs to summarize all the activity in the investment accounts over the relevant period to understand where the gains and or losses were incurred. This analysis will help determine whether the alleged losses resulted from a specific holding or from certain types of investments, whether the number of transactions and fees were excessive, or whether the alleged losses occurred in a relatively short time frame.

> Heads Of Damage. Damages should be quantified for each allegation. For example, the investor may have alleged that the advisor defrauded him by transferring the funds from his investment account to the advisor’s personal account. The investor may have also alleged that the portfolio was not “suitable” based on the investor’s age, risk tolerance, personal investment objectives and other factors disclosed to the advisor. The expert should calculate the investor’s losses as a result of the alleged fraudulent transfers and the alleged inappropriate investment mix separately. Evidence of the alleged fraud may be significantly stronger than the evidence of the inappropriate investment mix. In addition, combining the losses and presenting only one calculation would make it more difficult for the court to assess damages, particularly if the court finds that the investor should personally assume some responsibility for the losses related to the investment mix or if the losses were realized as a result of market activity and not as a result of negligence on the part of the advisor.

> Expected Returns. If the investor alleged that the portfolio was not suitable, the expert will need to incorporate an assumption as to a more suitable portfolio mix. For example, the expert may rely on the opinion of an independent investment advisor (the “suitability expert”) who will advise on the appropriate asset allocation. Because the returns of the underlying investments in the portfolio may vary considerably between investment categories, the portfolio may become significantly skewed over time. As a result, a further assumption must be made by the expert in relation to re-balancing. For example, the expert may assume that the portfolio was re-balanced at each monthend or at each year-end to maintain the stated investment mix.

> Tax Implications. For purposes of calculating what should have happened, assumptions must be made regarding the average “hold” period for investments and the income tax rate applicable to gains/losses and investment income. Income and gains accumulate in registered RRSP accounts on a tax-free basis. But income and gains in non-registered accounts are taxable. The income tax rate on the notional portfolio distributions is therefore dependent on the assumed portfolio mix, as interest income, dividend income and capital distributions are taxed at different rates.

@page_break@Investment advisors should ensure that they periodically review asset allocations with their clients and be prepared to explain any significant changes.



Kim Jezior CA-IFA and Vimal Kotecha CA, CBV are both directors at LECG Canada.