As the financial services industry encounters the growing volume of complaints from clients who have borrowed money to invest, there’s a push for financial advisors to face higher standards when assessing the suitability of this risky practice for clients.
In a recent letter to the Canadian Securities Admin-istrators, investor advocacy group Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) calls for better protection for investors who borrow money to invest. The letter urges securities regulators to institute a presumption that leverage is unsuitable for retail investors, thus placing the onus on the advisor and the firm recommending leverage to prove that it’s suitable for the client.
“There are a number of cases out there in which leverage has been used and it was not suitable,” says Marian Passmore, associate director of FAIR Canada in Toronto. “[Leverage] magnifies the risks of investing in products with risk. And, therefore, there has to be an analysis as to whether it’s suitable for that person to do it, based on a number of factors.”
FAIR Canada’s letter comes as the Mutual Fund Dealers Association of Canada finalizes changes to its “know your client” and account supervision rules that will formally require financial advisors and dealers to ensure suitability when employing leverage strategies. The MFDA’s suitability requirements have always been interpreted by the self-regulatory organization as including leverage, but this has never been explicitly stated.
“These rules are really just clarifying what was already required of members,” says Jon Cockerline, director of policy and research with the Toronto-based Investment Funds Institute of Canada. “It’s not really new. What they’re doing is bringing the minimum standards and guidelines into the actual policy.”
FAIR Canada would like to see suitability rules become even stricter than what the MFDA has proposed, says Passmore, but lauds the SRO’s effort.
FAIR Canada also wants to see other industry regulators — including the Investment Industry Regulatory Organization of Canada of Toronto and the CSA -— follow suit. Currently, neither national registration rules nor IIROC rules explicitly state that registrants must assess the suitability of leverage for clients.
FAIR Canada’s letter to the CSA calls for revisions to National Instrument 31-103, including the introduction of minimum standards for registrants in assessing the suitability of leverage, the requirement for clients to sign a document acknowledging that they understand the risks of leverage when it has been recommended and the requirement for clients to obtain independent legal advice when they’re using their home as security for leveraged investing, among other requirements.
FAIR Canada believes that better investor protection is necessary because the use of leverage often results in significant losses for investors, pointing to a 2010 New Brunswick Securities Commission review of leverage practices that found that in cases in which aggressive leverage was used, 68% of accounts were in a loss position.
A growing number of investors are voicing their concerns about such losses. The number of complaints that the Ombudsman for Banking Services and Investments has received in which leverage was the main issue have more than doubled in the past two years, to 25 in fiscal 2011 from 12 in fiscal 2009.
One reason for this increase in complaints is the volatile performance of markets. “When markets are doing well, you don’t hear any problems,” says Cockerline. “When clients lose money in their accounts — and, even worse, when they’re levered and they lose money — then they’re looking around for who to blame.”
But deficiencies in suitability practices also may be contributing to complaints. In 2009, the MFDA had identified leverage as an area in which there commonly were compliance deficiencies. Specifically, the MFDA says, leveraging recommendations often appear inconsistent with the client’s documented KYC information.
The MFDA has issued guidance on this topic in recent years, but enforcement statistics indicate that leverage continues to be an issue. Between July 1, 2010, and June 30, 2011, leverage suitability was among the top five types of enforcement cases opened by the MFDA. It had opened 33 of such cases during that period, representing more than 7% of all cases.
The MFDA’s proposed rules, which were out for comment until early October, aim to provide “increased clarity and consistency” by establishing transparent regulatory minimum standards for leverage suitability, according to Ken Woodard, director of membership services and communications with the MFDA.
The proposed rules will require advisors to assess the suitability of leverage with regard to the client’s investment knowledge, risk tolerance, age, time horizon, income, net worth and investment objectives. The proposed rules also set out minimum criteria that would trigger further supervisory review and investigation of leverage recommendations, among other requirements.
Many dealers and advisors are supportive of leverage suitability requirements, acknowledging that leverage isn’t for everyone.
“Leverage can be a double-edged sword,” says Joe Riche, a certified financial planner with Riche Investments, which operates under the FundEX Investments Inc. banner in St. John’s. “Clients have to be prepared and understand that just like the upside is amplified, the downside is amplified when we’re going through periods like we are now.”
Riche believes all advisors should be required to ensure leverage is suitable for a client before implementing the strategy: “There is a place for leveraging, but it has to be a fairly long-term decision, and it has to be somebody who’s comfortable with the risks.”
Most fund dealers already have leverage suitability policies in place, as the MFDA has issued guidance in this area in recent years. As a result, the MFDA’s proposed rules won’t mean many big changes for dealers and advisors.
“There are controls in place that are mandatory at all firms,” says Nelson Cheng, CEO of Windsor, Ont.-based Sterling Mutuals Inc. “[The MFDA is] formalizing some of the things we’re already doing, and [is] also adding a few new things.”
The industry has generally voiced concerns only with aspects of the proposed rules that would potentially create duplicate or burdensome requirements.
“We want to make sure,” says Cockerline, “that the policy, as it’s written, doesn’t put in place duplicative requirements or isn’t overreaching in its interpretation.” IE