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It’s not all high-level securities fraud

Financial Adviser
|Written By Alan Acton
It’s not all high-level securities fraud

High-profile securities fraud cases like Bernie Madoff often get a lot of media attention, while the examination of financial adviser negligence gets overlooked. According to the Investment Industry Regulatory Organization of Canada, there were a total of 99 enforcement actions against financial advisers in 2010. Twenty-seven per cent of decisions against advisers were classified as due diligence/suitability and misrepresentation violations. In addition, a considerable amount was won in civil suits against advisers in 2010.

Financial advisers in Canada owe a fiduciary duty to their clients to deal fairly, honestly, and in good faith with their clients. They also have to do their homework; not only on the investments they recommend, but also knowing their client’s risk tolerance level and financial situation. These are the know-your-client (KYC) rules that advisers are obligated to follow. Investment recommendations must match up with the client’s financial situation and knowledge level. Obviously, an adviser betting an elderly person’s life savings on a risky and complex option strategy is a gross violation of KYC regulations.

The KYC information must be updated any time there is a material change in a client’s circumstances. According to IIROC, the financial adviser should meet with the client at least annually to conduct suitability reviews. Or, if an adviser leaves the firm, the new adviser assigned to the account should meet with the client immediately to update KYC information.

If proper KYC documentation is not done, the financial adviser may be negligent, even when no transactions were made. This is a failure to consistently monitor the client’s situation and investment account, and act accordingly.

Another area of enforcement action is misrepresentation. This happens when an adviser misleads a client by making false statements or withholding important information, specifically if it applies to details that may impact a client’s investment decision. For example, an adviser may not disclose all the risks related to a particular security in an attempt to convince the client to buy it.

According to securities litigation specialist John Hollander (who partners with Harold Geller) of Doucet McBride LLP in Ottawa, many times there is an absence of informed consent. “The fact is that what goes up can come down. The potential for gain coincides with the potential for loss. This means both the size of the gain or loss and how often the gain or loss may occur must be fully explained to the client. To reach for a higher profit, the client must face a higher risk of loss,” says Hollander.

He goes on to say, “If an adviser fails to fully explain both the likelihood and the size of the potential loss an individual might incur, the client may have cause to sue.”

Many more cases come to light when the stock markets drop. As Warren Buffett says, “Only when the tide goes out do you discover who’s been swimming naked.” When the markets decline and volatility increases, many risky strategies go south quickly. Oftentimes clients do not even realize their investment portfolios were at risk.

With approximately 29,000 registered advisers in Canada, the incidence of enforcement actions is minimal. However, suitability and misrepresentations violations represent the largest enforcement actions of last year. Advisers have to do a better job of keeping their KYC information up to date, and explaining all of the investment risks clients face, or face disciplinary penalties and the possibility of civil litigation.


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