To most clients, investment policy statements (IPS) might mean just another set of legalese they need to put their signature on, but to portfolio managers these are critical documents that could make or mar their careers if a disgruntled client took them to court.
“People only look at contracts at two times: once at the beginning when everyone is in agreement; and a second time, when they are anything but in agreement,” Richard Austin, counsel, Borden Ladner Gervais, told advisors at an Investment Policy Statements seminar organized by Toronto CFA Society’s Private Client Committee.
“In the beginning everyone is happy, and most clients sign blindly. But when things go wrong, clients don’t remember what they signed,” Austin added. “And when they’re not happy they scour through pages, paragraphs, clauses and sub-clauses to solve the one puzzle that matters to them at that moment: ‘How should I juxtapose all the pieces of paper that apply to my relationship to my money manager together and make my problem his problem?’ “
According to Austin, the favourite basis for making a claim in the financial services industry is breach of fiduciary duty. You’re on slippery ground if the plaintiff can establish that you (the fiduciary) had the scope to exercise some form of discretionary power, and didn’t, and he (the beneficiary) was vulnerable and at your mercy.
Most often, the plaintiff will also sue for negligence. If you failed to meet your obligations, the client was stuck with a loss that was foreseeable, and you can’t provide any special circumstance to warrant the chosen investment, your lawyer will tell you to settle and settle quickly.
The difference between fiduciary and contractual duty can be critical in determining the damages awarded by the court. Compensation for of fiduciary duty puts plaintiffs in the position they would have been had there not been a breach, including all consequential damages that resulted in the breach and legal fees. Breach of contract may diminish the amount of damages.
But despite their critical role in linking a client’s financial needs to the investment strategy employed by his or her portfolio managers, there’s no common view as to what investment management agreements and investment policy statements should look like, and what information they should contain, Austin said. “Anyone is free to adopt any approach, goal or philosophy they wish to borrow from friend or competition.”
Even securities legislation doesn’t clearly stipulate what IPS documents should contain. “The proposed changes to NI 31-103 provide very barebones guidance as to what should be included in a contractual agreement with a client.”
There’s a constant battle between the sales and legal departments of firms — between those who like it short and sweet, and those who want comprehensive and complete information. But rather than fretting over the nomenclature of such documents, Austin suggests paying more attention to the role they should play in the advisor-client relationship, and more importantly the features to be included in terms of a binding contract with clients. “Securities regulators judge investment policy statements based on clarity, not length or titles.”
From a legal standpoint, IPS documents must have:
• Clarity in the nature of the relationship from a legal perspective;
• Clarity in terms of costs and expenses borne by the client;
• Clarity in identification and disclosure of conflicts of interest and any steps taken to address them;
• Transparency in presentation of performance and the risks borne to achieve the performance; and
• Clear and understandable language.
Austin underscores the importance of having these documents written in plain English, not legalese. He is surprised by how often dreams and goals can be interpreted in totally different ways. “Often, one interpretation favours the manager; the other favours the client.”
Managers must ensure clients are aware of their investment strategies in both qualitative and quantitative terms. For example, when asking clients how risk tolerant they are, it isn’t enough to categorize risk as high, medium or low. To a litigator these classifications mean very little. The advisor needs to provide definitions in real terms: “If you were to lose 15% of your portfolio would that upset you?”
The contractual agreement, according to Austin, should include:
• Investment guidelines in terms of strategies, prohibitions, limitations and restrictions;
• Portfolio management fees, how are they calculated and payable;
• Performance fees, how are they calculated and when are they payable;
• Client reporting, detailing what will be provided and when;
• Indemnification provisions;
• List or description of permissible investments;
• List or description of prohibited investments;
• Client information regarding risk tolerance, time horizon, liquidity, information relevant for taxation matters; and
• A clear indication of who has the authority to give instructions on the account. Too often Austin says advisors take instructions from people who have no authority.
If there’s anything in the client file that will appear extraordinary or unusual to a third party, either regulator or judge, you need to have a clear explanation, Austin noted. “It isn’t enough to say the client wanted it, or the client was knowledgeable. You will need to ascertain what policies, regulations and guidelines applied to your firm.”
(02/11/09)