The best defence: A good paper trail

“These are basic concepts, so you might be inclined to skip over them,” says John Fabello, a lawyer at Torys who spoke at the annual Investments Management Consultants Association conference on Thursday. “But questions like this will be a centrepiece for litigation.”

It’s not enough to get your client to sign a form saying you disclosed all the pertinent information either. Paul Le Vay, a lawyer at Stockwoods who also spoke at the conference, says if a client tells a judge that his financial statements and forms weren’t explained, even though he has seen them, and if the judge believes him, the advisor could be out of luck.

Updating the KYC documentation is also vital to a defence. Oftentimes clients’ understanding of the process will change — they may become savvier, or they might want less risk — or they could experience a life event like a job loss, either of which would require the advisor to revisit the forms.

Le Vay says constant communication between advisor and client is the only way to keep apprised of any alterations to a profile. “If a client is aware of the changes to the forms and acts accordingly, they can’t come back and make the claim,” he says. “Don’t wait for the client to update the form themselves.”

As essential as it is to know your client, it’s equally important to know about the product you’re selling. Fabello reveals that judges will ask advisors what they know about their products. “The sufficient answer is not, ‘I have a research analyst who told me about its attributes, and I’m relying on that research,'” he says. “You have to do your own due diligence.”

As an advisor, you don’t have to delve as deeply into the inner workings of a product as an analyst does, but you need to read reports, investigate who manages a fund and what the manager is doing, and find out anything else that will allow you to explain how a product works and why you put your client’s money into it.

Understanding a product’s risk, and explaining that to your client, is also required. “There seems to be an aversion to telling clients how they can lose money on the investment you’re recommending,” says Fabello. “When you’re pitching a product, you might be inclined to leave risks to the side, but it’s essential that the client is aware of potential downsides or risks.”

Of course, it might seem strange to talk to a sophisticated investor about risk. The law recognizes that, so advisors don’t need to spend the same amount of time talking to a savvy client as they would a newbie investor. But, says Fabello, “don’t think for a moment that your CEO client understands as much as you do about a particular product.” He implores advisors “not to take them for granted” and make sure they understand what they’re getting into. “The law does help you out,” he says, “but it’s not a free pass.”

When it comes to fund failures, such as a hedge fund suddenly collapsing, advisors might think they’re in the clear. After all, it’s not their fault a fund went south. But the court says it’s the advisor’s duty to be aware of what’s happening with the companies or funds in a client’s portfolio.

Fabello explains that in the case of a fund failure, the court will ask advisors if they had seen any red flags, if they had personally monitored that particular investment and if they’d had any indication that the fund was in trouble. “The court will say that the advisor should have been aware of what was happening, based on publicly available information,” he says. “And he should have made the client aware of the potential warning signs.”

One of the more difficult issues advisors face is what their obligation is when a client wants to make a move that’s contrary to the health of his or her portfolio. Fabello says that in non-discretionary accounts, the advisor has the right to refuse the trade. “It’s too onerous to saddle you with that responsibility,” he explains.

An advisor who does place the trade has to tell his or her superiors about the move, update the KYC form and, most importantly, write down what’s happened. It’s a good idea to send the client a note or e-mail explaining why you don’t want to make the trade, so if it’s called into question later, there’s a record of your conversation with the client.

“If you take the time to send a short note to the client, you [should] avoid a lawsuit,” says Fabello. “And if the client sues, you will provide us the ability to defend you very well.”

While writing things down and explaining products to clients is all well and good, the best way to avoid litigation is not to work with a litigious client in the first place. Of course, this is often difficult to do as you’re not going to know how a client will behave down the road, but if you have a gut feeling that says not to accept this investor, then listen to it.

“More than one advisor has told me that the most important decision they made in their career was deciding not to take on certain clients,” says Fabello. “If a client doesn’t seem to have a good fit with you, if you’re not comfortable with them, make the decision to refer them to one of your colleagues.”

“There are warning signs,” adds Le Vay. “If you’re the eighth advisor the client has contacted in the last three years, you know there’s a potential issue.”

Rejecting a client is especially hard if he or she represents a large account. But a big commission or fee isn’t worth a ruined practice. “In one case an advisor was brought down by someone who had $90 million to invest,” Fabello reveals. “That client took an inordinate amount of time up in the advisor’s life and ultimately sued and caused the advisor to lose his licence. The lure of money and building a book is strong, but we suggest it should be tempered.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com