It’s no secret that leveraged investing is risky, but that doesn’t mean advisors across the country have stopped employing the strategy. A panel of lawyers, however, suggests thinking twice about going the leveraged route with a client.
Clearly, leveraging is a volatile issue, especially in downward markets, but while it’s risky for clients, it can also pose problems for advisors, as lawsuits often follow complaints.
“The top complaints involve suitability of leveraging,” said Laura Paglia, a partner at Torys, at the Association of Canadian Compliance Professionals’ annual compliance conference on Monday. “From July 1, 2006, to June 30, 2007, the MFDA had 25 suitability complaints regarding leveraging and 50 complaints regarding suitability at large.”
Robert Brush, a lawyer with Crawley Meredith Brush, says many advisors are quick to sell leveraged investments, so they downplay the risks. That, however, puts a target on the advisor’s back.
“In the first conversation about leveraging with a client, the upside is emphasized and downside risk isn’t really explained,” he says. “What an advisor would say to me is, ‘We had the risk disclosure form, I sent the form out and made sure I got it back, and it’s in my file.’ The advisor thinks he’s safe, but if they don’t actually explain the form, then they’re leaving themselves terribly vulnerable.”
Being uninformed of the risks is the most common argument by a client. Paglia says that clients always say that they didn’t understand that the value of the investment can fall below the value of the loan. “This appears over and over again,” she says. “Clients say they are relying on the return of investment to cover the cost of the loan.”
“I hear bewilderment and genuine lack of understanding in many cases,” explains Brush, adding that even if a client learns the ins and outs of leverage investing during the process, the advisor who hadn’t outlined the risks from the start is liable.
Ellen Bessner, a lawyer with Gowling Lafleur Henderson, says MFDA guidelines dictate that advisors explain the risks to their client. Unfortunately, many advisors know about as much about leveraged investing as their clients do. “Some advisors don’t understand the risks themselves,” says Bessner. “And if they do understand them, they’re not able to explain them.”
The best protection against a litigious investor is keeping meticulous notes on everything from conversations to investment decisions and whatever else comes up when dealing with a client.
Brush says a handout or PowerPoint presentation that explains the downside risks can go a long way in proving that the advisor did tell his or her client about the potential pitfalls. He also suggests downloading the plain language Ontario Securities Commission pamphlet “Borrowing to Invest” to give to clients.
However, even reams of notes might not save an advisor from losing a lawsuit. “If [your handouts] include a section that’s straightforward, the plaintiff has to fall back on the, ‘I’m an idiot argument,’” says Brush. “That can still be an effective argument at trial, though. When you’re a 78-year-old widow trying to get money back, the court will assume [that defence], rightly or wrongly, and won’t hold it against that person.”