Are firms responsible for advisor misconduct?

When advisors are fined by regulators but can’t pay, their firms aren’t responsible for picking up the tab.

Philip Anisman, a Toronto-based securities lawyer, confirms this. “If an advisor violates securities laws and is sanctioned by the Commission, his employing firm should not be indemnifying him. That diminishes the sanction.”

Also, firms aren’t typically responsible for repaying harmed clients on behalf of advisors. Why? “While OSC has authority to distribute funds to investors that are paid as fines, there isn’t a formal public process for doing that,” explains Anisman. “Also, OSC does not have direct authority to make orders requiring compensation of, or restitution to, investors, even though they should have that authority.”

Further, IIROC can’t use fine dollars to directly benefit harmed clients. Instead, funds are put toward educational programs for investors.

So what options do investors have to recuperate their lost funds? If complaints against participating members haven’t been addressed within 90 days, a client can ask OBSI to investigate on her behalf for free. If OBSI finds an advisor’s or firm’s error has resulted in financial loss for that client, OBSI may suggest compensation (up to $350,000 depending on the case), but its recommendations aren’t binding.

Or, investors can take their cases to court. “A firm would be responsible in a civil court proceeding for harm to investors caused by an advisor’s improper conduct,” says Anisman.

The court, unlike OBSI, has the authority to enforce compensation or restitution payments, with no cap. And, the court can also take into account all involved parties (not just the firm, but also investment dealers, for instance), as well as their assets, says Shayne Kukulowicz, partner at Cassels Brock in Toronto. That could potentially mean a larger settlement. The catch: it’ll cost investors in time and legal fees, and there’s no guarantee of success.

For these reasons, a proper indemnification system is crucial. But, it’s unclear where the funds would come from to support such a system, says Jonathan Heymann, president of Wychcrest Compliance Services in Toronto. “Market participants are already paying large compliance fees. To add another layer and make [compliant] firms subsidize those that don’t [follow the rules] isn’t fair. It’s hard to think of a system that serves investors but doesn’t punish [compliant] firms.”

Client complaints that are escalated to regulators are usually about unsuitable recommendations, unauthorized or discretionary trading, and/or misrepresentation.

Handling formal complaints

There are cases when a firm could be held financially responsible. If there’s a formal client complaint and IIROC finds the firm didn’t do its due diligence in supervising the advisor and reporting that complaint, IIROC will fine the firm along with the advisor. The firm is responsible for its own fine. E&O insurance, which is optional, won’t cover the costs of wrongdoings—unless the error is unintentional.

Further, if a firm fails to detect and report employee misconduct, it can’t depend on financial institution bonds, which is insurance that all dealer members are required to have. IIROC says if a firm is fined along with an individual for supervision failures, the firm is not covered under financial institution bonds. However, IIROC notes that if the firm has fulfilled its due diligence, then the bonds will insure the firm against any related losses.

Meanwhile, if a firm goes bankrupt and can’t pay a fine owing to an investor, that investor may think she can turn to IIROC’s Canadian Investor Protection Fund. However, says IIROC, “CIPF coverage doesn’t include coverage for losses arising from circumstances of fraud, material non-disclosure and misrepresentation.”

Other impacts

When advisors break the rules but firms aren’t found liable, firms still have to deal with the fallout of client complaints. If a client decides to stay, the firm may want to move him to a new advisor, says Heymann. Further, errant advisors, who are often suspended and forced to retake industry courses such as the CPH and supervisory classes, may need to be closely supervised for long periods.