Best of 2010: ‘I did what?’ A compliance field guide

By Vikram Barhat | August 30, 2010 | Last updated on August 30, 2010
6 min read

This story bears repeating. Vikram Barhat tracked down some of the most common compliance problems among advisors.

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A slew of financial violations have been keeping the hearing panels of MFDA and IIROC busy. Although many are deliberate, some of these offences are the result of glaring ignorance that leads financial practitioners afoul of existing regulations.

Either way, recent disciplinary measures clearly show how seriously compliance issues are taken by the industry SROs. Then why do firms and financial advisors continue to find themselves in breach of regulatory by-laws, rules and policies?

We spoke to some legal experts to try and uncover those tripwires that activate the legal landmine of compliance rules.

Some obvious, others obscure, here’s the list of lurking legal “gotchas” that most frequently compromise the integrity of firms and their members, and land them in the dock.

Suitability of investments Unsuitable investment recommendations are by far the most common offences. These include recommending investments without adequate research and analysis, investing in securities that were speculative and under-diversification. This is becoming more common as the products being sold to retail investors become more and more complicated. Advisors are now being held to account by the regulators and the courts for recommending products to clients that they themselves did not understand.

Deficient KYC Ignoring the golden rule of the industry, ‘know your client’, results in the failure to determine and understand the investors’ personal circumstances and objectives and recommending investments that are not aligned with the client’s true risk tolerance. The focus of the KYC is less about the specific form used, but on building a relationship with clients so that advisors truly know them on a personal level. A particularly slipper slope, this one, given clients’ risk tolerance can be as mercurial as the market itself.

Breach of fiduciary duty Simply put, placing your own interests before the clients’ by recommending investments that would increase commissions, rather than be in the best investment interests of the investor. Those dispensing financial advice must have a better understanding of the obligation they take on when they agree to run a client’s money. A good fiduciary communicates to the client in a clear and concise manner that he/she can be trusted to act in the client’s best interest at all times. Failing to do so is more a case of moral turpitude than just ineptitude.

Unsuitable investment objectives Recommending unsuitable investment objectives is often a lurking liability. When some advisors see that their recommendations are causing a client’s account to take on greater risk than is justified by the client’s current KYC profile, they may update the investment objectives and risk tolerance in the KYC forms to match the greater risk now associated with the account. By doing so, these advisors may believe they are protecting themselves against liability for investment recommendations they know are unsuitable for the client’s original KYC profile.

Acting like a portfolio manager Some advisors put all of their clients into the same investment or strategy, irrespective of their different KYC profiles. Such advisors like to come up with a strategy and “shop it” to their entire client list. They will get their client’s general authorization to pursue the strategy, but will then execute the strategy without getting specific instructions on each trade. This practice invites a hearing for unsuitable investment recommendations since it will be a very rare case that the same investment or strategy is suitable for every client. It also invites discipline for discretionary trading, since the advisors are essentially carrying on their practice as if they were portfolio managers with full discretionary authority.

Inappropriate use of leverage A very common offence that is a current focus of the MFDA’s enforcement branch is the unsuitable recommendation of leverage. Borrowing to invest became a favourite strategy for mutual fund salespersons to recommend, but the last two years have brought home the inherent dangers. Advisors who recommended this strategy recklessly, perhaps not appreciating the full risk that was being taken on by their clients, are now exposed to civil claims and disciplinary action for unsuitable advice.

Outside business activities and off-book transactions This can range from negligent mistakes, such as sitting on the board of a company while trading in its stock on behalf of clients without recognition of blackout periods, to such intentional misconduct as selling clients products which are not authorized by the firm. Advisors must be diligent in following the rules and their dealer’s policies, as this issue has become a focus of the regulators.

Failing to cooperate with regulators and/or misleading regulators Advisors who fail to cooperate with IIROC or the MFDA typically face a lifetime ban from the industry. The consequences can be just as severe if an advisor misleads a regulator. It is therefore wise to be both well-prepared for an interview with a regulator and well-represented. Well-prepared subjects who are represented by experienced counsel are in a much better position to deal with the investigation process. Advisors cannot just wing it and expect to come out unscathed as honest mistakes can be misinterpreted as deliberate lies.

Failure to document Although failure to document advice and take notes only occasionally forms the basis of a hearing, it is probably the single most common mistake made by advisors. Not only do advisors need to give appropriate advice, such as warning a client about the risks of a product, they have to record that they have done so.

This is not only a regulatory requirement, it is the single most important means an advisor has to protect themselves from civil liability and regulatory action. In a lawsuit, clients rarely remember things the same way as the advisor. Notes made by the advisor at the time the advice was given can make all the difference in who is believed.

These days it’s not enough for an advisor to do the right thing. He or she must be able to prove it.

Conduct unbecoming Firms and approved persons must observe high standards of ethics and conduct in the transaction of their business and refrain from engaging in any business conduct or practice which is unbecoming or detrimental to the public interest.

Specific activities that resulted in penalties include the misappropriation of client funds, the facilitation of suspicious or questionable transactions without making diligent inquiries to ensure the legitimacy of the transaction, and the acceptance of large deposits of cash contrary to legislation on the proceeds of crime (money laundering).

It’s a complex category which makes the job of a firm’s compliance department very tricky. However, getting slack with compliance could cause a firm to incur huge expenses in terms of dealing with the regulators, their time, unfavourable judgements and legal expenses.

Conflicts of interest Because an advisor is handling other people’s money, they have a fiduciary duty which dictates that advisors put their clients’ interest above their own. You can face a conflict of interest allegation when the client feels that the advisor was just recommending changes in investment just so the advisor could get commission.

Similarly, when an advisor has an undisclosed financial interest in recommended investments, it gives rise to a conflict of interest. In the event that a potential conflict of interest arises, the advisor should immediately disclose that to the client and should address that by using responsible business judgment.

Transfer of accounts An advisor/firm has an obligation to transfer a client’s account if they decide to move to another advisor/firm. Once the client has authorized it, his/her files and records must be forwarded to the new advisor. Occasionally the transferring firm may be slow to provide client information to the new advisor and may fail to prioritize their client’s requests. They are also often accused of dragging their feet on the paperwork necessary to facilitate a smooth and swift transfer.


Vikram Barhat