Keeping abreast of your client obligations is no easy feat, and following proposed legislation—like Finance’s tax reforms for businesses—adds to the burden.
If the department’s reforms are passed, your business-owning clients might require new planning. If you don’t inform them of the changes in a timely manner, could you be held liable?
“It’s completely settled law that all advisors owe their clients a certain duty of care,” says John Fabello, partner at Torys in Toronto, referring to common law. “That’s the starting point.” He adds that the duty is “informed by and borrows from all the regulatory duties”—such as the duty to act fairly, honestly and in good faith, and the duty to fulfill KYC, KYP and suitability obligations.
“That’s not your grey area; that’s clear,” he says.
However: “There are other components of the duty of care that depend on the circumstances of each advisor-client relationship.”
Know your services and what affects them
One such circumstance involves the services offered by the advisor and those requested by the client.
For example, if the advisor pitches tax services to the client, a court may say the advisor’s duty of care includes tax, says Fabello. If an advisor later has to defend herself, she’ll be held to her contemporaneous notes and marketing materials, he says, adding that clients are also entitled to rely on advisors’ verbal offers.
And though advisors aren’t tax specialists, most judges will require advisors to know the basic tax principles that factor into their advice, says Fabello. For example, “If you’re selling [investments in] registered accounts, then you should be able to speak to the basic tax principles that relate to them.”
Similarly, when a specific investment product is used expressly for its tax advantages, and the associated tax scheme changes, the advisor “would have a higher burden to give notice to clients,” says Alex Zavaglia, partner at Gowling WLG in Toronto.
The further removed an issue is from a securities account, the less likely the advisor will be held to a duty, says Fabello. With income splitting, for example, there are many factors beyond the account, such as number of children or type of business. “Those are not securities-account specific,” he says. “Unless the advisor’s saying, ‘I will provide you with tax advice with respect to income splitting, and I’ll factor that in,’ then the advisor won’t be tagged with that as being part of their duty.”
However, that doesn’t mean you can ignore pending tax changes, like Finance’s proposed reforms for income sprinkling.
“If a major change comes up that for sure affects the client directly, you’ve got to flag it for the client,” says Fabello. “Most courts would say you’ve got an obligation to be aware of those major changes.”
Understand evolving obligations
Advisors must also understand where regulatory change is headed.
Because of CSA consultation paper 33-404 Proposals to enhance the obligations of advisers, dealers and representatives toward their clients, the interpretation of KYC, KYP and suitability obligations is evolving, says Prema Thiele, partner at Borden Ladner Gervais in Toronto. (The paper outlines proposals for targeted reforms and a best interest standard.)
Those proposals are “our most recent public enunciation of what’s in the minds of the regulators,” Thiele says. For example, there’s a more nuanced interpretation of knowing clients’ tax positions.
“A KYC form completed 10 years ago is not going to cut it from an advisor liability perspective,” she says. “You have to, as a financial advisor, make sure that that KYC information is periodically updated to reflect your client’s knowledge and to reflect their entire financial situation.” The proposals in 33-404 suggest KYC information is updated at least every 12 months, and more frequently in response to material changes in a client’s circumstances.
To protect themselves, advisors must be “viewed as diligently looking back from time to time [at] their clients’ changing needs,” says Zavaglia.
Maintaining an ongoing look at KYC, KYP and suitability presents a challenge, however.
“The controversial [part] is the in-between,” says Thiele, referring to events that change a client’s position between annual updates.
“It isn’t clear what outward-bound obligation does the advisor have to continuously monitor for KYC/KYP,” she says. “How do you maintain that relationship such that you put yourself in a position to recognize events that happen during a year that might impact your clients?”
Relationship development is key, Thiele says, calling it a bulletproofing exercise against liability. “What you don’t want to do, obviously, is just lump clients in the same boat all the time—not all seniors are alike,” for example. “You need to do that critical look and always challenge and investigate.”
When it comes to KYC, KYP and suitability, “passivity is what the courts tend to frown on,” says Zavaglia.
Keeping with the example of seniors, Zavaglia says maintaining a consistent relationship helps advisors to be aware of potential declining capacity, for example, which could require updating their risk tolerance.
Sidestep the pitfalls
Case law provides specific examples of where advisors have previously been held liable.
“While each case is different and decided on unique facts, courts have held that advisors have breached client duties for not investing cash in a bull market—and for putting elderly clients in long-term investments, including growth equities and insurance products,” says Fabello.
Advisors must also honour gatekeeper obligations under the Securities Act and IIROC rules, he says. “An advisor needs to report, and in some cases refuse, instructions if […] what the client is doing is improper,” such as manipulative or deceptive trading.
It’s also part of an advisor’s job to consider these things when they become aware of them and react to investments outside clients’ investment accounts, such as real estate or accounts at other dealers. This is particularly important as advisors increasingly market themselves as providing full financial plans, says Fabello.
Case law also demonstrates the importance of knowing a client’s unique needs when making investments. Consider a client who plans to buy a house in a year and asks the advisor to make as much money as possible in the meantime with the saved down payment. The advisor invests, the market tanks and the client loses capital.
It’s a situation easy to fall into, considering conservative clients have faced low returns in recent years, which puts pressure on advisors, says Fabello.
But advisors must clearly explain risk in such situations.
When doing so, advisors should show potential losses using hard numbers, says Thiele, since using a dollar amount aids client comprehension. “If you’re sued, you can whip out your notes and explain that.” In particular, she suggests clients avoid using margin—a focus of IIROC enforcement and compliance. If a client insists on using margin, advisors should establish documentation and disclose leverage dangers.
Thiele also adds outside business activities to the list of compliance areas to watch out for, adding that IIROC’s amended rules took effect Oct. 6. For example, advisors can no longer act as trustees, powers of attorney or executors for clients, subject to exemptions.
Finally, she suggests that advisors read the OSC’s statement of priorities; the OSC’s annual summary report for dealers, advisors and investment fund managers; and IIROC’s enforcement report. “If you read those three things over the year, you as an advisor will have a good sense of what to emphasize in your own compliance regime.”