Investment loans carry risk for advisor

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.”

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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.”

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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.”

So why keep notes if they can’t protect you? Brush, who represents both clients and dealers in his practice, says that paperwork can speed up the settlement process or, in many situations, a lawyer might not take on the case at all. He says most of his work is on a contingency basis, so the only way he makes money is through a settlement or judgment. Therefore, he’ll only take on cases he thinks he can win.

While a paper trail might not result in a win for the advisor, it almost certainly means the case will be dragged out until it’s not worth the lawyer’s time anymore. “If there’s a one-month trial, that’s two months of work prepping and three years’ building that case, and if I go to trial and lose, I make nothing,” he says. “So what do I not want to see when assessing a case? Paper.”

Another seemingly surefire defence for an advisor is that the client is experienced and knew what he or she was doing. However, there’s almost no way that argument will hold up in court.

Read: Regulators rein in advisors on leverage

Brush points to the “Robinson case” as proof that the sophistication logic won’t work in court. Robinson, he says, was a “wildly sophisticated investor, the most sophisticated you can imagine.” He was the CFO of a major public company, a managing partner at a large accounting firm, and he wasn’t afraid to take risks. Robinson, however, wanted to invest in a medium-risk portfolio. For some reason, though, the mutual fund salesperson put him in a high-risk one.

When the plaintiff lost money, even though he may have known what was happening, he sued, claiming he expected to be in a medium-risk portfolio, and that didn’t happen. The court agreed and the firm had to pay up.

The other problem with experience is that many high-net-worth clients might seem knowledgeable and successful, but when it comes to things like taxes or investing, they outsource the work to accountants and advisors.

“The client will come in and go on and on that they didn’t understand what they were investing in,” says Paglia. “Part of that is true. This type of sophisticated client is used to hiring people. He says ‘I hired you, I write the check, and I’m not really going to pay attention.'”

In order to prevent litigation, advisors need to understand the strife leveraged investments can cause. And that’s where the compliance officer comes in. Bessner says getting advisors on board is a “huge challenge” for compliance departments, considering advisors can make double or triple the revenue from investments made with loans. “It’s a slippery slope, because they rely on that income and the lifestyle that goes along with it, but when the market goes down, it’s a big, big problem,” she says.

Compliance officers should talk to their risk managers and CFOs and explain to them how vital it is to make sure advisors know what they’re doing. “You need to start with the dealer’s senior members, and get their attention,” says Bessner. “Only then is it going to permeate down to the advisor.”

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Bessner has a trick up her sleeve to get advisors thinking twice about leveraging. She asks them what they want to do with their book of business when they retire. Of course, they all say they want to sell it. She points out that anyone who is going to buy a book of business will do a risk assessment, and if 50% or more of the clients are leveraged, there’s no way the sale will go through.

Even if the leveraging is legitimate, no one will take the time to review each individual file to determine whether everything is on the up and up. “You have to scare them a bit,” she says. “And that’s where they’re really motivated — in buying or selling their business.”

In the end, there’s not much advisors can do to shake a lawsuit other than removing leveraging as an option for their clients. Paglia says some clients will gun for a lawsuit no matter what, so compliance departments need to make sure they’re on top of things at their firm. All it takes is one rogue advisor to bring down a company.

“When regulators see a whole bunch of clients complaining against one advisor, and they’re all in leveraged loans, not only does it go to the advisor, but the branch manager and then the second tier on compliance,” says Bessner. “The question will be, ‘Where were they?'”