Avoiding liability (Part 3): Your KYC process and other tools

By Harold Geller | April 7, 2009 | Last updated on April 7, 2009
6 min read

The Know Your Client (KYC) process is commonly misunderstood.

In general, the misunderstanding is born of the financial advisory and planning services’ history of being purely sales driven before it turned into a true profession. The misunderstanding is easily corrected, and should be, since correction is likely to result in more effective client communications, improved service and decreased liability risk.

The misunderstanding is four-part:

• The KYC obligation is not a single form, step or activity. KYC obligations are ongoing and should be part of an in-depth process. The KYC form is simply a “tip of the iceberg” snapshot. Completing a KYC form alone is not enough to prove that an advisor or planner is meeting his or her KYC obligations.

• Meeting KYC obligations requires ongoing and dynamic investigation of a client’s KYC attributes. The KYC process is multi-part and involves rigorous examination of information provided by the client.

• Some “mandatory” KYC forms used by IIROC and MFDA dealers are misleading to both the client and the professional financial advisor or planner. The KYC process requires holistic planning. Limiting the planning process to assets under administration or the products offered by the dealer is a breach of acceptable standards. A representative may be required to complete this form for the dealer’s use, but completion of this form does not provide meaningful evidence that advisors have fulfilled their KYC obligations.

• Life insurance agents must also undertake a meaningful examination of KYC attributes much like that required of an MFDA or IIROC representative.

The KYC process should include diligent and systemic efforts to gather all available information about the client’s assets, liabilities, routine expenses and foreseeable potential expenses that are often associated with life-cycle events.

The KYC process should involve an investigation of the client’s life-cycle hypothesis — foreseeable events and the client’s potential to accumulate net worth and wealth as he or she ages. A newly licensed professional (doctor, lawyer, accountant), for example, may have lower income than a unionized production worker or an oil rig worker, but the licensed professional’s ability to accumulate net worth is likely to be materially greater. So, too, wealth accumulation for your clients may be highly dependent on their health unless they hedge using appropriate insurance policies. Without consideration of a client’s unique life-cycle hypothesis, meaningful advice and planning cannot occur.

Collecting KYC information must involve a stepped process to educate all but the most sophisticated clients. It must build a communications bridge using language common to both advisors and clients.

The need for an educational process is self-evident: in almost all professional advisory relationships, the professional inherently knows more about the KYC process and planning. The professional financial advisor or planner understands the six-step planning process, the service and products available, the risks, benefits, complex concepts and highly specific industry jargon. All but the most sophisticated clients must be assumed to have limited relevant knowledge, education and experience in this respect. In order to obtain the client’s meaningful participation, the professional financial advisor must educate the client about the six-step planning process and the KYC process in particular.

Building the communications bridge is a key element in this education. KYC forms, engagement letters, information materials and disclosure forms used by most, if not all, companies are undermined by the use of industry jargon and subjective terms.

Two examples come to mind. One comes from the MFDA, the other from an IDA (now IIROC) case:

• What do the terms “diversified,” “balanced” or “long-term” mean? I have heard senior industry professionals testify under oath that a diversified holding can be composed of leveraged, sector-specific funds and that “long-term” means two years or more. Did witnesses believe this? Would any reasonable client agree? Would a judge buy this hogwash?

• What does “moderate risk tolerance” mean? In my opinion, I have a moderate risk tolerance. I would risk more than 10% of my present assets by investing in equities or mutual funds with equities components. I have an ongoing case, though, in which a major IDA dealer thinks a judge will agree that a recent divorcee who earns $40,000 each year, has $350,000 net worth with $250,000 of it invested in only one equity sector — 70% of which is invested in only one stock (which has a 100:1 price-earning ratio, no less) — is invested in a “moderate risk” portfolio. Who is he kidding? If you have a dealer who allows this, you should be concerned about whether or not your compliance department is doing its job.

Professional financial advisors and planners can overcome communication barriers during the KYC process by asking clients, in plain English (or French), what the different terms mean. A discussion of “risk” should begin with the fundamentals — that stocks are inherently risky, as are the mutual funds that invest in stocks; all money invested in stock markets is at significant risk, any company could go bankrupt, and the ownership interest of equity could be lost. That is where we start. Next, the discussion should examine the difference between highly regulated and capitalized shares (Canadian bank stock, for example) and highly leveraged shares (from, say, many mining companies), or the significant difference between those stocks and government GICs.

Related articles:
Part 1: Second opinion seekers Part 2: Letters of engagement and your get out of liability free card Part 3: Your KYC process and other tools
From the series: Avoiding liability in uncertain times, by Harold Geller.
The bottom line is that a client needs to be educated about the difference between “return on capital” and “return of capital.” The client must be quizzed to ascertain his or her true risk tolerance, not just asked an opinion.

If a client were claiming to prefer “moderate risk,” the professional financial advisor should engage in an investigation to determine how much volatility a client would withstand in his or her portfolio (5%? 10%? 20%? more?) before running for the hills during an extreme market downturn (it happens in a regular cycle). Failing to put “moderate risk” into objective terms is a missed opportunity and a failure to communicate.

A meaningful KYC process requires professional financial advisors or planners to think beyond their own silo of products or services. An MFDA- or IIROC-regulated representative must consider the client’s risk of exposure to loss of income, loss of work or loss of the ability to work. Insurance agents conducting their own KYC process before recommending a universal or whole life policy must consider this same issue. Failing to consider all foreseeable potential downside events exposes the professional financial advisor or planner to meritorious negligence claims and regulatory complaints.

Two final points:

• Show your work. When clients experience a loss, professional financial advisors and planners should be able to prove that they met all reasonable standards of care and reasonable client expectations by making good on their process guarantee. The documents that are created during a meaningful KYC process are an essential part of proving fulfillment of this process guarantee and a powerful tool for responding to client concerns. If questioned, you can share your documents with clients to show how and when they bought into the planning process and that they were fully informed and fully engaged when they did so. Most clients are satisfied once their memories are refreshed.

• The KYC process is a dynamic and ongoing process. Your clients must be educated about what “material change” is and why you must be informed promptly when potential or existing material changes occur. You must educate them about why this is so important and what it means to their financial future. Regardless of whether they “get it,” follow up with them regularly (at least once each year — an absolute minimum) to ensure you have up-to-date records.

Harold Geller is an expert on legal issues affecting financial intermediaries. Harold assists and represents dealers, MGAs, branch managers, compliance officers and advisors dealing with their compliance, regulatory and negligence issues. Harold also helps financial intermediaries with internal business and their clients’ legal issues. Harold is a well-known industry commentator, a CE provider and administrator with foradvisorsonly.com. Harold’s law firm, Doucet McBride LLP, also provides advice on tax issues, Succession Planning, Retirement Planning, Estate Planning and buying and selling books of business. Harold can be reached at hgeller@doucetmcbride.com.


Harold Geller