Recently, the investment industry has witnessed a new crop of claims against financial advisors. Conventional equity holdings dropped by 40 per cent from early 2008 to March 2009 in portfolios that held only large Canadian company shares.
From summer 2006 to January 2012, the Toronto market (the TSE60) rose by 20 per cent. Investors who did not sell these portfolios recovered their former positions, including dividends. However, finance experts tell us that the investment herd tends to buy high (as it did in 2006-7) and sell low (as it did in 2009). That is what happened in many cases, and there are two types of recurring claims that subsequently arose:
- To increase their business, many mutual fund dealers and investment counsel portfolio managers encouraged clients to take out unprecedented loans to leverage investments. Many promised no-risk investments with no margin call. Of course, this was too good to be true. People borrowed to invest, often as much as $500,000, with no money down. This dramatically increased their overall losses. Investors who had previously had no debt faced $150,000 deficits, with no way to repay their loans. Others, who had equity, panicked when the market fell and sold at the worst moment.
- Some advisors made bets on penny stocks, warrants or single sectors that were hurt more than were blue-chip investment products. By 2010, it became obvious that these portfolios would never recover their pre-2008 positions. An 85 per cent loss followed by a 100 per cent gain still works out to a 55 per cent loss. These portfolios did not find 2011 kind to them.
The claims now on their way to court follow these two themes:
- People who could not afford to lose substantial sums invested too much money in equities, often in shares of small companies.
- People who borrowed money they did not have to buy investments they did not need now face losses they cannot repay.
In both cases, financial advisors had a professional obligation to warn their clients to avoid these risks, and a legal responsibility to document these warnings.
This is the third and final post in our series on New Client Application Forms (NCAFs). In the first two, we discussed what they contain and what they do not contain. Now, we will discuss what they should contain.
The purpose of the NACF is to record information a financial advisor has learned about a client that is significant for investment purposes. To acquire the relevant information, the advisor needs to ask the appropriate questions.
Why has the client decided to invest? If for retirement, the form should record the date the client intends to retire. It should also record what the client expects or needs to earn in retirement. What sources will fund that level of earning? Perhaps the goal is education, capital purchase, or support of others. This should be recorded, again with the expected amount of capital or earning power necessary to cover the payment goal.
To what degree does the client depend on the advisor? Sophisticated investors may depend on their advisor, just as inexperienced ones may not. This is not apparent from the current form, but only from a discussion between the advisor and client. Even then, the actual trading by the client may show that the indicated level of reliance is inaccurate. It does not help for the supervisor to observe a series of “solicited” or “unsolicited” transactions. It does help for the supervisor to understand the relationship that led to those transactions.
How will the financial plan be revised to accommodate success? How will the advisor recognize that the client has achieved the stated investment goals?This is more difficult to put in writing. Still, a reasonable expectation of objectives can alert the advisor and the supervisors for the day when the client no longer needs to take financial risks to achieve goals.
Responsible advisors write investment policy statements based on careful analysis of client needs. However, too many financial advisors do not fulfill this obligation. Apart from lack of training or diligence, there is no reason why advisors do not seek and record this information. Much of this information can be gleaned from the same discussion through which an advisor completes the existing NACF, with very little additional time or effort required. If advisors are required by their compliance departments to ask these questions during initial client interviews, this essential process would become automatic.
We know that the current NCAF does not convey much information to supervisors and compliance departments. A nudge from above would compel advisors to adopt more professional practices and ensure that the appropriate information is recorded.
In our previous blog post we discussed the investor information that financial advisors record on New Client Application Forms (NCAFs). This includes contact information, assets and liabilities, income, dependents, investment knowledge, investment objectives, risk tolerance and investment horizon.
What NCAFs do not contain is the information necessary for anyone else to determine whether an investment mix or recommendation is suitable for a client.
First, let us examine the information that is not recorded about the client’s financial circumstances:
- When does the client intend to retire?
- What other sources of income or assets can the client rely upon – for example, inheritance or survivor pension?
- What other needs for cash can the client anticipate and how pressing are these needs?
- How solid are the client’s family relationships? Admittedly, financial advisors are neither marriage counselors nor psychologists. However, marriage (and other family) breakdown is now so common that they must take this possibility into account when dealing with clients.
- Does the client have investment accounts with another advisor? If so, how are these being managed? To what extent will one complement or conflict with the other?
Next, let us examine the information that is not recorded about the client’s knowledge, objectives, risk tolerance and investment horizon:
- If the client has investment experience, what impact does this experience have on the current relationship? Will the client be more or less likely to rely upon advice from the advisor, and to what degree? How, and how often, will the client and the advisor communicate with each other? Will the client treat the advisor as an "order taker" or rely on the advisor for trusted guidance? Can, and will, the client read and understand periodic financial reports from the advisor’s firm? Will the client look to a third person for explanation and advice?
- Why does the client invest? The average client wants to save for retirement, pay down a mortgage, finance education for children and leave an estate. These goals have a great deal of influence on risk tolerance and time horizon. Oddly, many clients have already achieved their goals, and yet advisors continue to recommend risky investments. If a client only wants to invest to achieve a profit without any rationale for doing so, how can the advisor assess what level of profit represents success?
- What happens if the client fails to achieve the investment goals? This may compel the client to find a second job or to postpone retirement. It may compel the client to reduce expenses. In many cases may result in financial disaster for the client. Without knowing the answer to this question, a financial advisor cannot fulfil the KYC obligation.
- When will the client need to access some, most, or all of the money invested? This crucial question should appear under "investment horizon" on all NCAFs. Unfortunately, it never does.
As you can see, the current NCAFs leave out a tremendous amount of information. Typically, a competent advisor can answer most of the questions raised, but a supervisor or compliance officer cannot assess the suitability of transactions without knowing much of what the advisor knows. The day is fast approaching when investment firms will be called to account for the information that is clearly missing from their NCAFs.
In this and our next two blog posts, we will discuss what New Client Application Forms (NCAFs) contain, what they do not contain and what they should contain. Our goal is to inform investors of the role these forms currently play in the Know Your Client (KYC) process. More to the point, we want to inform investors of the role they should play in that process.
NCAFs are designed for financial advisors to record clients’ contact information, assets, liabilities, income and dependents. They also contain boxes for investment knowledge, investment objectives, risk tolerance and investment horizons. Except for the contact information, the content of these forms can be misleading.
First, let us examine the information recorded about the client’s financial circumstances:
- Do assets include real estate? Is that real estate assessed at market value or at cost, and before or after mortgage costs? Are assets determined before or after tax? Are all assets registered or not? Are any assets jointly-owned? If so, what portion does the client own?
- Do liabilities include mortgages, student loans and guarantees of the debts of others? Do they include income tax owed and accrued capital gains tax on unrealized gains? Do they include spousal support, anticipated liability for division of net family property, and obligations to a dependent in need of money now or in the future?
- Does income include income from investment assets? Does this include capital gains unrealized? Should it be taken for the previous financial year, the previous calendar year or averaged over a period of time? Does it include spousal income where the account is not joint? What about bonuses that may or may not be repeated? How predictable is the income and over what period of time?
- Does the word "dependent" include adult children who have some income? Does it include those who are self-supporting, but will need help with large purchases? Does it include aged parents, or grandchildren?
Next, let us examine the information recorded about the client’s knowledge, objectives, risk tolerance and investment horizon:
- How exactly is investor knowledge gathered on the form? Is the answer to each question the conclusion of the advisor or the opinion of the client? How does the advisor know which box to check and upon what information the opinion is based?
- What do the objectives categories mean? Clients’ investment objectives do not match the categories in current NCAFs. The average client wants to save for retirement, pay down a mortgage, finance education for children and leave an estate. Most do not think that a bond that earns 5% is different than blue chip equities that grow by 7%. Both are growth products and both are safe, each within its context. Is the 3% dividend paid by a blue chip growth, income or preservation of capital? Is the interest earned on a government bond income or preservation of capital? What is a preferred share of a large company? What is a balanced mutual fund? Manuals given to advisors do not define these terms.
- What does risk tolerance mean? Does it apply to each transaction, or to the portfolio as a whole? Does it apply to each account? Does it apply to each category within each account? (For example, blue chips are low-risk relative to equities, and government bonds are low- risk relative to fixed income.)
- What does investment horizon mean? Does it describe the time before any, part or all of the money is needed? Does it describe the time before a material change in circumstances, such as retirement or completion of a child's dependency, is foreseen?
In short, NCAFs are designed by investment firms to serve as summary notes by advisors. Clients do not fill out these forms; they are filled out by the advisors who interview them and who use subjective language to complete them. The forms contain industry jargon that is rarely defined by the advisor or understood by the client. As such, they fail to disclose what an advisor actually discussed with or proposed to the client.
There are far too many questions raised by a NCAF for a client to answer without advice. If the client receives advice, how can the supervisor or compliance officer know what advice was administered? Advice administered varies dramatically from registrant to registrant. Under the current NCAF system, there is little guidance given by firm supervisors or regulators. In short, there is no guarantee that advisors who complete NCAFs will fulfil their KYC obligations.
There are three tasks that every financial advisor must perform for each client:- Complete the Know Your Client (KYC) process to learn the important facts about the client. Only with these facts can they appreciate their clients’ goals and risk tolerances, which will inform their advice.
- Complete the Know Your Product (KYP) process to learn about the range of financial products available that may meet the client’s needs.
- Put the KYC and KYP information together to generate appropriate investment recommendations.
Financial advisors who follow this formula recommend only products suitable to their clients’ circumstances and needs. Yet so often, clients suffer losses due to unsuitable investment recommendations. How does this happen, and who is responsible for the failure of these investments?
No one wants to admit fault for losses. When investors complain, often their advisors blame them, with standard replies:
- You received statements and trade slips. You must have accepted these.
- You have bought and sold in the past. You are sophisticated and understood what you got into.
- The Ponzi scheme was a fraud by others. It was not our fault.
The law is now clear.
Advisors cannot pass the responsibility for client-investment suitability on to their clients. Either the investment is suitable or it is not. If it is not, the advisor must warn the client in clear language that the client will understand.
On the other hand, if a client misleads the advisor on an important fact, the responsibility for a bad investment could shift to that client. However, what was the “fact”? That the client wants “investment growth” is not a fact. The desire for “growth” is a judgment that the client pays the advisor to assess. The advisor cannot pass the burden of this judgment, and others like it, to the client.
Investment regulators now understand that advisors have an obligation with professional diligence, even when their training falls short. Advisors and their firms’ compliance and ombudsman departments must also understand this. When they fail to do so, investment regulators should firmly remind them.
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