Advisor-sold investment loans pose conflict of interest

Offering an investment loan to help finance a client’s mutual fund purchases might seem like a good idea, but one Ottawa-based lawyer questions the practice.

Harold Geller, an expert in financial advisor liability, says offering a client an investment loan can be a conflict of interest, pointing out that the more money advisors put into products, the more they make on trailer fees.

“The industry recognizes that these loans are advisor sold,” he says. “Companies offering investment loans through advisors report a strong rise in these things being sold. That’s a clear indication that the clients aren’t questioning this; it’s the advisors recommending it.”

The main problem Geller has isn’t that advisors are making more money; it’s that clients don’t know about the extra commission. “The advisor doesn’t explain how this is going to increase his compensation, and then they’re offside.”

To solve conflict-of-interest issues, Geller says, it’s imperative that the advisor tell the client he’s getting a kickback when an investment loan is used to purchase additional funds. If the client is informed and agrees to the loan, then “it’s not a problem as long as the advisor puts the client’s interest first at all times.”

“The advisor has a duty to say, ‘I’m going to be making more money off you taking more risk,'” he says.

But many advisors don’t disclose their fee structure or mention that more risk equals more money for them. Geller says the problem stems from advisors who don’t know how to service their clients properly, rather than from malicious acts.

“The vast majority of people who are failing in this regard is because of the continuing problem in their education and failing to recognize the conflict and their duties with respect to the conflict,” he says.

Mario Causarano, president and COO of AGF Trust Company, says using an investment loan has to make sense for the client, and if that’s the goal then it’s not a conflict of interest.

“From an advisor perspective, they have to do what’s best for their client in terms of managing and helping them create wealth.”

He says it’s true that advisors get compensated depending on how much money goes into a product, but that’s not the issue. “The real issue is that advisors have their clients’ best interest in mind and if they are taking a long-term approach to their client base,” he explains.

However, Geller is familiar with many cases where advisors don’t take a long-term outlook with their clients’ investment loans. The lawyer cites one case where a woman in her 70s sold her farm, and the advisor put all the proceeds into a leveraged product. When the investment lost money, margin was called, eventually draining the woman’s entire investment.

“As a result, she was in her 70s and driving a school bus,” says Geller, who acknowledges that this is an extreme case. “She’s in her 70s, and it’s ridiculous to think that she has a ten-year time horizon or longer.”

Causarano says investment loans are generally of the 20-year variety. “These are long-term. It’s not meant to be a short-term win. The advisor really needs to take a long-term perspective to managing a client’s return,” he says.

But even with a long-term view, many middle-class people can’t afford to get into a loan situation like this. Geller says buying leveraged products is for “sophisticated, well-moneyed individuals who can withstand significant downturns in the economy.”

He goes on to say that a well-earning, 40-something Chrysler employee might be able to invest long-term, but other considerations need to be taken into account, such as the risk of job layoffs or a failing economy, before moving ahead with an investment loan. “They might have the time horizon, but without due consideration, it really isn’t suitable for that person.”

While avoiding huge risks for the average person might seem like a no-brainer, Geller says a lot of advisors don’t know enough about the potential downsides to investment loans. He adds that he’s been to many information sessions related to these products but has never heard a company discuss the associated risks.

“Not once have I seen the downside risk illustrated in any of the sales material. They may explain it in small print, but even lawyers have problem reading the legalese. What about the average consumer?”

Causarano says that AGF helps their advisors understand what situations call for an investment loan, but education is a never-ending process. “There’s always work to be done to get them to understand, not only the benefits but the appropriateness of the solutions in the right circumstances,” he says.

“They’ve all got KYC rules, and those kinds of rules help them make sure they’re making the right decisions.”

Geller’s not so sure that education coming from the mutual fund company is giving advisors the full scope of the risks. He says the companies promote the positive aspects of the products without fully disclosing the risks and suitability requirements.

He adds that companies fail to compare their products with ones from other firms, so advisors can’t tell if their option is better or worse than someone else’s. “That puts the responsibility on the back of the advisor to do expansive due diligence, or to have failed in their duties.”

Whatever the reason advisors have for not understanding investment loans properly, it all comes back to the client and those extra trailer fees. If you take advantage of your client for personal gain, you can probably kiss your practice goodbye. “They’re not going to be in business for long if they don’t have their clients’ best interest in mind,” says Causarano.

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(08/31/07)

Bryan Borzykowski