Brown: You can’t sell what you can’t understand

(May 10, 2005) In one of his last addresses to the investment community before leaving his position as OSC chair, David Brown told the Toronto CFA Society that advisors should be held accountable for any inappropriate investments made by clients they referred to the firm.

“There may well be some issues to address in relation to the manufacturers of some of these investment products. But the responsibilities of the intermediaries involved are clear,” said Brown. “They are professionals with a duty to understand the products involved and the risks entailed.”

While refusing to answer any specific questions regarding the investigation into Portus, Brown concedes that the OSC is more focused on the advisors who sell complex products, than on the manufacturers of those products.

Some question whether there are gaps in the current regulations which allowed Portus to be sold to inappropriate clients in the first place. Brown disagrees, saying the “know your client” rule places the onus on advisors to understand the products to which they direct their clients. If they don’t understand the product, they cannot possibly consider it to be suitable.

“In fact, the complexity of the foreign intermediaries involved in the international aspects of the transactions — and the lack of regulatory compliance by Portus — has made it difficult for investigators to understand this product after months of forensic accounting,” Brown admitted. “You can’t apply any particular investment recommendation to the client’s needs, unless you have an understanding of the risk attributes of the investment.”

Much of the furor over Portus is that as a hedge fund investment, it should only have been available to accredited investors. When asked if the industry has been able to sidestep such rules, Brown said it was too early to tell and he had seen no evidence of this.

“We’re working with the two SRO’s — the IDA and the MFDA — to make sure that our rules are adequate,” he said. “We are quite prepared to look at our own rules and make sure they are explained well enough, but we also want to make sure they are being complied with by those who are out making these investment recommendations.

“What everybody involved in the recommendation of complex financial products needs to do is to reassess their understanding of the product, reassess their commitment to investors, to make sure that products are suitable for them and to make sure they are motivated with the best interests of their investors in mind.”

Many advisors have said the focus on referral fees has been unfair, saying that if they were simply “in it for the money” they could have earned more by selling their client a DSC fund.

But Brown says the regulator is really interested in finding out how Portus products found their way into so many portfolios so quickly.

“The fees that were being paid were comparable to fees that are being paid on the sale of mutual funds, but these were fees being paid for referrals and we need to understand whether that indeed was a factor in such a broad penetration of this product in such a short period of time.”

While advisors were comfortable collecting a similar payout as they would have with a mutual fund, they are accepting none of the responsibility that would have accompanied the transaction had it been a fund sale.

“When formerly elite investment instruments become more widely available, the industry has to take a good, hard look at them to determine their suitability for the average investor,” Brown said. “We also have to make sure that the industry is clear on its responsibilities.”

Pointing out that hedge funds are not regulated by the OSC, Brown urged all investors who are interested in such products to be sure they understand what they are getting into and how the product matches their own risk parameters.

“I’m asking all those involved in the distribution chain to ask themselves whether they are comfortable, whether they understand the products they are selling,” he said. “It is really a call to the industry — to us as the regulators, to the SROs who are responsible for setting the education standards — to stay current.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com