Lawyer raises red flag over leveraging

(May 13, 2003) Borrowing to invest has become common practice in the mutual fund industry, but lawyers say the leveraging strategy can be fraught with danger for both advisors and their clients, particularly in a bear market environment.

“Leveraging is like the iceberg that hit the Titanic,” said Jim Douglas, a partner with Borden Ladner Gervais, at IFIC’s annual compliance forum yesterday in Toronto.

“When you look at the 70-year-old couple who have mortgaged their house at 80% to buy mutual funds, the wisdom and suitability of leveraging starts to look pretty questionable,” Douglas said. “And it will look pretty questionable to judges and regulators.”

Douglas advised compliance officers to start looking around their company to find out how much leveraging is out there, noting that it’s not always transparent because fund firms don’t sell on margin, like brokerages.

“Most of that leveraging comes from bank or trust companies loans; they don’t have the same fiduciary obligations,” he explained. “But when the bank calls that loan because the mutual fund has dropped in value, the people come back on you.”

Douglas listed leveraging as a major civil liability risk for fund companies and their representatives, suggesting that the general “non-litigious” nature of Canadians has limited the amount of cases that have gone to the courts. “If we were in the U.S., you would all be subject to lawsuits in the leveraging area,” he declared.

For firms that do end up in court, a sympathetic response is unlikely, the lawyer added. “The investment industry is suffering right now before the courts,” he said, for the simple reason that many judges are also investors. “They were buying and holding as well in the 1990s. They don’t trust the investing world any more than the average person on the street.”

Regulators are also seeing evidence of problems related to leveraging. Mark McManus, manager of the Ontario Securities Commission’s contact centre, said leveraging is one of the most common complaints the centre receives from investors. “It’s a big concern to us,” he said at the forum.

Similarly, Mike Lauber of the Ombudsman for Banking Services and Investment (OBSI) said suitability and leveraging are the most popular investment related complaints he sees on a regular basis. Lauber also noted that the OBSI has seen a spike in the overall number of complaints received this year, mostly related to the banking sector.

Off-book investing is another potential legal minefield for the fund industry, Douglas added, noting that companies shoulder the liability when their registered reps sell any unapproved products to clients. It’s an attraction for some advisors, he admitted, who can make commissions as high as 30% on investments such as limited partnerships.

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Douglas suggested that companies communicate directly with clients, spelling out exactly what products representatives are allowed to sell. Those who do sell unapproved products should be immediately dismissed, he added, noting that the odds of a fired rep managing to move his or her book of business to another firm are “slim and none.”

“If you want to deal with the issue, you have to get tough with people,” Douglas said. “If you get tough with a few, the rest will fall in line.”

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Compliance lawyer Ellen J. Bessner writes a regular column in Advisor’s Edge entitled “Compliance check.” She recently wrote a three-part series about credibility in court (in the March, April and May 2003 issues).

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Is leveraging something you regularly recommend for your clients and does this “red flag” concern you? If so, will you change how you deal with clients who ask you about borrowing to invest? What other compliance issues concern you? Share your thoughts or ideas with your fellow advisors in the “Free for All” forum of the Talvest Town Hall on Advisor.ca.

Filed by Doug Watt, Advisor.ca, dwatt@advisor.ca

(05/13/03)

Doug Watt