Off-book transactions: Unlimited liability, zero upside

Off-book products might occasionally generate windfalls for investors or commissions for brokers, but when it comes to dealers, they’re nothing but a liability, according to litigators speaking at the Advisor Group’s Fall Compliance Conference.

“Such products tend to thrive when the markets are down,” says Jim Douglas, partner, Borden Ladner Gervais, “as retail brokers desperately scramble for innovative ways to invest their clients’ money, and generate more commissions.”

David Hausman, partner at Fasken Martineau, is even less gentle, calling off-book transactions nothing but a euphemism for fraudulent transactions. “Sometimes the brokers who recommend them are as duped as the investors who buy them,” he says. “And in the end it could be the branch managers who end up getting implicated for negligence, in terms of vicarious liability.”

According to Douglas, civil liability issues for brokerages have become exacerbated over the past few years because the attitude of the Canadian courts has liberalized considerably.

In the past, firms faced civil liability only if the broker had ostensible authority, such as wearing the firm’s hat, and handing out the firm’s business cards while selling the product. This would naturally lead clients to believe that the dealer endorsed the sale, he explains.

But lately, due to a series of fraud cases, the Supreme Court of Canada has decided liability should be addressed more on a risk-assignment basis rather than an ostensible authority basis. So, between the party that suffers the harm, and the party arguably responsible for it, courts tend to assign the risk to the one best positioned to absorb it, namely the broker and the firm that hired him or her.

“So if your sponsored rep is engaging in off-book activity, particularly fleecing widows and orphans — or assisting someone else in doing so, which is more often the case — you’ll be the one liable for civil liability action,” Douglas says.

“And if folks in the hinterland are losing money, you won’t have just the regulators and civil litigators chasing you down; you’ll also have local politicians clamouring for justice for their constituents,” he warns.

But firms should not wait for a regulator or judge to alert them to off-book activity taking place under their noses. There are usually indicators along the way.

For example, branch managers and compliance officers should be wary of any oddball promotional material for investment products the brokerage doesn’t list on its book, Douglas says. They should be equally concerned about unfamiliar people who regularly come in and out of office, and are not employed by the firm.

Hausman suggests managers should also be on the lookout for journal entries. “Why would stock be transferred from one unrelated account to another unrelated account within a brokerage without it being traded, unless there’s some unwarranted transaction behind the scenes?”

Other red flags on Hausman’s list include third-party cheques being deposited to a rep’s account or to one particular client of the rep, or large amounts of money suddenly flowing in from third parties. Anonymous wire transfers should ring a compliance bell as well.

According “sacred cow” status to anyone in the dealership because that client generates a lot of revenue is another major red flag in the regulator rulebook, Douglas asserts. “No one should be able to bully the house into not being within the compliance stream of things.”

The risk of litigation and class action lawsuits, especially in a down market, is propelling dealerships to respond to the perils involved in off-book transactions. Dundee Wealth Management recently changed its operations to ensure off-book transactions don’t take place under their banner, starting January 1, 2009.

In MFDA-land, regulations already oblige advisors to place all mutual fund business through one dealer. Insurance regulators, however, do not require insurance advisors to place all of their business through a single MGA. Dundee plans to bring all life insurance and GIC business under the DIAL (Dundee Insurance Agency Ltd.) banner. The new policy means advisors will now have to choose between continuing as Dundee advisors and terminating sales through outside MGAs, or leaving Dundee.

A memo issued by the firm does however permit certain exceptions for existing contractual arrangements. Group insurance is also exempt. Existing blocks of business will additionally be allowed to remain with the existing MGA.

John Kelleway, regional vice-president, GTA, and branch manager, Dundee Securities, says the decision is a risk management move and was made because complaints and situations have arisen in the past few years. “It hurts the brand name. Advisors are using Dundee business cards to get clients, but are selling products outside the dealership. We end up taking on the risk, but not the revenue.”

(11/28/08)