Suitability: Time for a refresher?

While more stringent regulations likely would not have prevented Earl Jones from robbing hapless widows and trusting seniors — since he wasn’t actually registered to sell investments in the first place — this most recent financial scandal has nonetheless reignited the compliance debate.

But, no matter what the source, when it comes to client complaints, unsuitable trading still tops the list.

Trouble generally arises when advisors try to apply their own investment philosophies or to sell a product they “believe in” without due regard for the true investment objectives and risk tolerances of the people across the desk. And advisors fall into trouble when they try to push things on clients or convince them to take this approach, such as leveraging, or to buy that product, which a manufacturer is currently promoting and which you think is going to do well.

While it’s imperative to stay abreast of new products and broaden offerings at regular intervals, with many firms offering upward of 2,000 products on their shelves, it’s humanly impossible for an advisor to truly know all those products. So stick with what you know.

It’s also part of your job to identify client circumstances that lend themselves to particular strategies, such as leverage as a means to reduce tax burden. Educating clients and laying out a variety of options for them is certainly part of an advisor’s job. But when the rubber hits the road and it’s time to make a recommendation, in this highly regulated environment it’s a good idea to focus much more on the comfort level of the client.

The 2001 decision of the Alberta Securities Commission (Lamoureux v. Alberta) is widely regarded as a benchmark on meeting suitability and “know your client” obligations. It explains suitability as being a three-step process:

Step 1: It all starts with due-diligence: Know the client; know the product.

Filling out a form that summarizes a client’s age, net worth, investment knowledge, time horizon and risk tolerance isn’t enough. According to the decision, “Forms and procedures are merely tools that can assist in performing a task and may provide reminders or evidence of efforts undertaken or not undertaken.” In other words, you must “be the client” — step into his or her shoes and let suitability determinations flow from him, not to him. This is an ongoing obligation.

And the requirement to update client suitability information regularly is not just a perfunctory exercise. It exists so you actually know about changes to your client’s circumstances such as divorce, job loss or other impacts on risk tolerance and investment objectives.

Updates are also not to be used to “paper” the account or bring an unsuitable investment into line with know your client information. Updates that alter a client’s investment objectives, risk tolerance or time horizon must be supported by objective evidence that there has in fact been a change in the client’s profile to justify the update. And you should know that the less sophisticated a client, and the more reliance they place on your advice, the higher your fiduciary obligation toward them.

Knowing the product involves carefully reviewing and understanding the attributes and risks of the investments you are recommending. The best advisors stay out of trouble by knowing a handful of sound products in each risk category or for use with each strategy or need, and knowing them well. They study them before they are offered and keep track of them over time.

Step 2: Determine whether specific trades or investments — solicited or unsolicited — are suitable for that client. In other words, is there a “match” between the client and the investment or strategy?

Step 3: Disclose material negative factors. This step is intended to assist the client in making an informed investment decision. It’s important to note, however, disclosure of negative factors does not absolve an advisor of his or her obligations in the first two steps, even if the advisor obtains a written acknowledgment from the client that they are aware of the material negative factors. Acknowledgement from the client “does not convert an unsuitable investment into a suitable one” according to the Lamoureux decision.

Step 4: Record your discussions with a client in writing in the client file. If you have followed steps one through three diligently, this disciplined practice is far more likely to save the day in any regulatory or civil liability situation. And the further on the risk spectrum the proposed strategy or investment, the more critical this step becomes. It is the medium-high to high-risk investments, heavy use of leveraging, shorting etc., that rear their heads during market volatility. Complaints rarely flow from clients with low to medium risk investments in their portfolios. It is especially good practice to record the client’s response to this disclosure: “I don’t care, this is my play money anyway,” or, “I need to take more risk here because my portfolio is not where it should be at my age.”

The MFDA released suitability guidelines in April 2008 that provide guidance to approved persons on meeting their suitability obligations. The 27-page Member Regulation Notice holds the advisor to quite a high standard on the issue of risk:

“It is not just the client’s comfort level or attitude toward risk, but also his or her actual ability to withstand financial losses. Risk tolerance therefore should be determined as the lesser of both criteria,” the document says.

Incorrectly assessing client risk tolerance is one of the most common allegations made in client complaints to the MFDA. Clients often allege the risk tolerance indicated on the KYC form was higher than his or her actual risk tolerance.

In some cases, there is a difference between the risk a client is willing or able to take and the return the client expects, which can result in an advisor assessing risk tolerance higher than it should be in an attempt to meet client expectations.

Some guidelines

So, in order to increase your chances of success when a regulator or plaintiff lawyer comes knocking on a suitability complaint, follow these golden guidelines:

1. Ensure the client is correctly filling out the forms, and use additional tools to assess a client’s needs and objectives.

2. Put yourself in the shoes of the investor, rather than try to sell him or her strategies and products you have learned about and found effective in other situations. Every client is unique and your KYC exercise should reflect that.

3. Suitability is an ongoing process. Stay in touch with clients and update their information when material changes occur.

4. Know your product. Understand all its attributes and downsides. Limit the number of products you offer to manageable levels.

5. Disclose the downsides of the product at the time of sale. This will come in good stead if a client later complains he or she wasn’t told about the drawbacks.

6. Record, record, record. Keep written records of discussions with clients, especially when recommending higher-risk products and strategies, and make sure there are notes about any downsides and how the disclosure of those was absorbed by the client.

(07/16/09)