Borrowing trouble

(December 2005) Sure, you might be able to borrow money from a client at a better rate than you could get from a bank. But just because you can, doesn’t mean you should.

It does happen, though, and that’s why the Mutual Fund Dealers Association chose to issue a notice outlining how it expects advisors to behave. The guidance acknowledges the MFDA’s rules don’t explicitly prohibit borrowing from clients, but then quickly states such behaviour is clearly a conflict of interest and should be prohibited.

It goes on to say, “borrowing from a client by either the member or approved person raises a significant and direct conflict that in almost all cases will be impossible to resolve in favour of the client.” Lending, by contrast, is specifically covered in the MFDA’s rules. It’s generally prohibited, as are the extension of credit to clients and the selling of securities on margin. The exceptions are generally situations in which the borrowers are family members of the advisor.

Bottom line, according to MFDA compliance director Karen McGuinness, is that the self-regulatory organization doesn’t want advisors putting their own interests before those of their clients. “We’re asking [advisors] to bring things to their compliance officers if they think it’s a conflict of interest,” she says. “And it’s letting the dealer know that once this is brought to their attention they have a responsibility to consider the conflict issue.”

McGuinness says a lot of advisors figure they’re good for the money and can pay the client 3%. But, at the end of the day, an advisor needs to ask himself whether the client would make the same loan to someone with whom there wasn’t a fiduciary relationship.

The MFDA’s not alone. The Investment Dealers Association recently expelled an Alberta registrant for a borrowing scheme that took thousands out of the pockets of his clients. His multi-year pyramid scheme used the proceeds of recent borrowings to pay off older loans. He also funnelled money into offshore investments that his firm and his clients knew nothing about.

The problems aren’t unique to Canada. In the U.S., both the National Association of Securities Dealers and the New York Stock Exchange instructed compliance departments to watch trading in reps’ personal accounts to see if more stock was being bought than a person would reasonably have cash to purchase. In theory, that tips a compliance officer as to whether he’s borrowing to trade.

Lending activities at day-trading firms also caught regulatory attention during the late 1990s. Using a process called “journalling” daytrading firms facilitated the lending of money among traders to ensure margin calls were met.

Similar surveillance systems are employed at Canadian firms. According to several branch managers, exception reports generated daily, weekly and monthly tell managers and compliance officers when buying spikes take place in reps’ personal accounts. “If something looks fishy,” says a branch manager at a bank-owned firm, “the rep will be called into an office and asked, ‘What’s going on?’”

John Rothwell, president of Wellington West Capital, was surprised the MFDA felt compelled to issue its notice. The idea of borrowing from clients is nonsensical in his view and such an obvious conflict of interest. Rothwell says Wellington is working up a mortgage lending business and is going to make sure it’s clearly separated from the other investment operations to ensure there’s no confusion in clients’ minds about what’s going on.

Lending arrangements do crop up, though, says McGuinness. “We’ve seen people who borrow money from clients and that’s generally inappropriate,” she says.

In some cases, the arrangements emerge when an advisor starts participating in an investment club. Sometimes, advisors join clubs with an eye toward becoming a de facto portfolio manager and, ultimately, generating themselves additional income. “They could have their own money in it and say, ’This is an appropriate strategy,’” says McGuinness. “But in an investment club, it’s supposed to be everyone’s joint decision.”

Worse, a branch manager says he’d likely view an advisor taking a lead role in an investment club as engaging in outside business activity. If an advisor was skimming extra commission off that kind of arrangement, or borrowing money from other club members to purchase investments, then a manager has to ask why that rep didn’t simply bring the club member into the office, fill out the proper paperwork, and open a client account.

Absent some good answers, the advisor might find himself a member of the stripped-of-registration club.