Ignorance isn’t bliss

(July 2007) It doesn’t take a hot-shot advisor to know that if a client commits fraud, you’ll be in hot water. But what if you have no clue that a client is manipulating the market? Turns out you can still kiss your job goodbye.

Speaking at the 9th Annual Compliance Readiness Strategies for Investment Counsel Portfolio Managers, lawyer Robert Brush warned that a lack of due diligence can get an advisor in a heap of trouble. “Advisors who are in a position to detect wrongdoing and either negligently fail to detect it or fail to move forcefully to prevent it will be prosecuted,” Brush said.

According to Brush, not looking into a client’s history or following their transactions closely can violate the “gatekeeper” rule, which is set out by the Investment Dealers Association (IDA) in bylaw 29.1 and the Know Your Client rules.

Alex Popovic, the IDA’s director of enforcement, explains that “advisors are the gatekeeper. Part of that obligation is to ensure the people who they service belong in the marketplace.” Violating the gatekeeper rule, even without knowing that you’re in breach, can result in discipline from the IDA.

Brush cites the case of Stephen Toban, an advisor who was accused of violating bylaw 29.1 and regulation1300.1(a) (the KYC rule), by not knowing that some of his clients had shady pasts. According to Brush, the IDA said Toban was “alleged to have facilitated certain activity in the accounts…without making diligent inquiries to ensure the legitimacy of the transaction in circumstances which should have called the activity into question.”

Toban claims that he did act properly. “Mr. Toban testified that he did his due diligence for all new accounts,” says Brush, “but there was no documentary evidence or paper trail to corroborate his due diligence efforts.” Toban was given a lifetime ban and fined $100,000 in December.

Brush says it all came down to proof. “You have to prove that you were lied to. If you can’t prove it, even if you didn’t know, you can be prosecuted.”

While Brush thinks Toban’s penalty was too harsh, he says this could happen to any advisor, so they should pay closer attention to their clients.

So what can an advisor do to avoid this situation? In Toban’s case, a simple Google search would have solved the problem. “If Toban had done a check on one of the individuals, he would have found a 1995 NASD notice of disciplinary action,” says Popovic. “If Toban had been aware that some of his clients were not trustworthy, then perhaps he would have questioned the Nutraceutical transactions that went through their trading accounts.”

There are a number of red flags that can make it easy for an advisor to deduce that a client is doing something illegal; cash transactions; large amounts of OTC Bulletin Board stock being journalled into an account; or the size of a transaction not matching the client’s net worth. “If you’re not sure why a trade makes sense, you’ve got to ask questions,” says Brush, who adds suspicious activities in multiple accounts to the red-flag list.

Probably the most important way an advisor can save himself from a lifetime ban is by keeping meticulous records of every interaction and transaction. “Document, document, document,” says Popovic. “At the end of the day, this is about protecting the registered representative and the firm.”

Popovic says more cases of negligence are popping up all the time. The IDA is on the lookout for criminals and advisors who fail to follow the rules, and it’s doing a better job at cracking down on dubious individuals. “We’ve improved at identifying key players who use IDA members and IDA reps to facilitate wrongdoing,” he says. Doing proper due diligence will be even more important if new anti-terrorism and anti-money-laundering regulations come into effect.

Despite the best intentions, it’s still easy to get duped. Popovic says a lot of fraudsters are smart, well traveled and know the financial business inside and out. So, follow Popovic’s advice: “If it doesn’t smell right, you should take additional steps.”

This article first appeared in the June 2007 issue of Advisor’s Edge Report.

Filed by Bryan Borzykowski Advisor.ca, bryan.borzykowski@advisor.rogers.com