Legally speaking: OSC states the obvious

The basic duties of an MFDA or IDA advisor may seem obvious to anyone familiar with the association rules and regulations, or the Canadian Securities Course, but these duties are routinely challenged by lawyers when we defend advisors before their regulators and courts. The lawyer’s purpose might be well intentioned (protect their client), but it is contrary to the investment industry’s interest in having strong consumer protection rules.

Earlier this year, however, the Ontario Securities Commission clarified the basic duties of an MFDA or IDA-licensed financial advisor. In large part, this decision adopts for Ontario the duties formally recognized by the Alberta Securities Commission in 2002.

The OSC’s decision, Daubney and Littler, summarizes the twin advisory principles that are known as the “Know Your Client” Process (KYC) and suitability analysis.

The KYC process comes from OSC Rule 31-505, Conditions of Registration (1999), which requires an advisor to make enquiries about each client as “are appropriate,” given the nature of the client’s investments, and the type of transactions being effected for the client’s account, to ascertain general investment needs, objectives and the suitability of securities bought by or sold to the client.

In a 1995 decision, E.A. Manning Ltd., the OSC recognized that the KYC process and suitability analysis requirements “are an essential component of the consumer protection scheme.” It also said both were basic obligations for any registrant. “Failure to comply with them is an extremely serious matter.”

The OSC stated that the KYC process includes examination of the following “essential facts and characteristics”, for each client, including their:

• age; • assets, both liquid and illiquid; • income; • investment knowledge; • investment objectives, including plans for retirement; • risk tolerance; • net worth; • employment status; and • investment time horizon.

The KYC process is not the completion of a KYC form. KYC forms are a starting checklist; the advisor must make detailed enquiries about their client’s circumstances to ensure that suitable investments are recommended, and to assess their client’s likely reliance on the advisor’s advice and recommendations. Furthermore, the client’s KYC forms must be amended whenever the client’s circumstances, investment objectives, or risk tolerance change.

Need help keeping on top of this? Click here to read KYC: Links and resources from Advisor.ca.

The advisor has a duty to know their products, including both those they recommend and those they do not recommend to the client. This is adapted from Alberta Securities Commission advisory standard — for an advisor to “know” the product, they must carefully review and understand its attributes, including the associated risks of securities they consider recommending.

The OSC uses the long-recognized, three-stage suitability analysis where an advisor is obliged to:

a) use due diligence to know the product and know the client;

b) apply sound professional judgment in establishing suitability of the product for the client; and

c) disclose the negative and positive aspects of the proposed investment.

Furthermore, where the advisor claims to be a “financial planner” or to offer “financial planning,” the advisor has a duty to discuss appropriate asset allocation and appropriate return objectives.

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In this discussion, the advisor must take into account the client’s time horizon and risk tolerance. These are closely related. A failure to understand the client’s time horizon when assessing the client’s risk tolerance can be a fatal flaw in the advisor’s suitability analysis.

If a client seeks safe investments in their retirement years, then financial plans must prioritize this objective.

Furthermore, an advisor has a positive duty to make appropriate recommendations and make certain that clients understand the potential risks and returns. The advisor has a duty to assess, from an objective viewpoint, a client’s ability to ride out bad markets to recoup market losses.

Finally, the OSC laid to rest the common defence by advisors that clients are responsible for their own unsuitable investments. The Ontario Security Act places the duty of care on the advisor, “who is better placed to understand the risks and benefits of any particular investment product.” Unequivocally, the suitability analysis duty cannot be transferred to the client.

With this authoritative statement of basic advisory principles, in many ways a mere restatement of material found in the Canadian Securities Course, and a restatement of earlier Ontario Court of Appeal decisions. a clear line has been drawn for advisory, compliance and dispute-resolution purposes.

Harold Geller is an expert on legal issues affecting financial intermediaries. Harold assists and represents dealers, MGAs, branch managers, compliance officers and advisors dealing with their compliance, regulatory and negligence issues. Harold also helps financial intermediaries with internal business and their clients’ legal issues. Harold is a well-known industry commentator, a CE provider and administrator with foradvisorsonly.com. Harold’s law firm, Doucet McBride LLP, also provides advice on tax issues, Succession Planning, Retirement Planning, Estate Planning and buying and selling books of business. Harold can be reached at hgeller@doucetmcbride.com.

(11/18/08)