Many mutual fund dealers are resorting to mergers and acquisitions as a solution for meeting rising costs in what is increasingly becoming a low margin business, but it’s “buyer beware” for firms planning to expand by this method, the annual Federation of Mutual Fund Dealers (FMFD) Conference in Toronto was warned Tuesday.
“Beware of your brand new acquisitions,” said David Di Paolo, a partner with law firm Borden Ladner Gervais in Toronto. “Dealers get excited about bringing in new assets by acquiring another dealer outright or by bringing in a team of new advisors. Initially, there is a honeymoon period but there are risks.”
The three most common problems that lurk beneath the surface include excessive leveraging in client accounts, inappropriate outside business activities on the part of advisors and compliance failings, Di Paolo said. Firms should conduct scrupulous due diligence to ensure they do not inherit problems which can lead to later legal difficulties and industry sanctions, even if the problems happened before the firm or team of people was acquired.
“Get a handle on how much leverage has been taken on by clients,” Di Paolo said. “Excessive or inappropriate leveraging is one of the biggest problems.”
He said much of the inappropriate leveraging was put in place before the financial crash of 2008, when the industry lacked the suitability guidelines that are in place now. However, in addressing client claims, the Ombudsman for Banking Services and Investment (OBSI) has a generous rule that allows clients six years since the time they should have known there was a problem with their investment account to bring a claim forward.
With the trend toward consolidation in the industry, problems are often coming to light after client accounts have moved to new firms. There have been client complaint cases where firms have publicly disputed their responsibility, but have nevertheless been subject to the reputational damage caused by OBSI’s power to publicly “name and shame” by disclosing the details when firms refuse to accept its non-minding rulings.
Paolo says client portfolios should be reviewed in a timely manner after acquisition, and that could even be before any new trades have taken place. A significant number of portfolios should be put through a financial means test, he said.
“If the value of the portfolio has declined, you may be exposed,” he says. “You may find a large number of unsuitable leveraged portfolios. The higher the leverage as a percentage of assets, the bigger the headache.”
If portfolios are found to be overleveraged, Di Paolo suggested a couple of options that can be presented to the client. Arrangements can be made to bring down the level of leverage, which may involve selling some assets to pay down the loan. Alternatively, the risks of keeping the leveraging strategy in place should be fully disclosed to the client and they should sign a document that acknowledges their understanding of these risks.
Paolo warns that in his experience, when clients pursue legal recourse related to inappropriate leverage, they often claim they simply took their financial advisor’s advice and signed whatever documents were put in front of them. He suggests that firms who have acquired these kinds of problems should “take the advisor out of the equation.” A formal meeting to disclose the risks that have been discovered in any client’s exposure to leverage should be arranged with senior management of the firm or a branch manager, and the client must clearly understand what they are signing, he said.