Advisors are at risk these days with firms’ propensity for terminating them at the first whiff of an infraction. Note taking to support suitability of a client’s account became the law since Dec. 31, 2021, with the client-focused reforms (CFRs). So, here is a primer on how you can ensure that your notes pass the sniff test.
Advisors are told to take notes, but they are not told how to chart notes that will satisfy a judge, regulator and their own compliance departments. As a litigator, I know first-hand how important good-quality notes are to prove your version of events and that you satisfied your legal and regulatory obligations. The problem is that most advisors have not received training on the “dos and don’ts” of note taking, and so the notes I receive to defend dealers and advisors are great examples to show gaps in note taking. You can fill those gaps with these steps.
Step 1: Take notes!
The first challenge is convincing advisors to take notes. Many advisors believe that contemporaneous note taking hampers client engagement. I suggest the opposite. As entrepreneurs, you need to appreciate how proper note taking can improve relationships with clients and prospective clients, because you can tell clients and show them that what they are saying to you is so important that you need to write it down during the meetings with them.
Step 2: Take detailed notes!
While I am unable to dissect all the CFR note-taking requirements in a single article, here is some direction illustrated by an example.
The client, Mrs. Sarnicky, launches a complaint, as she suffered investment losses. A review of her portfolio confirms that she was in medium-risk investments. Mrs. Sarnicky insists that her risk tolerance was low, and therefore the investments were unsuitable. The advisor has a substantial practice, so he onboards new clients regularly and does not have a specific recollection of completing this know-your-client (KYC) form two years before.
The firm performs an audit of the correspondence, notes and documents (KYC forms, etc.) associated with the opening of the account and assessment of Mrs. Sarnicky’s risk profile. While the risk profile on the KYC form indicates “medium,” the questionnaire answers support a low risk profile.
The advisor refutes Mrs. Sarnicky’s claim, relying on what he describes as his “regular practice” when clients disagree with the risk profile resulting from the questionnaire. He says he and the client must have discussed it, and the client must have insisted on a higher risk tolerance than the results of the questionnaire supported. The advisor points to his notes to support his position: “discussed risk and product fees.”
Will this be sufficient to prove the client insisted on medium-risk investments, supporting the choice on the KYC form of medium risk? No.
What if the advisor asserts he has a specific recollection of this discussion and that the client did insist on a higher risk profile and higher risk investments because the client wanted higher returns? Will the notes be sufficient to meet the test required under the CFRs? No.
Added complexity, and therefore added confusion, for advisors arises from the different content that must be in each note, depending on the particular topic being explored and addressed with the client. Therefore, the litmus test is whether reading the notes supports two things:
- What is required according to your firm’s policies and procedures manual concerning the specific topic, which likely reflects your regulator’s requirements/CFRs; and
- Whether the notes/records and other documentation support your version of events. If they do not, the client will likely be believed, not you.
Step 3: Test your notes against the two criteria
Do your notes, if they were read by someone else, sufficiently describe the discussions that took place to support the decisions made in the client account(s)?
Back to our example, contemporaneous notes like this would be better:
Questionnaire results: low profile — RT [risk tolerance] medium, RC [risk capacity] low. Client wants medium risk even tho I explain low is what Q [questionnaire] answers. Reviewed answers to questions 3, 4, 5, support capacity is low and reasons — don’t want to run out of money and retirement can be expensive; market can be volatile and lose capital problem.
Client: Q is flawed; can afford risk and wants medium for the returns.
Note, client is retired accountant who follows market and understands risk of market.
Warnings provided and she insists.
If the advisor doesn’t tell the client to take her business elsewhere, then an email confirming the conversation would be highly advisable, with a request that the client reply confirming that the email reflects the discussion.
This type of note and email would comply with my 5Cs of documentation (see article): correct, complete, consistent, current and contemporaneous.
The notes with your email will likely convince a judge that you warned the client, the client is sufficiently sophisticated to understand the risks, and the client went into the riskier portfolio with open eyes, and therefore the advisor should not be found liable.
However, the same may not be said of the regulator. Notes and email might have been sufficient before Dec. 31, 2021, before the CFRs were enforced, but it is less clear whether they would be sufficient after. The CFRs require evidence of both risk capacity and risk tolerance, and the client’s risk profile is assessed as the lower of the two. If Mrs. Sarnicky insisted on medium risk, that was likely her expression of a higher risk tolerance than what the questionnaire revealed for her risk capacity.
What would you need to have in your notes to satisfy the CFRs and your firm’s policy manual? You would have to have evidence that the risk capacity was at least a medium and that her risk tolerance answers were wrong and were actually medium, too.
So, what if your client insists on higher risk than what the lower of her risk tolerance and risk capacity indicates from both the questionnaire and your conversations in which you examine the two criteria?
You would be required to have notes that evidence that you explained to Mrs. Sarnicky why it would not be in her interest to invest based on higher risk than what the lower of the two criteria indicate.
Use examples like these:
- “Mrs. Sarnicky, you are saving for a home purchase in the next two years, so if you lose 10%” — express this in dollars as well — “that means you will be further from your goal, not closer.”
- “You are saving for your retirement, and you are healthy and don’t want to run out of money. If we invest based on higher risk, then you could lose substantial capital and that would be a problem for you.”
Of course, you need to explain why medium risk is too high for her given the specific information she imparted to you about her lifestyle or future plans, and your explanation must be at her level of financial understanding.
Note that NI 31-103CP, Part 13, speaks to this issue: “Where after discussion, it is determined that the client does not have the capacity or tolerance to sustain the potential losses and volatility associated with a higher risk portfolio [that they request], the registrant should explain to the client that their need or expectation for a higher return cannot realistically be met, and as a result, the higher risk portfolio is unsuitable. The interaction with the client and end results should be properly documented.”
If Mrs. Sarnicky loses money, launches a complaint to the regulator and/or sues you, follow the steps above to ensure that your notes include sufficient detail to pass the sniff test to protect your licence, livelihood and reputation, as well as help you sleep at night.