I have defended many litigation and regulatory cases in which the dealers or advisors assert a common defence against allegations of unsuitable investments: “But that is what the client wanted.”
Gone are the days when you simply marked the trade ticket “unsolicited” and executed what the client instructed, even if unsuitable. That will not cut it in court or with the regulator.
Know that if your client loses money, they will blame you for their losses and seek to have you repay them and report you to the regulator — regardless of the fact that the investment was their idea. This will risk your licence, your relationship with your dealer, and your reputation with existing and prospective clients, as well as cost you financially.
Below, I describe the common circumstances that lead to this problem and how a three-step approach can be used to protect your clients from making bad decisions and simultaneously protect yourself from going down with your client’s ship.
Scenario 1: The client thinks they know better than the advisor
Client: “I choose the investments in my account; my advisor executes the trades.”
This scenario is risky for advisors:
- The full-service advisor is not paid or registered as only an “order-taker” but needs to fulfil know-your-client (KYC), know-your-product (KYP) and suitability requirements. KYC, KYP and suitability are legal and regulatory obligations that need to be fulfilled for each client account in respect of every product and every trade in the client account.
- If the advisor does not fulfil KYC, KYP and suitability obligations in respect of products purchased and held in the client account, including those chosen by the client, the advisor may be subject to damages for client losses and regulatory penalties.
- For any purchase in a client account, the advisor must understand and follow the product to advise the client of any adjustments that need to be made. Adjustments may be required due to product, client or market changes. Advisors and dealers earn their ongoing fees because of this monitoring and continued advising. Transactions in a full-service account are not “one and done.”
The advisor must either fulfil regulatory and legal KYC, KYP and suitability obligations or insist the client purchase the product in a self-directed account. Many advisors do not want to lose the commission or fee, but they cannot have it both ways. Either the product is purchased in a self-directed account in which the fee is reduced to reflect that the client is making their own decisions without advice from the advisor, or the advisor must monitor the account for which the advisor earns fees or commissions.
If the client will not move the product to a self-directed account, you will need to follow the three-step process (see below) to protect yourself and your client.
Scenario 2: The client avoids capital gains
Advisor to client: “You are overweight XYZ Inc. The stock has done well, but I need to rebalance your account and sell some of the stock to take the gains and reinvest the proceeds.”
Client: “I don’t want to sell it! The capital gains tax will kill me!”
The advisor will need to convince the client that paying the capital gains tax is better than risking losses when the market tumbles. Or the advisor may be able to convince the client they can apply the gains against a loss, if there is one to take.
It would be wise to manage clients’ expectations at the beginning of the relationship and throughout so clients know you will be seeking instructions to rebalance investments, even if they are “winners.”
If you cannot convince the client to sell at least a portion of the overweight investment, you will need to follow the three steps (see below) to protect yourself and your client.
Scenario 3: The fearful client doesn’t like change
Advisor to client: “I am so sorry that we need to discuss your finances so soon after your husband passed away, but your circumstances have changed without his income. I want to be sure we discuss some of the higher-risk investments in your account and change them to protect your capital and arrange for a regular income to ensure you have the liquidity to pay your bills.”
Client: “My husband chose those investments, so I will not change them.”
This is a big risk to the advisor — especially if the client is a senior, and even more risky if she is unsophisticated or not financially knowledgeable. Even if she is sophisticated and has other sources of income, if she refuses to rebalance and reinvest for her new circumstances, you will need to follow the three steps (see below) to protect yourself and your client.
Scenario 4: The client insists on liquidating to cash or cash equivalents
Client: “Sell everything! I want to hold everything in cash.”
It is the client’s money, so they can go to cash if they want; however, you need to find out why and consider if going to cash is suitable for the client (e.g., they are elderly and need liquidity) or if it is unsuitable and a knee-jerk reaction trying to time the market.
You need to convince the client that timing the market is impossible and discuss with them the impact on their portfolio or financial plan of holding cash. Consider using a periodic table to show them that cash is at the top of the table in only two of 20 years (2004–2023).
Also, if the client tends to sell at the bottom and buy at the top, they need to understand that building a portfolio based on fear (selling when the market tumbles) and greed (buying when the market is doing well) is a losing proposition. The advisor should explain this to the client and tell them that advisors, as professionals, are not in the business of timing the market.
Further, you likely cannot keep GICs in a fee-based account, so consider telling the client they should move the money into a direct investing account. That way, they decide when they move the money in and out of the market — without your help — as this is not what you do, and you do not want to be held responsible.
Maybe you can convince the client to move only a portion of their account to GICs, if that will still be suitable. Otherwise, you will need to follow the three steps to protect yourself and your client.
Three steps to protect yourself and your clients
I didn’t design this three-step process. It is required under the client-focused reforms (CFRs), so it is the law (NI 31-103, s. 13.3(2.1); see the few exceptions under NI 31-103 s. 13.3).
In the decades before the CFRs, the advisor would mark the trade “unsolicited” and, barring the client denying it was unsolicited, that would be sufficient, even if the investment was unsuitable. Of course, if the client asserted that the trade was not properly marked “unsolicited,” the advisor would have to prove that the client so instructed.
However, since Dec. 31, 2021, these three steps are required for investments that are inconsistent with the advisor’s advice. This includes any time and for any reason that a client insists on holding or purchasing unsuitable investments, regardless of whether the client is knowledgeable or not.
If an advisor receives client instructions that render (or by holding the securities continue to render) the account unsuitable, the only way the advisor can carry out the client’s instructions is if they follow these three steps:
Step 1. Analyze the transaction so you understand why the trade is unsuitable or overconcentrated. Explain your analysis to the client. If the client is unsophisticated, make sure you explain the analysis in a manner the client understands. My strong recommendation is that you take notes and confirm this discussion in writing.
Step 2. Recommend a suitable alternative and explain to the client why this is better suited for them. My strong recommendation is to take notes and confirm this discussion in writing.
Step 3. Receive confirmation in writing (or if your calls must be recorded, then make sure you keep the recording) that the client:
- understands your concerns about how the trade or holding the investment would be unsuitable;
- has reviewed your recommended alternative; and
- still wants you to proceed with what they instructed you to do (or not do, if it is directions to hold on to overconcentrated investments).
Yes, this is a lot of trouble to go through for a single transaction. So, you may want to rethink:
- Do you want clients who do not follow your professional advice?
- Do you want clients who place themselves and you at substantial risk?
Clients pay you to give them professional advice. If they don’t want it, they should not pay for it, and you should not risk having clients take you down with their ship!