In the wake of several big securities scandals in the U.S., there is greater scrutiny of the actions of advisors by their clients. And regulators have been cracking down on advisors with increasing frequency.

According to leading Canadian liability lawyers who work closely with dealers and advisors, that means there is far more rigour around the role of the advisor. Ellen Bessner, a partner at Gowling Lafleur Henderson LLP in Toronto, Jim Douglas, a partner at Borden Ladner Gervais LLP in Toronto, Michael Nicholas, a partner at McCarthy Tétrault LLP; and John Fabello of Torys LLP, all agree: The onus is now on advisors to prove they have done right by clients — and that is getting harder to do.

In many ways, the problems have stayed the same over the years. There have been a few rule changes, but nothing radical. Rather, the climate has shifted in the wake of what Bessner calls the “big busts” — Enron Corp. and WorldCom Inc. come to mind — and the ensuing distrust that ushered in a new level of scrutiny from clients and the tightening of regulatory control.

What are the regulators cracking down on? What amber flags are they raising? According to Bessner, the issues are “repetitive” and the problems all too familiar: know your client and suitability. Obligations that begin with the client’s goals and the KYC form can lead to allegations that the advisor did not know the client and subsequently failed to select suitable investments. And in this new climate, it is not enough to know the investments are suitable; proof is needed.

Indeed, says Nicholas, the advisor’s best defence is diligence and thorough knowledge of the client — that is well documented. There needs to be a “culture of compliance” in the industry, he says. The courts realize that “risk is in the game” but still may favour the client if there is no documentation supporting an advisor’s decision.

Douglas suggests advisors approach the issue of suitability and due diligence with prospective clients with one question: “How much of this money are you prepared to lose?”

Douglas asserts that if the answer is “None,” then those clients should not be in the stock market. It is the concept of knowing the client’s appetite for risk that should guide the advisor. Then the advisor can tailor the investments accordingly. But there should be a clear understanding between the parties at the very beginning that losses are a very real possibility.

Douglas is one of the most respected voices on broker liability. He, too, sees brokers working in a shifting environment — an environment sped up by the “tech wreck” of 2000-01. Since then, he says, the courts have taken the investor’s side more often than not.

“The courts have swallowed the industry regulatory standards and made them apply to the advisors,” Douglas says. This has increased the onus on advisors. Court decisions have increasingly allowed negligence to be a cause for action in broker liability cases.

“This has made the whole process uncertain,” he says.

He also laments the ongoing duty regarding suitability. It would be better if the duty of suitability were transactional. That would make the question: “Was the investment suitable at the time?”

Instead, advisors have to comply with the more stringent duty to ensure each investment is and remains suitable. This onus allows for more lawsuits to be brought by disgruntled investors, creating more court decisions, which create more confusion.

Before too much despair sets in, there are possible solutions. Douglas does see a way out of this morass. “Right now the Investment Dealers Association of Canada’s arbitration tribunal system applies only to actions that are less than $100,000. This is much too low.” The IDA should increase the limit to $5 million, he suggests: “This would effectively capture 90% of the cases.”

What is the advantage of a tribunal? Why is it a better option than the courts?

“Well, first you have to remember that judges are only human,” Douglas says, dispelling a widely held belief. “They see a small investor stacked up against a rich financial institution… ”

Another reason to favour a tribunal is the expertise tribunal members would bring to the process. Douglas believes that improving the arbitration process will bring some much needed predictability to the area of broker liability.

@page_break@On this, McCarthy Tetrault’s Nicholas doesn’t necessarily agree with Douglas. “I am not sure that arbitration is the panacea people believe it to be,” he says with a shrug.

Nicholas explains the events leading up to the changes in advisor regulations this way: “Whereas before, the advisor could rely on the underwriter to investigate the product, that is no longer possible.”

The regulations are clear about the duties to which advisors must adhere, and the courts have clearly stated that there is a standard of care, as well. The result is that financial institutions now are proceeding to implement changes that will allow them “to weed out the acceptable from the unacceptable,” Nicholas says.

This is in addition to friction arising from unsatisfied clients armed with three main causes of actions: a breach of contract; negligence; and, depending on the facts, a breach of fiduciary duty.

In 2004, the Ontario Securities Commission released a concept paper entitled Fair Dealing Model, containing three categories of investor/advisor relationships: the self-managed, the advisory and the managed-for-you account. While it remains a concept paper only, the case law agrees with the categorization, says Nicholas. The duties in the first and third categories are clear, but the advisory category, which has a standard of care attached, seemingly can bleed into the fiduciary. The courts are still sorting this out.

“It now all turns on the facts of the case to see what the duty is,” Nicholas says.

Torys’ Fabello, however, thinks that arbitration offers one strong advantage over the courts: privacy. This is something of supreme importance to financial services institutions.

In Fabello’s reckoning, though, the arbitration decisions are fairly similar to those of the courts. He does not see the situation as uncertain as some may believe. Certainly, there has been some disrepute attached to the industry, and events such as the collapse of Portus Alternative Asset Management Inc. and of Norshield Financial Group have not been helpful, but the situation has improved since the trigger-happy days following the tech wreck.

The “clarification of the regulations” has imposed more onerous duties on advisors, which are being enforced by the courts, Fabello says. Advisors’ jobs have gotten harder as a result. But new advisors are entering the field well equipped to meet the challenge.

And while there is some merit to the argument that the courts have tended to favour the client, the amount of “silly” litigation is decreasing. But litigation, legitimate or otherwise, persists.

This concept is something that Fabello tries to pass on to the advisors at his educational seminars. “In the battle of memory” — absent documentation supporting one side — he tells advisors, “the client almost always wins.”

Certainly, answers may lie in education and institutional change. While neither would seem to be a particularly fast route to surer ground, they could be reason for optimism. While the self-regulating duty was clarified in a Mutual Fund Dealers Association notice, and the courts can flesh it out, advisors can protect themselves through education and diligence.

But advisor and manager education hasn’t necessarily kept pace with the stepped-up scrutiny and the added duties placed on managers.

“The industry educators are more focused on client education than advisor education,” says Gowling’s Bessner. “Advisors and branch managers are often ill-prepared to fulfill their obligations.”

Bessner, whose own workload has increased, admits she feels sorry for those advisors and branch managers who are ill-prepared for the high level of scrutiny by regulators. Even simple activities such as maintaining a paper trail can be arduous for men and women pressured to increase the size of their books of business.

And the record-keeping checks are not limited to the advisor; now regulators will look into the paper trail between advisor and manager, and between manager and compliance officer, as well. This regulatory intensity is an attempt to ensure problems are investigated early and thoroughly.

Bessner’s response is a course designed to give branch managers and advisors the “tips and tools” necessary to perform their jobs in a manner that aims to reduce their risk when regulators investigate and clients commence complaint proceedings.

Bessner works to educate dealers and advisors about their new roles and the increasingly difficult task of being in full compliance with the evolving regulatory environment.

Another lesson Fabello bequeaths: “In the battle of risk explanation, the client wins.” Basically, keep a record.

Sounds simple enough, but it isn’t. Another hardship — also part of the “sea change,” according to Fabello — is the positive obligation to report questionable investments.

Is this another way of saying there is a self-regulating duty?

“No,” Fabello responds. It not enough to avoid bad investments. Now, if something appears off-kilter, you cannot ignore it and hope it works itself out, although that may happen. Rather, you have to report it to the regulators. Repeat: amber flags are to be reported.

In Fabello’s mind, this gate-keeping function is probably the biggest change in the industry. It would cause any advisor waking from a blissful 10-year coma to question his or her sanity. IE