Leverage class action certified

“This is the first case that we’re aware [of in which] the court ruled that [an allegation of] a systemic breach of a duty to give good advice can be covered in a class action,” says John Hollander, a lawyer with Doucet McBride LLP in Ottawa, which represents one of the representative plaintiffs.

The decision has been appealed, but, if successful, the lawsuit could lead to others against advisors and their firms that have counselled clients to borrow to invest, with large resulting losses. The suit could also result in hefty damages – by the end of March, about 800 people had registered with Doucet McBride to be included in the class.

In opposing certification, the defendants argued that the financial circumstances of each individual client were too different to be the subject of a class action.

In rejecting that argument, Justice Bryan Shaughnessy concluded that the crucial questions are: what were the defendants’ duties to their clients; and were those duties breached?

Shaughnessy’s judgment states: “I find that the substantial common ingredient of each class member’s claim relates to a duty of care and whether there was a breach of that duty of care. Further, the question relating to the liability of Investia involves a consideration of whether it failed to ensure compliance with the [Mutual Fund Dealers Association of Canada] regulations and guidelines and the internal guidelines of [Money Concepts (Barrie)].”

In essence, Shaughnessy says, the position of the defendants (that the financial circumstances of each class member were too different from one another to be dealt with together in a class action) confuses “the commonality of the questions with the commonality of the answers.”

The case comes at a time when both regulators and public opinion leaders are on alert for signs that the investing industry is not meeting its obligations to keep clients fully informed about the risks and costs of various types of investments. This concern has led to calls to impose a fiduciary standard of care on advisors, which requires that the advisor put the client’s interests ahead of his or her own.

The current standard requires that advisors ensure that recommendations that they make to their clients meet the industry’s suitability standards. Advisors also have a general duty to act fairly and in good faith toward their clients.

A key point in the debate is whether the duty to clients should be the standard that is already in place or a higher one, says Edward Waitzer, senior partner with Stikeman Elliott LLP, professor at Osgoode Hall Law School in Toronto and former chairman of the Ontario Securities Commission: “I would argue that there should be more of a fiduciary duty, which is to put the client’s interests first or, where there is a conflict, make sure the conflict is not only disclosed but understood.”

Waitzer provides an example from an advisor’s point of view: assume that there are two products that are equivalent and both suitable for the client; however, one pays a higher commission than the other. “Clearly, the lower-cost product,” Waitzer says “is better for the client.” In such a situation, he says, an advisor who has a fiduciary duty to the client would have to disclose that cost difference to the client.

While there may be circumstances in which it would be appropriate for the advisor to request the higher commission – as a way of the client compensating the advisor, for instance – the crucial point is that the difference is disclosed and that “the conflict is transparent,” Waitzer says.

In the Investia case, three representative plaintiffs brought the action against their respective advisors, David Karas and James Stephenson, who co-owned Barrie-based Diamond Tree Capital Inc., which operated MCB. Karas opened the predecessor company of MCB in 1986 and was the “leader” of the advisors at that branch, according to the judgment. (MCB was closed in March 2010.)

The plaintiffs allege that they were involved in an “investing scheme” in which they were counselled by their advisors, Karas and Stephenson, to borrow money to invest in mutual funds, and that the plaintiffs were not suitable candidates for this type of investing. The plaintiffs have alleged that this was a “one size fits all” investing strategy used “without regard to suitability of the strategy,” the judgment says.

The defendants have denied the existence of such an approach and maintain that “borrowing money is a long-standing investment strategy,” according to the judgment. They have also argued that “whether leveraging is a suitable investment strategy for investors cannot be determined on a common basis.”

The defendants also maintain, the judgment says, that: “The suitability of leveraging as an investment strategy requires an assessment of the individual investor followed by an assessment of whether the portfolio purchased is suitable given the individual characteristics of the investor.”

Dairy farmer George French is one of the representative plaintiffs. He claims that Karas had counselled him to borrow almost $900,000 to invest in mutual funds. French also alleges that, even after he sold his provincial dairy quota in 2005 and ceased to receive income from his farm, Karas continued to advise him to borrow to invest.

Bruce and Edith Irene Smith are the other representative plaintiffs. From December 2005 to March 2010, the Smiths were clients of James Stephenson. At the time, the couple was living on disability payments. The Smiths allege that Stephenson advised them to borrow money to invest in mutual funds after their first meeting with him. The couple borrowed $100,000 against their home, despite already having a substantial mortgage.

Eventually, the Smith’s medical-related expenses became too great for them to service the loan and they were forced to make withdrawals from Bruce’s locked-in retirement account. By 2009, the Smiths still owed $100,000 on their loan, even though the underlying investment had decreased in value to $61,000.

The plainitffs allege the risks of investing were never fully explained and that neither advisor discussed the clients’ risk tolerance levels with them.

But Karas stated in an affidavit that all his clients had been taken through a “financial planning exercise to determine a suitable financial plan.” Leveraging to invest would only be recommended for clients who met the “appropriate criteria,” the affidavit says.

Class actions like this one are likely to increase in future, says Waitzer, particularly as the population ages and more seniors become involved in complex investing strategies.

That’s why it’s important, he adds, for the OSC to develop a clear policy on the appropriate standard of care for financial advisors. (The OSC is currently studying the issue.) “It’s a lot more efficient for the commission to set the bar,” Waitzer says, “than to have this play out in a bunch of litigation.”

As for setting standards for leveraged investing in particular, the Toronto-based Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) wants to see much stronger proof of suitability.

FAIR Canada has been advocating for a presumption of unsuitability for leveraged investing for retail clients, says Ilana Singer, FAIR’s deputy director and a former securities lawyer: “There would have to be more explanation provided about why leverage in this investor’s case, given his or her risk tolerance and investment goals, would be suitable.”

In an open letter to the Canadian Securities Administrators in October 2011, FAIR Canada called for better protection for investors from the risks associated with borrowing to invest: “FAIR Canada believes that this is a systemic problem that regulators must address or investors will continue to be placed into unsuitable investments with resulting financial losses and an increasing number of investor complaints.”

(For more on the issue of suitability, see page 30.) IE

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