Leveraging’s hard lessons

The class action against financial advisors David Karas and James Stephenson and the company that purchased Money Concepts, Quebec-based Investia Financial Services Inc., involves some 760 clients who collectively may have lost more than $40 million in investments bought with borrowed money, including mutual funds and segregated funds. The lawsuit was settled earlier this year (Investment Executive, March 2013). Final approval of the settlement agreement has been postponed until a proper challenge process is put in place for clients unhappy with their individual compensation.

Due to regulatory issues, the lawsuit covered only mutual funds but not segregated funds, which are considered an insurance product and subject to a different regulatory regime. The lawsuit also covered only mutual funds that were bought with loans arranged with Manulife Bank of Waterloo, Ont., through Money Concepts (Barrie), although many of Karas’ and Stephenson’s clients had borrowed independently, using home-equity lines of credit arranged through their own banks.

These restrictions limited the size of the eligible claims to about $23 million, says John Hollander, a lawyer with Ottawa-based Doucet McBride LLP, who represented the plaintiffs in the class action along with his colleague Harold Geller and Toronto-based law firm Thomson Rogers LLP.”It is not a happy story,” Hollander says. “[The clients] lost a ton of money.”

The court also approved legal fees of $2.9 million that will come off the top. After a few other expenses, the net amount available for clients will be a mere $6.8 million. The proposed settlement involves no admission of wrongdoing by the defendants.

According to the decision from Justice Mark L. Edwards: “The various class members have suffered significant financial losses, which have left them in precarious financial circumstances – and, for many, circumstances at a stage in their life that they can ill afford.”

Hollander says the loans were made in the years preceding the financial crash of 2008, but the market meltdown of 2008 and early 2009 wiped out much of the value of the investments. Many investors were forced to sell at a loss to pay back their loans, and some who had been relying on investment returns to pay their loan interest had to sell other non-leveraged investments, including RRSPs, to satisfy their bankers.

One of the key plaintiffs in the class action was George French, a retired dairy farmer. Before seeking advice from Karas in 2000, French had saved $380,000 for his retirement, invested in guaranteed bank deposits. French claimed he was encouraged by Karas to borrow more than $1 million to invest in mutual funds. With 92% of French’s assets subsequently held in stocks, his portfolio was devastated by the market crash in 2008. French claimed he lost more than $500,000.

The class action against Karas and Stephenson was based on their alleged practice of recommending a formula for leveraging, regardless of whether the strategy was suitable. According to the statement of claim, this practice led to extensive losses, with the alleged purpose of the recommendations to increase the amount of fund units purchased and, therefore, the advisors’ fees.

Karas had a high profile locally and was a media personality in Barrie. He was the top producer for his firm between 1989 and 2009.

“Few people have the strength to hold when markets go bad,” Hollander says. “All of these leveraged clients were underwater when the market dropped, and many began eating up their RRSPs to make interest payments. The market meltdown finished them off.”

Hollander questions how suitable a leveraging strategy could be in a case in which there is a conflict of interest: “The more money is borrowed, the more money is administered by the advisor, and the higher the trailer fees and commissions.”

The court also allowed some of the relatives of Karas and Stephenson to make claims. The court found that various family members, including brothers, sisters and parents, suffered not only financial losses but also the loss of trust in a direct family member.

For more on leveraging as part of a financial strategy, see page B6.

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