Many clients are angry and upset about recent steep declines in the value of their portfolios and are looking for someone to blame. So, what happens if they decide to sue? You may think you have done everything right, but what will the courts think?

The vast majority of advisors are unlikely to be found liable, say legal experts — if they are armed with excellent record-keeping and compliance with “good practices,” especially when it comes to explaining risk to clients. Vigilance, nonetheless, is crucial, both as a professional obligation and as the best defence against lawsuits — especially as litigation, like the markets, is cyclical. It is highly probable that a wave of lawsuits from irate investors will hit the courts in the near future.

The Supreme Court of British Columbia released a judgment in this area this past fall. Although financial advisor Douglas W. Robinson was found not liable to a former client for losses in the client’s portfolio arising out of the 1999 stock market decline, the case dragged on for several years. And as with any defendant in such a situation, Robinson was required to go through the full litigation process, including giving evidence at trial.

What, then, is the best way to steer clear of such situations? Peter Willcock, a senior litigator with Harper Grey LLP in Vancouver, defended Robinson. Willcock notes that the recent downturn provides a certain degree of protection for advisors, due to its broad nature: when everyone is losing money, it’s harder to argue that advice from a particular advisor was at fault.

However, in general, Willcock notes that findings of liability are highly dependent on the facts in each case, with courts looking closely at the details of the client/advisor relationship. This reality alone should guide the actions of advisors who want to avoid liability. At the very least, you should keep comprehensive notes of every client conversation relating to investments and financial planning.

The area tends to be murky because of the great variation in the levels of obligation — from low to high — that is possible. These can vary, for instance, from clients who request only a little advice to those who repose their full trust in an advisor’s judgment, such as those who have discretionary accounts.

The issue becomes even more complex if the client-plaintiff alleges that a fiduciary relationship exists between the client and the advisor. (See page 31). A fiduciary obligation is a more specialized type of relationship than that usually found between clients and advisors.

Usually, advisors are required to act with reasonable care in carrying out their client’s instructions and not act negligently in the performance of their professional duties. Advisors who fail to follow the “know your client” rules to assess the client’s investment objectives and suitability properly, resulting in losses for the client, may be found negligent and liable for damages.

However, when an advisor is also found to have a fiduciary obligation, the advisor must go a step further. That means specifically placing the client’s financial interests ahead of the advisor’s own. A fiduciary, says Willcock, must therefore “act with a degree of carefulness, honesty and good faith that goes beyond the usual contractual relationship between an investment advisor and a client. It means taking someone else’s interests into your own hands and dealing with them as if they were your own.”

Usually, it is necessary for a client to rely substantially on an advisor in order for the courts to support a finding that there is a fiduciary obligation. And the degree of client sophistication and vulnerability can become a key factor when the court is assessing the relationship. Elderly or financially naïve clients, for instance, are more likely to create a fiduciary obligation. But a range of other situations could easily qualify as well.

“Courts look quite closely at the history of the relationship between the parties,” Willcock says, “and the degree of reliance.”

PARTICULAR FACTORS

Paul Le Vay, a seasoned litigator with Stockwoods LLP in Toronto, has acted for both advisors and clients and has watched recessions come and go since the late 1980s. When it comes to whether or not a fiduciary obligation exists, he notes, “There is no clear bright line.”

@page_break@ The Supreme Court of Canada has ruled in this area, Le Vay points out, and has held that — unlike trustees or lawyers — the nature of the client/advisor relationship does not automatically determine whether a fiduciary relationship exists. ”You have to look to particular factors,” he adds, “such as dependence and vulnerability.”

In the B.C. decision, Robinson was found to be a fiduciary. But because he gave advice that was found to be consistent with both the client’s stated objectives and industry practices, the court concluded that there was no breach of Robinson’s obligation to his client. (It was important to the final decision that the client had followed similar advice received from a subsequent advisor.)

In Willcock’s view, perhaps the single most important practical step that an advisor should take is to ensure that each client is completely clear about the limits of the advice that is being given. Essentially, advisors should tell clients what they cannot do for them.

“We hear — across the board, when we are dealing with [advisors] — that they are not certain where their obligations start and end,” Willcock says. “What advisors forget is that, to a certain extent, this is in their own hands. They can say to the client, ‘Here is what I am doing, here are the limits of what I can do for you — and here is what I expect you to do for yourself.’

“Everyone, to some extent, has to say: ‘My own expertise or my practice or the type of products I offer or the type of advice I offer is limited,’” he continues.

By making clients understand this crucial point, Willcock maintains, advisors will limit the scope of their potential liability.

Willcock also points out that taking this step is, in the end, in the clients’ interest as well, even though some clients may initially view it as self-serving. “Clients should have a good understanding of what is being done for them,” he says, “and what the limits are of what can and can’t be done.”

Another area in which advi-sors can trip up is knowledge of the products they are selling. “That is becoming more of an issue,” Le Vay says, noting that the increasing complexity of financial products in general often creates landmines for those selling them.

“One fundamental rule that is important to follow in order to avoid liability and do your job properly is: if you don’t understand a product or you don’t completely understand all of its features, then don’t sell it,” Le Vay cautions. By the same token, he adds, the firms devising the products must ensure that they properly explain the products to the people who will be selling them.

In general, however, Le Vay says, the industry is to be commended for improving its practices in this area, especially in comparison to the 1990s. Since then, a wave a litigation and a stepped-up response from the sector have led to improvements. “Both compliance standards and compliance practices are a lot better than they once were,” Le Vay says. “Also, the industry is somewhat more responsive to legitimate complaints short of a lawsuit.”

FULL DISCLOSURE

Tracey Cohen, litigation partner with Fasken Martineau Dumoulin LLP in Vancouver, has acted frequently for advisors and investment companies. She agrees that understanding the precise nature of a particular relationship between an advisor and his or her client can be a “moving target” because of the wide number of “fact situations” that are possible.

And although advisors may sometimes be reluctant to address fully the risks or features of a complex product, or to disclose fully how they are compensated — perhaps for fear of instilling unease in a client — Cohen says that is simply a reality that must be faced.

“I don’t think advisors can get around this,” she says. “They have to understand that it is a cost of doing business and that if they don’t do it, they may find themselves in a lawsuit.”

At the same time, there’s also room for gut instinct. Cohen has found in her litigation practice that advisors often say they had a sense that a particular client might create problems for them. “Advisors have a sense of who might be a problem later on,” she says. “When advisors have that type of intuition, they need to act differently if they are going to keep that client. Or they need to get rid of the client.”

And what if, despite everything, litigation becomes a reality? If things do not turn out well for the advisor, the downside can be enormously expensive — even without taking into account legal costs, which are generally borne by the losing party.

Successful investor-plaintiffs, says Le Vay, are entitled to be put in the position they should have been in if the breach of the advi-sor’s obligations to the client had not occurred. Typically, that means restoring capital plus a notional rate of return.

The results at this stage, at which the court takes on the thorny task of assessing damages, are among the most difficult to anticipate. As Le Vay, notes, damages can even extend to cases in which there is no loss of capital, only an “opportunity cost” when too little was earned, perhaps because too much of a portfolio was held in cash, contrary to the instructions of the investor.

But although Le Vay agrees that more litigation in this area is virtually a certainty following last fall’s market crash, he doesn’t necessarily expect a flood. “In my practice, I turn away more people than I take in,” he says. “If you drill below the surface and you find the only complaint is ‘I lost money,’ [that person is] wasting your time.”

On the other hand, he notes: “You don’t really know how many people are swimming naked until the tide goes out.” IE