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GameA sharp rise in investor lawsuits is expectedwithin the coming months. Much of these will likely beattributable to selective memory — clients who have sud-denly forgotten the nature of equity markets and why theywere in those investments in the first place.

How can advisors protect themselves against suchcharges and allegations from angry clients? At times likethese, advisors need their firm and, more precisely, theircompliance department, on their side.

THE GOLDEN RULE: KNOW YOUR CLIENTThis is where it all starts. Does the advisor truly knowthe client? Know Your Client (KYC) forms (also knownas New Client Application (NCA), New AccountApplication Form (NAAF) or some other variation)

exist to help advisors gather necessary information,thereby satisfying the professional obligation to knowtheir clients. These forms contain some of the basics,such as a client’s investment experience, financial andpersonal situation, investment objectives, marital sta-tus, net worth and risk tolerance, to help advisorsbecome familiar with clients.

There are, however, many other relevant factorsrequired to gain an in-depth understanding of eachclient’s unique situation.

“When completing KYC forms, advisors really need todelve into it and get the information behind the answers.But this isn’t always easy,” says Ellen Bessner, litigationpartner in Gowlings’ Toronto, Ont. office. “Advisors oftenhave to tackle sensitive issues and there must be a certainlevel of comfort in the advisor-client relationship to facil-itate open and effective communication.”

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Compliance is a hot topic these days and will likely continue toheat up even more. Plummeting equity markets have no doubtcaused many clients to open their account statement, only to dis-cover they’ve incurred horrific losses. Unfortunately, many of thesedisgruntled clients are looking to point a finger of blame and, asMichael Callahan explains, advisors are often an easy target

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A CONTINUOUS PROCESSKnowing your client does not begin and end with the comple-tion of a form. Clients change over time and staying up to datewith these changes is of paramount importance. According toBessner, regular contact is critical.

“One of the most effective ways to strengthen an advisor-clientrelationship and develop a deeper understanding of a client’s per-sonal situation is through regular and consistent contact,” sheexplains. Clients may get married, have children, get divorced,lose a job or get a raise, for instance. Any such change needs tobe properly documented so that client’s information is up to date.

In addition, life changes such as these may involve a changein goals and, therefore, dictate a change in a client’s currentinvestment strategy. For example, a client previously suited toan aggressive growth strategy may now be more interested inprotecting principal. Or, as we’ve experienced in the past andas we’re experiencing again in today’s roller-coaster-like mar-ket, clients may change their risk tolerance according to cur-rent market conditions. Risk tolerance, along with most otherinformation gathered on the KYC form, is subject to constantchange. In order to offer meaningful advice, advisors need tostay abreast of these changes, as products that were once suit-able may no longer be appropriate.

BURDEN OF PROOFIt’s one thing to know your client. Being able to demonstratethis, however, is an entirely different kettle of fish. When it comesto compliance, simply “knowing your client” just doesn’t cut it.Advisors have to be able to prove they know the client.

In an advisor-client relationship, the advisor is the profes-sional and, therefore, assumes an inherent duty of care to theclient. After all, that’s why clients deal with an advisor— theycan’t do it alone. In court, many clients will emphasize thispoint: that they lack the necessary sophistication and knowl-edge and, therefore, yield to their advisor’s recommendations.

Unfortunately, what often accompanies this point is that theclients did not understand their investments or their associat-ed risks. The onus is now on the advisor to prove otherwise.Advisors need to demonstrate not only that they were acting intheir client’s best interest and that the recommended invest-ments were in line with the client’s goals and risk tolerance, butthat the client was aware of the investment strategy and anyrelated risks, thereby acknowledging the advisor’s actions.

This is where an advisor’s practice goes under a microscope.Fortunately, there are several key exercises that can help advi-sors safeguard against client allegations. Cilia McGee, CFP, CSA,financial advisor and branch manager of the downtown Ottawa,Ont. office of Manulife Securities Inc./Valcore PlanningSolutions, discusses her approach.

“My focus, after trade suitability, is accurate and useful doc-umentation,” she explains. “I encourage advisors to use a note-book with pre-numbered pages. The notebook would containthe details of conversations with clients and would include thedate as well as a start and an end time of the conversations. This

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Documentation: Advisors should document all con-tact with clients. Face-to-face meetings, conversationsby telephone and email correspondence are all impor-tant. It’s important to save all client-related email andtake detailed notes during all meetings and telephoneconversations with clients. Be sure to include anyquestions asked or comments made by the client.

KYC: Know your clients and know them well.Advisors can stay up to date with changes in theirclients’ personal situation through regular and con-sistent contact.

Disclosure: Advisors need to properly notify theirclients, in writing, of any potential conflicts of interest.Written declarations should be signed and dated byboth the client and the advisor and stored in client files.

Risks: It’s important that advisors outline the poten-tial risks (such as principal risk, interest rate risk,longevity risk, etc.) associated with any recommendedinvestment strategies and investment products.

Product: Before recommending any investmentproduct, advisors should do their due diligence inorder to gain a solid understanding of the product.Only then can advisors truly determine if the productis suitable for clients.

type of documentation will go a long way if an advisor is everput in the unfortunate situation of having to defend heractions. Contact management software [with capabilities for]emails, letters, tasks, etc., is also an invaluable tool. It’s impor-tant that sufficient time be taken after every client contact todocument the conversation and subsequent actions to be taken.”

McGee works very closely with the advisors in her branch,helping them manage their businesses in accordance with theappropriate compliance procedures and guidelines. “No detailis too trivial,” she adds. “When I conduct reviews, I am expect-ing to read a story about the client. If the story is there, then Ifeel confident that the advisor really does ‘know the client.’ ”

McGee runs a tight ship and there’s no doubt that follow-ing this advice can prove invaluable, especially if an advisor’sactions are called into question.

KNOW YOUR PRODUCTIt seems straightforward that advisors should have a solidunderstanding of the products they’re selling. But that’s notalways easy, depending on what types of products an advisor

When working with clients, advisors can take the steps necessary to ensure compliance for general advice-giving:

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uses. “Investment products of today are vastly different thanthose of yesteryear,” says Jeff Kehoe, director of enforcementand litigations for the Investment Industry RegulatoryOrganization of Canada (IIROC).

According to Kehoe, the density of structured products todaycan cause a great deal of confusion. Investments such as mort-gage-backed securities, asset-backed commercial paper, hedgefunds, credit default swaps and funds of funds can prove veryconfusing for even the most seasoned investor. “Products areincreasingly sophisticated, making it harder for advisors andclients alike to understand exactly what they’re buying,” he says.

But understand it they must. Kehoe cites this is one of themost common ways advisors get themselves into trouble — byselling products they do not understand.

SUITABILITYBessner describes a “triangle of suitability,” which starts withthe client, proceeds to the KYC form and finally the product.Only then can advisors truly determine the appropriate suit-ability of investments. The trouble begins when advisors jumpto the third step, delving into the product and its merits, andthereby omitting the client from the process. This is a big no-no. The basis for an advisor’s recommendation must come froman intimate knowledge of the client’s personal situation.

Another common pitfall is failing to properly communicatethe associated risks of an investment product or strategy to the

client. Bessner lists several reasons advisors sometimes omitthis explanation: “The client wouldn’t understand even if I didexplain it,” or “The client will buy whatever I tell him to buy, sowhy waste everyone’s time?” While that may be true, it’s the kindof logic that can land advisors in hot water. Bessner offers a sim-ply eloquent solution: Say to the client, “Please bear with me, Ihave an obligation to go through this,” followed by the appro-priate explanation. Advisors who chose to gloss over such detailcould be heading for trouble.

THE COST OF NON-COMPLIANCEThe cost of non-compliance can prove quite extreme. Variousfines, a suspended licence or being permanently banned fromthe industry are all possible outcomes. When engaging in non-compliant behaviour, an advisor’s lifeblood is truly at risk:licence, reputation and income — they’re all on the table.

Consider the cases of Robin Anderson in Edmonton, Alta.and Robert Ernest Leo Hart in Toronto, Ont. Anderson and Harthad embezzled hundreds of thousands of dollars from elderly,unsophisticated clients, depositing the funds into their own per-sonal accounts. Both advisors were fined and banned from theindustry by the Mutual Fund Dealers Association (MFDA) andIIROC, formerly the Investment Dealers Association (IDA).

In another case, Sean Shanahan, Stephan Katmarian andNicole Brewster participated in trading schemes designed to

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benefit one client while damaging another. All were punishedfor their actions, including Shanahan, who was permanentlybanned from the industry and fined $482,353.58.

While these cases of fraud and embezzlement may seemextreme, advisors often end up in complicated positions, evenwhen acting appropriately. Bessner describes one of the mostdifficult issues facing advisors today.

“Consider the case of a client who is properly asset allocat-ed, properly diversified and whose investments are well in linewith goals and risk tolerance. But due to current market con-ditions and through no fault of the advisor, the client has lostmoney. Continued discussions with clients concerning the mar-ket and its impact on some of the investments, along with apaper trail to prove that these discussions occurred, will helpsupport the advisor’s version of events that the client did acceptsome risk and understood the investment choices,” she says.

Without appropriate records, advisors leave themselves vul-nerable to a client who claims that he or she did not understandthe risks associated with their investments. According to Kehoe,this often results in a “he said, she said”-type scenario, whichis a very unfortunate position to be in. Indeed, the risks an advi-sor takes by not keeping proper documentation are substan-tial. On the other hand, advisors who act appropriately andkeep a paper trail are in a better position to defend their actions.

“Take comprehensive notes and document all conversations.Because in the end, that’s what we [IIROC] want to see,” addsKehoe.

A HAPPY ENDINGIn a recent article in the Financial Post, Gowlings’ Bessner dis-cusses a case of particular interest where an advisor who main-tained a paper trail of communication in which the client iswarned of the risks regarding an investment strategy taken is suedby the client. The client’s action was dismissed.

In March 2008, Superior Court Justice Thomas Lederer dis-missed Ron Parent’s claim when he sought to have his financialadvisor, Leach, and investment dealer, Merrill Lynch, reimbursehim for losses incurred in a risky investment strategy. It’s theclassic case of an aggressive client who wanted to take high risksin order to enjoy high returns, but pointed a finger of blame atthe advisor when the strategy didn’t pan out.

Leach kept a good paper trail. He had warned Parent of theassociated risks on several occasions and there was ample doc-umentation to support his testimony. Leach had letters deliv-ered, one of which was received with Parent’s signature andreturned to Merrill Lynch. Parent argued that Leach told himthe letter was unimportant and that he should disregard thecontent but sign and return it as required.

Judge Lederer didn’t buy it. Parent denied regular contactwith Leach, but Leach had notes of discussions with Parent overdecisions made regarding accounts and specific trades. Forexample, The Option Account Agreement, signed by Parent,was accepted as evidence of what was told to Parent. Attachedto that agreement was a list of the risks associated with optiontrading and, ultimately, Leach’s evidence was preferred overParent’s. Judge Lederer concluded that Parent’s allegations wereunsubstantiated. Parent could not blame his losses on Leachor Merrill Lynch, as there “were too many warnings and toomany opportunities to make the necessary changes.”

While it’s clear that the advisor had acted appropriately inthis case, it’s the sound documentation that helped prove it —the advisor had the records necessary to defend his actions.

To help advisors, Bessner has recently published a book titledAdvisor at Risk: A Roadmap to Protecting Your Business (avail-able at Chapters-Indigo). Intended as a guide for advisors, deal-ers and insurance agents, it is designed to equip advisors withthe tools necessary to reduce the risk of client complaints.

In the end, advisors must protect themselves.

MICHAEL CALLAHAN can be reached at callahan_michael@yahoo.com.

The risks an advisor takes by notkeeping proper documentation are substantial. On the other hand,advisors who act appropriately andkeep a paper trail are in a betterposition to defend their actions.