Trade Compliance In Canada - Too Reactionary To Protect Investors?
Are investors being properly informed of the risks associated with their investments? A quick review of the IDA website confirms both compliance officers and the firms they work for regularly show up in violation of IDA Regulation 1300.2 – Improper supervision. Although advisors (and indirectly the firms they work for) are hired by investors to help guide investment decisions and increase awareness in the products being purchased, it seems clear: too many investors end up not understanding the risks associated with the investments they are buying.
According to ComSet (a database built to receive and store client complaints, disciplinary matters, internal investigations, disciplinary actions, settlements, and civil, criminal or regulatory action against the firm or its registered employees), in 2003 there were 2670 events entered. Of those, 1936 were customer complaints, and 1249 complaints were specifically concerning unsuitable investments. This means nearly half of all ComSet events, or over 60% of all customer complaints are unsuitable investment complaints. In 2004 there were 1896 events entered. 1276 were customer complained, and unsuitable investments made up 776, or over 60% of all customer complaints.
With approximately 24000 registered IDA members, one would have to assume that between 3 and 5% of all advisors may be facing at least one unsuitable recommendation complaint at any given time. Even more worrisome, with 629 civil claims in 2003 and 500 civil claims in 2004, perhaps as many as 25% of all unsuitable investment complaints may actually be turning into expensive, drawn out civil claims. With the recent push from regulators to firms in an attempt to help smaller investors recoup losses from ‘rogue’ advisors, the number of complaints turning into fines could rapidly increase
At the root of this problem is the reactionary way many compliance departments are forced to deal with potential trade supervision problems. When it comes to assessing risk, investors, advisors and compliance departments are often not reading from the same instruction manual. Although an investor might sign an account opening form confirming they are 100% ‘medium’ risk, what ‘medium risk’ means to the investor, advisor and compliance department may differ greatly. In the absence of a solid representation of risk, investors are being forced to use their past investing experience as a guide. In this type of scenario the results are predictable; advisors and compliance departments often end up using signed investor documentation to defend themselves and the firm from litigation rather than to protect and educate the investor
To compound the problem, when an inappropriate trade is detected in an investor’s account, the compliance department will order the advisor in charge to either reverse the offending trade, offset the trade with a purchase of a lower risk security, or ‘update’ the investor’s Know Your Client information. Many advisors feel reversing or offsetting a trade make them look foolish in the eyes of the investor. After all, the investor is relying on an advisor’s investing experience and product knowledge. Instead, it’s much easier for an advisor to say, ‘If you don’t want my firm freeze your account, you’ll need to sign this Know Your Client update.’ Simply updating the Know Your Client does not solve the problem. The updated Know Your Client might now match the compliance department’s assessment or risk, but in such a situation it’s hard to imagine the Know Your Client matching the investor’s interpretation of risk.
For the trade approval process to protect the investor rather than the advisor or firm, thorough risk return analysis of an investor’s proposed account must be presented in graphical or numerical representation that the average person can understand. Risk category percentages or account standard deviation summaries mean little to the average investor. When approving a proposed portfolio, investors should be confirming a proposed portfolio (at least historically) has achieved a return suitable for long-term investment plans, within a level of downside risk acceptable to the investor. It should be up to the advisor and the sponsoring firm to determine what the standard deviation of that proposed portfolio is, how that standard deviation number should translate into Know Your Client data, and most importantly to continue monitoring the account over timeto ensure performance continues within the limits originally agreed to by the investor
Even though there may be considerable training or technology costs associated, what’s clearly needed is a commitment by the industry to a more proactive version of the traditional trade approval process. The proper training and tools to measure risk, explain risk and accurately transcribe that risk tolerance information onto dealer paperwork must be provided to advisors if firms want to ensure the proper information is getting into the hands of investors. Without such change, policy concerning trade suitability issued from regulators or compliance departments will ultimately continue to fail.
According to ComSet (a database built to receive and store client complaints, disciplinary matters, internal investigations, disciplinary actions, settlements, and civil, criminal or regulatory action against the firm or its registered employees), in 2003 there were 2670 events entered. Of those, 1936 were customer complaints, and 1249 complaints were specifically concerning unsuitable investments. This means nearly half of all ComSet events, or over 60% of all customer complaints are unsuitable investment complaints. In 2004 there were 1896 events entered. 1276 were customer complained, and unsuitable investments made up 776, or over 60% of all customer complaints.
With approximately 24000 registered IDA members, one would have to assume that between 3 and 5% of all advisors may be facing at least one unsuitable recommendation complaint at any given time. Even more worrisome, with 629 civil claims in 2003 and 500 civil claims in 2004, perhaps as many as 25% of all unsuitable investment complaints may actually be turning into expensive, drawn out civil claims. With the recent push from regulators to firms in an attempt to help smaller investors recoup losses from ‘rogue’ advisors, the number of complaints turning into fines could rapidly increase
At the root of this problem is the reactionary way many compliance departments are forced to deal with potential trade supervision problems. When it comes to assessing risk, investors, advisors and compliance departments are often not reading from the same instruction manual. Although an investor might sign an account opening form confirming they are 100% ‘medium’ risk, what ‘medium risk’ means to the investor, advisor and compliance department may differ greatly. In the absence of a solid representation of risk, investors are being forced to use their past investing experience as a guide. In this type of scenario the results are predictable; advisors and compliance departments often end up using signed investor documentation to defend themselves and the firm from litigation rather than to protect and educate the investor
To compound the problem, when an inappropriate trade is detected in an investor’s account, the compliance department will order the advisor in charge to either reverse the offending trade, offset the trade with a purchase of a lower risk security, or ‘update’ the investor’s Know Your Client information. Many advisors feel reversing or offsetting a trade make them look foolish in the eyes of the investor. After all, the investor is relying on an advisor’s investing experience and product knowledge. Instead, it’s much easier for an advisor to say, ‘If you don’t want my firm freeze your account, you’ll need to sign this Know Your Client update.’ Simply updating the Know Your Client does not solve the problem. The updated Know Your Client might now match the compliance department’s assessment or risk, but in such a situation it’s hard to imagine the Know Your Client matching the investor’s interpretation of risk.
For the trade approval process to protect the investor rather than the advisor or firm, thorough risk return analysis of an investor’s proposed account must be presented in graphical or numerical representation that the average person can understand. Risk category percentages or account standard deviation summaries mean little to the average investor. When approving a proposed portfolio, investors should be confirming a proposed portfolio (at least historically) has achieved a return suitable for long-term investment plans, within a level of downside risk acceptable to the investor. It should be up to the advisor and the sponsoring firm to determine what the standard deviation of that proposed portfolio is, how that standard deviation number should translate into Know Your Client data, and most importantly to continue monitoring the account over timeto ensure performance continues within the limits originally agreed to by the investor
Even though there may be considerable training or technology costs associated, what’s clearly needed is a commitment by the industry to a more proactive version of the traditional trade approval process. The proper training and tools to measure risk, explain risk and accurately transcribe that risk tolerance information onto dealer paperwork must be provided to advisors if firms want to ensure the proper information is getting into the hands of investors. Without such change, policy concerning trade suitability issued from regulators or compliance departments will ultimately continue to fail.
posted by Edward Iftody, BA, CIM at
1:42 PM
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