Suitability Infractions By Investment Advisor
An IIROC panel approved an investment advisor's settlement for a $12,500 fine, a $3,000 disgorgement, and a four-month suspension. The investment advisor presented an investment philosophy to the client that was focused on securities of small-cap companies. The Know Your Client (KYC) Form for a cash account set out 100% high-risk tolerances that the client advised the investment advisor he did not agree with, as he had no intention of risking his capital. The investment advisor told him this was "administrative paperwork" so that the dealer would allow him to invest. The client also signed risk acknowledgment letters that informed him that he could lose his capital. On occasion, the client repeated his discomfort in respect of the risk tolerances for his cash account, but did not object to maintaining them. He later opened a registered account with a 20% high-risk tolerance where he wanted a more conservative investment strategy.
The client transferred in a portfolio comprised primarily on growth mutual funds. The investment advisor told him the 2 stocks he was recommending were of lower risk in part because he knew the top executives personally. In approving the settlement agreement, the Panel held that the investment advisor should have reasoned with the client or refused to act for him. Read the full settlement agreement here.
Failure to supervise For Suitability: By The Branch Manager
Prior to implementing the strategy that focused on inverse exchange-traded funds ("IETFS"), the investment advisor discussed his strategy with the Branch Manager in detail. They were both of the view that the IETFs were not high-risk investments, and Branch Manager believed that the IETFs were significantly less risky than leveraged ETFs.
The Branch Manager did not advise against the strategy nor did he advise the investment advisors of the risk statements in the respective prospectuses or that the IETFs might not be suitable for clients who had no tolerance for high risk as recorded in their KYC form NAAFs where risk tolerances were shown as medium and/or "medium-high". IETFs were described in their prospectuses as riskier or highly speculative.
The Compliance Department made inquiries of branch management when they noted that most of the advisor's accounts were concentrated in two IETFs and in a fixed income fund and that 41% of his book was invested in Horizons IETF.
The Branch Manager had a detailed discussion with the advisor wherein the advisor again explained his strategy. In response to an inquiry from Compliance, the advisor explained his strategy in writing. Branch Manager reviewed the written explanation and asked that advisor add to it the explanation he gave to his clients. The explanation offered by the advisor did not refer to the statements in the prospectuses for the IETFs regarding risk.
The Branch Manager also responded promptly to an inquiry from the Compliance department regarding advisor's trading. While he advised the Compliance department that he was likely going to call some of the advisor's clients directly, he only spoke about these issues with two or three clients, in the course of other discussions.
In 2012, prior to any investigation or review by IIROC, the dealer instructed the advisor to recommend to clients that they discontinue the strategy.
Following an appeal to the OSC who ordered the matter back to IIROC, a second panel revisited the Branch Manager's original penalties of $30,000, a 6 month suspension, educational requirements, and $3,000 and found that that the first hearing panel imposed the appropriate penalty but notwithstanding amended the penalty to no suspension, a fine of $20,000.00, a rewrite of the supervisory exam before seeking approval for promotion and $3,000.00 for costs.
They held that the change was due to the branch manager having been deprived of the opportunity of being branch manager and whatever benefits might be derived therefrom, for over a year that his conduct has been the subject of at least four publications from IIROC to its members and that he had faced the costs of three hearings, being successful in the second.
Both IIROC panels were of the view that the Branch Manager's conduct was closer to negligence or an error in judgment because it wasn't clear that the strategy itself was high risk, despite the high-risk ratings in the prospectus. While there were many transactions in putting the strategy in place it was one decision involving one strategy. This is a case where there was supervision not only at the outset but regularly. The compliance group with the dealer was concerned with the percentages of IETFs in the various portfolios and if the conduct was "reckless" they would have done more. In hindsight the Branch Manager in supervising the advisor should have done more than he did. Read the full decision here.
By settlement agreement another branch manager was fined $50,000, plus $2,500 in costs for failing to supervise a registered representative who was disciplined by IIROC for conducting discretionary trading with 2 clients; recommending unsuitable investments for 4 clients and churning for 3 clients.
Red flags identified for which both Branch Manager and Tier 2 failed to take the necessary action to investigate:
- the Clients were retired, or nearing retirement, and vulnerable with very little investment knowledge;
- the dealer's policy required NCAF updates at least every 3 years, but many of the NCAF's in this case were not updated as required;
- the nature of the trading reflected an aggressive and speculative trading strategy of attempting to capture small gains;
- significant trading in higher risk securities including leveraged exchanged traded funds ("LETFs");
- the trade volume was extraordinarily high for retirement accounts (approximately 1,225 total trades in the 4 client accounts over less than 2 years);
- common account ratios were indicative of possible churning. The turnover ratio was approximately 15 times, the cost to equity ratio was approximately 17%, and the commission to profit ratio was approximately 53% in the clients' accounts;
- the clients represented approximately 13% of advisor's book of business by asset size, but they comprised approximately 87% of his total gross commissions over a 2 year period of January, 2009 to December, 2010;
- the clients appeared on the commissions over $1,500 reports at least 40 times, and the commissions over $3,000 reports 19 times, and in addition, appeared very frequently on the daily commission report;
- some of the funds invested by certain clients were borrowed, and upon advisor's urging and assistance, they made a very unique application for hardship withdrawals to access additional funds in locked in accounts.
The trading is further described as frequent trades in medium to high-risk securities. The medium risk securities were primarily resource issuers trading on the TSX, and the high risk securities were primarily commodity-based LETF. Profitable positions were held for short periods while unprofitable positions were held for longer periods. The performance in the clients' accounts was compared to the performance of the S&P TSX Composite Index in the settlement agreement. Read the full settlement agreement here.
Obligations of the Dealer to Supervise for Conflict of Interest and Excessive Trading
(Conflict of Interest)
A dealer was fined $130,000 and $20,000 for costs for failure to disclose conflicted interest, failure to provide proper reporting on the national registration data base and failure to supervise a registered representative for charging excessive commissions to 8 clients.
With respect to issues of conflict interest, an investment advisor at the dealer operated a corporation with administrated investment vehicles. To address the conflict, upon hiring the investment advisor, the dealer acquired all the shares for the corporation. The dealer opened new accounts for several clients who had participated in these investments prior to becoming client at the dealer. The dealer also sold these products to additional investors. The investment advisor continued to have a personal interest in the products. His shares were placed in escrow with the issuer's lawyers. These escrow shares were seen as representing a potential conflict that was not disclosed to investors until the issue was raised by IIROC at a business review. The dealer then sent letters to investors so advising them and providing them with the right to cancel their purchase and redeem at their initial purchase price with interest to the date of redemption. Two clients accepted the recession offer though indicated they were doing so as a result of need to liquid the investments and for reasons unrelated to the conflict.
(Excessive Trading)
Another investment adviser at the same dealer engaged in excessive trading practices over a three-year period in one client account. From June 2007 to April 2010 he executed approximately 290 trades, over 80% of which were purchases and sales of large Canadian Banks. The month and value of the client's account fluctuated between $1.7 million and $2.8 million. The client and the investment adviser had a very long relationship with the client who was over the age of 65 and a retired nurse with no dependants. She brought a lawsuit which settled and to which the investment adviser contributed personally. The IIROC settlement agreement sets out a chronology as to the concerns raised by branch management and compliance staff in respect with the account from 2006 onward. In July 2009, the Branch Manager contacted the client by phone, who advised that she was aware of all transactions and commissions and spoke highly of the investment advisor. She also confirmed that the adviser spoke to her before entering any trades. The Branch Manager contacted the client again the following year after which the investment adviser was directed to cease any activity in her account. Her lawsuit arose as a result of a complaint through her accountant. Read the full settlement agreement here.
UMIR Infractions: Pre-trade controls for Electronic Access
An investment dealer was fined $170,000, plus $5,000 in costs for violating the UMIR by 7.1(6) and 7.1, Part 7, Specific Provisions Relating to Electronic Access that detail pre trade controls that cause, amongst other things, a Participant to exceed predetermined or capital thresholds. The dealer had an honest belief that these auto marked controls were in place. Instead, their controls allowed for the entry of an erroneous order (the "Trading Error") that resulted in an intraday (approximate 1 hour) capital deficiency of $8 million. According to the dealer's systems, after an order was generated, the trader could modify price or volume before submitting it to the marketplace. A trade station has 'soft controls' to prevent the entry of an order which exceeded pre-set limits. This was an additional pop-up window with an alert to warn the trader, which the trader was able to override. The dealer proceeded to cover the short position resulting from the Trading Error immediately, with the position closed for a profit within an hour. The dealer has since taken steps to adopt other controls. Read the full settlement agreement here.