Protect Yourself in the Financial Advisor – Investor Relationship

(Last Updated On: March 22, 2017)

Good financial advisors are invaluable. They can help you stay focused on your long-term goals and can offer retirement, tax and other financial planning advice that goes well beyond the selection of stocks or funds. You must, however, protect yourself in the Financial Advisor – Investor Relationship. This post provides tips on how to do so.The idea for this post came from following the developments surrounding New York-based hedge fund Platinum Partners.

Frauds to the magnitude of those perpetrated by Platinum Partners, Bernie Madoff, and Allen Stanford receive wide media coverage. There are, however, countless frauds perpetrated by investment advisors that never receive the same level of media attention.

I performed a search on the U.S. Securities and Exchange Commission’s website and entered “Advisor Fraud” in the search field. There are countless pages of cases.

Despite the much smaller amounts to which countless investors have been defrauded, the amounts were of material importance to the victims. These investors’ lives have been ruined. In many cases investors never receive restitution that remotely matches the size of their losses.

Infamous Investment Scams

Platinum Partners

Platinum Partners was founded in 2003 and claimed to have in excess of $1.3 Billion in assets. It purported to be what every hedge fund within the industry should emulate as it boasted of annual average returns of more than 17% since inception.

On December 19, 2016, however, the United States Attorney for the Eastern District of New York issued  a 48 page criminal indictment and a statement announcing the charges. The statement reveals “their returns were the result of the overvaluation of their largest assets, which eventually led to Nordlicht and his co-conspirators operating Platinum like a Ponzi scheme, where they used loans and new investor funds to pay off existing investors.”

The indictment alleges senior partners schemed to defraud Platinum investors by overvaluing illiquid assets held by its flagship Platinum Partners Value Arbitrage Fund dating back to 2012.

Charles Ponzi

A Ponzi scheme is a fraudulent investment operation where an individual or organization pays returns to its investors from capital received from new investors and not from investment related profits. In order to continue the perpetration of the fraud, the operators of a Ponzi scheme must entice new investors by offering abnormally high or unusually consistent higher returns than available elsewhere.

The term “Ponzi scheme” is named after Charles Ponzi’s famous pyramid scheme. He promised investors returns of 50% in 45 days but payments to investors were actually paid with funds from new investors.

Ultimately the scheme failed in 1920 leaving 5 banks and all investors ruined. Investors were only able to recoup 30% of their initial investment. While the $20 million Charles Ponzi generated through this pyramid scheme pales in comparison to more recently perpetrated frauds, you have to remember that $20 million in 1920 is equal to over $240 million in 2016.

Nature of the Financial Advisor/Investor Relationship

The nature of the financial advisor/investor relationship is one where investors have “inherent trust and confidence” in the advisor. The honesty of financial advisors is critical otherwise no investor would turn over the management of their investments to them.

Not all financial advisors, however, are honest and trustworthy. If you want an eye opener as to what goes on in the investment industry, I urge you to read Naked Investor Revised Edition: How To Beat The Odds With The Investment Industry by John Lawrence Reynolds for examples of how some financial advisors have taken advantage of their clients. I also suggest you watch CBC’s Marketplace Show Me the Money episode originally broadcast February 28, 2014.

Tips to Minimize the Risk of Being Defrauded by a Financial Advisor

A financial advisor is not a controller of your financial affairs. You need to do what is best for you and must be comfortable with the advisor and the investment recommendations provided.

Be vigilant and always check the paperwork. If something does not look right, ask questions. Remember the old adage “Trust but verify”.

Here is a short video with tips on how to select a financial advisor.

Check the Financial Advisor’s Credentials

If you are a Canadian resident, you should check the Investor Tools tab on the Canadian Securities Administrators website to see if your advisor is registered or has been disciplined.

If you are a US resident, check the US Government’s Investment Adviser Public Disclosure website and Financial Industry Regulatory Authority’s (FINRA) BrokerCheck website.

Verify the financial advisor’s registration. Look for an “advising representative” or “portfolio manager” because they have a fiduciary duty, which is a legal obligation to look after the client’s best interests.

Not all financial advisors have a fiduciary duty to you. In fact, most financial advisors are registered as a “dealing representative” which is another term for sales person. Dealing representatives are required sell products that are “suitable” which is not the same as a fiduciary duty to the client.

Use of Leverage

Be wary if your advisor recommends the use of leverage (ie. borrowing via a mortgage, bank loan, margin account, or other form of debt). Leverage is a double-edged sword. Just as your investment returns are magnified when your investments increase in value, your losses are magnified when your investments fall in value.

I am not advocating that leverage never be used. I have used leverage but did so when stock valuations were depressed which enabled me to acquire shares in solid blue chip companies at superior prices.

Be EXTREMELY cautious when using leverage. Ensure you have the ability to repay the financial obligation without having to rely solely on the success of your investment.

I have followed a rule that I should have more than one way out. If I borrow money for investment purposes, my first way out should be from the profitability of my investments.

I also need a second way out in the event my investments fail to generate the anticipated profits. I must be prepared and able to liquidate other assets if required or to take on extra work to generate additional income.

In my opinion, if you are unable to come up with more than one adequate source from which you can generate funds to retire an investment related liability then the use of leverage should be avoided.

Be aware that when an advisor encourages the use of leverage, the advisor is increasing the assets under management (AUM) on which commission is calculated. You, however, assume all the risk.

Know Your Customer Documentation

Retain a copy of the Know Your Client (KYC) statement which must be prepared at the time of establishing your relationship with the advisor. Ensure the information reflected on the document is accurate and that you have signed the KYC documents.

Circumstances change over time so ensure your KYC documentation is updated as required. Examples of when your KYC documentation should be updated include a major life event or a dramatic change in your assets/liabilities/income.

Determine How Your Investments Will be Benchmarked and How the Financial Advisor Will be Compensated

Insist your advisor:

  • provide information on how to obtain details on your portfolio’s performance relative to appropriate benchmarks such as the S&P 500 composite index or the S&P/TSX composite index;
  • explain how fees are determined and how much you pay;
  • disclose in writing all compensation he/she will receive.

Financial Advisor Claims to Have the Ability to Forecast Accurately

Move on if your advisor claims to be able to forecast the extent to which the market will rise/fall or what will happen to the price of certain investments. Markets are unpredictable and nobody can consistently accurately forecast the future.

Suitability of Investment Products

Some unscrupulous advisors load client accounts with investments that pay them fat commissions but for which the client takes on excessive risk. New issues and structured products (eg. principal-protected notes) are money-makers for advisors.

Several years ago, a co-worker who was a single mother with limited income and nominal net worth had a financial advisor who loaded her up with investments in Labour-Sponsored Venture Capital Corporations (LSVCC), known alternately as Labour-Sponsored Investment Funds (LSIF); a LSIF is a fund managed by investment professionals that invests in small to mid-sized Canadian companies.

The risk of these investments is so great the Canadian federal government and some provincial governments offer tax credits to LSVCC investors to promote the growth of such companies! This truly was not the appropriate investment for an investor with this profile.

Ensure Reporting is Provided by an Independent 3rd Party

Financial advisors who have perpetrated fraud have repeatedly produced records (eg. investment statements, transaction confirmations) which were not prepared and delivered by a respected 3rd party custodian. In the fraud perpetrated by Bernie Madoff, for example, internally prepared falsified investor statements were sent by his firm directly to every investor.

Investor Protection

Securities are sold locally by professionals who are licensed in every Province or State in which they conduct business.

In the US, State Securities Regulators work within the State government to protect investors and help maintain the integrity of the securities industry. They can also help you protect yourself from investment fraud.

Your State Securities Regulator:

  • Verifies that a broker-dealer or investment adviser is licensed;
  • Provides information about a broker-dealer’s prior run-ins with regulators, serious complaints that may have been lodged against them, their educational background and their work history;
  • Provides information on where to file a complaint;
  • Offers investor education and protection materials.

The North American Securities Administrators Association (NASAA) website (“Contact Your Regulator” tab) has the regulator’s contact information for each province and state. I highly recommend you also visit the Investor Education segment of the site.

In Canada, non-profit Small Investor Protection Association (SIPA) aims to raise awareness about financial fraud and provide guidance to victims seeking restitution. If you think you have fallen victim, speak with a good securities lawyer to determine whether you have a case and how to proceed. There is a section on the SIPA site if you require help on how to find a securities lawyer.

SIPA recommends civil litigation for large claims (eg. in excess of $100,000). You may be able to find a good securities litigator who will work on a contingency fee basis if you can get together with a number of victims.

If your loss isn’t big enough to justify the cost of civil litigation you must complain directly to the firm. If your complaint is not resolved to your satisfaction, you can escalate the matter to the Ombudsman for Banking Services and Investments (OBSI). They provide a dispute-resolution service.

While OBSI can make recommendations for compensation, the recommendations are merely recommendations. They are not binding and a growing number of firms are refusing to accept OBSI’s rulings.

In Canada, the national self-regulatory organizations (ie. the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association of Canada (MFDA)) have the power to discipline members and levy fines. They do not, however, order restitution.

IIROC can refer you to arbitration but it can prove costly and the feedback from mediators suggests this is not a good option for small investors as the decision is final and binding.

The system is better if you live in Quebec, where the provincial regulator, the Autorité des Marchés Financiers (AMF), has the power to provide compensation with its indemnity fund.

More information is available at “How to make a complaint against your advisor”.

Final Thoughts

There are several precautionary measures to follow to minimize the risk of becoming a victim of financial advisor fraud. Conducting proper due diligence at the outset to minimize the risk of establishing a relationship with an unscrupulous financial advisor is a good first step.

Finally, it is imperative that you remain cautious and vigilant throughout the term of your relationship with your financial advisor.

Additional Resources

Here are some sites worth reviewing.

Canadian Foundation for Advancement of Investor Rights

Stock Broker Fraud – What You Must Know – The 11 Tell-Tale Signs of Stock Broker Fraud and What You Can Do To Protect Your Investments

International Association of Registered Financial Consultants

Lewis, Hooper, and Dick LLC (Certified Public Accountants)

Five Ways to Avoid Financial Adviser Fraud

Top Financial Adviser Scams and How to Avoid Them

Financial Fraud – Tips to Protect Yourself