march, 2009
The Second Opinion: Can You Sue Your Advisor? (Part One)

Can you sue your advisor? (Part One)

It is sometimes said that in recessions the only winners are the lawyers—because divorces, employment grievances from laid-off workers, and both commercial and personal bankruptcies can all be expected to increase as a result of a deep recession. Here’s another one for the lawyers—how about suing your advisor?

It is possible to sue an investment advisor, but as Ken Hawkins explains at the bottom of this page, you must first have solid grounds. The fact that you lost money is not enough. Even if your advisor made a mistake it may still not be enough—which makes sense, because even the best will make mistakes. In a letter to his shareholders, legendary investor Warren Buffet openly discussed his mistakes in the recent downturn, even calling them akin to “unforced errors” in tennis. So if even the best can make a mistake, your advisor certainly could have as well. This may or may not mean that you can sue, but you can always hold your advisor accountable! This may mean moving your account to a new advisor/firm.

In light of the worsening economic situation, and a corresponding increase in the number of people contacting us with questions regarding suing their financial advisor, we dedicate a two-part series of The Second Opinion to the issue of suing advisors. In this issue we look at Warren’s tip, Hold Your Advisor Accountable for Results, and an article by Second Opinion Vice President Ken Hawkins. Next month Ken will continue where he left off by explaining some of the things that can be done before you call your lawyer.

By Carlo Palazzo, CIM

Hold your advisor accountable

Why this is important: The squeaky wheel gets the grease.

There are times when we are likely to complain — for instance, if our cars don’t work properly after servicing or an appliance goes on the fritz. Yet, we rarely hold our financial advisors responsible for a specific level of performance. We assume that the advisor does not control the stock market and therefore cannot control the risk or the return of the investment portfolio.

This is the wrong way to look at the situation. While the advisor does not control the stock market she can increase or reduce the risk of the portfolio. The advisor can do this by recommending a larger or smaller allocation to the higher-risk part of the investment portfolio. She can also reduce risk by recommending investments that have a low correlation with each other. For instance, she can select investments where the loss on one is normally offset by the gain on another.

You want to take no more risk than the minimum level of risk necessary to achieve the average return your financial plan shows is necessary to reach your financial goals. A competent financial advisor can put together a portfolio that can be expected to earn your required rate of return, within an agreed upon, predetermined range of results. The expected range of results — agreed to by advisor and client — will be part of the Investment Policy Statement.  A good advisor will also tell you if your “required” rate of return is realistic.

If you decide you want a higher average rate of return, the range of possible returns will also be higher (good years should be better and bad years are likely to be even worse). The range of returns, although higher, is still predictable. There should be very few surprises in a properly designed portfolio. It may perform near the bottom of the range, the middle, or the top, but you can anticipate that 95% of the time the actual results will be within the expected range.

As a client, you are owed a sound explanation for results outside the expected range. The advisor is not liable for any losses, but the explanation should be reasonable. It is not enough just to say that results are poor because the markets were down this year. All advisors know that markets have good years and bad years. A properly designed portfolio will make allowances for this. In a bad year, the performance may be near the bottom of the expected range, but the return should not be significantly lower than what was expected in the worst likely year.

The advisor should not be able to escape accountability by providing such a wide estimate of volatility that results are bound to fall within the predicted range. The advisor who says that it is impossible to predict the market and that your overall portfolio, therefore, might be up or down by 50%, may be trying to avoid being held accountable.

In one way, your relationship with your financial advisor is like your relationship with your spouse. You need good communication. If something is brothering you, the issue should not be allowed to fester; it should be discussed.

Bottom line: Your financial advisor should be able to design an investment portfolio in which the results fall within a predicted range. Holding your advisor accountable means that you demand a reasonable explanation if results are outside the expected range. A loss, outside the expected range, should not be explained away simply by saying it was a bad year for the market.

What you can do now: Ask your financial advisor for an IPS that shows what range of returns your portfolio could be expected to yield over one, three, five, and ten years.

Can you make a claim?

Most investors have been badly hurt in the worst bear market since the great depression. Those who are without a pension and who are in retirement or close to retirement have suffered losses so great as to be life altering. Many are blaming themselves for their predicament, but they might not be at entirely at fault. In some cases the blame should be assigned to their trusted financial advisor. If it can be, then the investor may be able to make a claim and may be able to recover at least a portion of the investment losses.

Just because you lost money does not mean you have a claim against your advisor for bad advice. You take risks, against which no laws or regulation can protect you, whenever you make an investment in the stock market. However, there are laws and regulations that can protect you if your losses occurred as a result of your advisor’s misconduct. If your advisor acted in a way that contravened those regulations then you may be able to recover some of your losses. The more common types of misconduct include:

  • unsuitable recommendations
  • excessive trading
  • unauthorized trading
  • failure to execute a trade
  • misrepresentation
  • misappropriation

Unsuitable Recommendations

An advisor has a responsibility to make only those investment recommendations that are in your best interests. An unsuitable investment or recommendation is one which is not suitable for you based on your personal circumstances, investment objectives, needs, or tolerance for risk. If your advisor does not understand your financial condition or goals he cannot meet this responsibility. Unsuitable investments might include risky strategies such as investing in small-cap stocks, taking concentrated positions, speculating with options, or borrowing for investment purposes. If an investor holds a substantial portion of their assets in illiquid investments for which there is no ready market, or where there is a substantial penalty for early redemption, then this strategy might be deemed unsuitable.

Excessive Trading

Excessive trading or "churning" occurs when the advisor excessively trades the account in order to generate large commissions. There is a fine line between active trading and excessive trading and the truth can only be determined by analyzing past trades.

Unauthorized Trading

Unauthorized trading occurs when an investment advisor makes a trade on your behalf without your authorization prior to the transaction. The only exception is when you have signed papers giving your broker permission to trade on a discretionary basis. However, even with a discretionary account, your advisor is still supposed to follow your instructions. As an example, if you told your advisor you do not want to buy junior resource stocks, the advisor has an obligation to respect your wishes.

Failure to Execute

Regardless if your account is discretionary or nondiscretionary, your investment advisor has a duty to follow your instructions. If you want to sell a stock or liquidate your portfolio and your advisor fails to follow your instructions you almost certainly have a case. If the trade does not happen because he talked you out of it and you lose money as a result, then it is still possible that you have a case although it is less likely.

Misrepresentations and Omissions

Misrepresentation is the legal term for “lying”. If your advisor deliberately withheld or misrepresented the material facts in making a recommendation he can be held liable for the consequences. Even a prediction or statement of opinion by an advisor can constitute fraud if you relied on the statement and there was no reasonable basis for making the assertion. Failure to disclose all the risks in an investment may also be grounds for a claim.

Misappropriation

Finally, an advisor may simply misappropriate or “steal” from an investor's account. This could occur in situations where the advisor is not reporting a particular transaction to his employer or when transferring client’s funds to his own accounts. Even if the firm employing the advisor is unaware of the transaction in question, or even of the existence of the customer, the investor can often recover from the firm.

Do you have the basis for a claim?

Whether or not you can recover any of your losses will be based on your own unique circumstances. Like most legal issues it is not black and white. It is one thing to believe you have a legitimate case; it is an entirely different matter to prove it and make a recovery. It is unlikely that your advisor would voluntarily pay for any of your losses even if he was permitted to do so. (Securities regulations prohibit an advisor from voluntarily refunding money to a client, except with the consent of his employer). It is equally unlikely that he will pay if you ask him directly. If you do make a claim and ask him to refund your losses he is required to immediately report the claim to his compliance officer.

Before starting any action that is going to create problems for both of you, and one which will surely require you to transfer your account, it is wise to get some trusted legal advice.

There is however a process one can follow to file a claim for losses and following that process will improve their likelihood of making a recovery. We will discuss it next month.

By Ken Hawkins