Last year, FAIR Canada identified leverage as a retail investor protection issue and wrote an open letter to the Canadian Securities Regulators (“CSA”), calling for better investor protection from unsuitable advice with respect to borrowing to invest. Leverage is a problem that needs to be addressed urgently.
The Investment Industry Regulatory Organization of Canada (“IIROC”) has found an increasing number of cases where inappropriate leveraging strategies have been recommended to consumers and has become aware of situations where consumers were not provided with sufficient information to properly understand the risks associated with such strategies or the details of the debt servicing obligations that the consumers had taken on as a consequence of using leverage. There have been two recent class actions which also involve the recommending of leverage to consumers.
In July, IIROC issued draft guidance regarding borrowing for Investment purposes (the “Proposed Leverage Guidelines”). Last week, FAIR Canada made a submission supporting the Proposed Leverage Guidelines but noting that regulators must do more.
FAIR Canada is of the view that there is simply no reasonable basis for an advisor to conclude that a highly leveraged sale of investment products is suitable for any but the most sophisticated investor with a high tolerance for risk. In these times of low interest rates and potential volatility, the use of leverage, particularly for the purchase of high-fee products, is simply a meritless strategy that will result in significant financial losses to the majority of consumers. Canadian securities regulators (including provincial commissions and self-regulatory organizations) need to implement a harmonized approach to protect investors from inappropriate use of leverage.
FAIR Canada supports the Proposed Leverage Guidelines as they set out existing obligations in IIROC’s rules and other securities regulations. They also provide needed guidance to dealer members and registered representatives to properly supervise client accounts that employ a leverage strategy, both “on-book” (margin loans advanced by the dealer member) and “off-book” (loans advance by third parties) borrowing and provide best practices. However, in the absence of further action by the CSA, IIROC and the MFDA, the Proposed Leverage Guidelines will not be sufficient to prevent more consumers from being put into high risk leveraged situations to which they are not suited.
We have outlined in our earlier letters (to the MFDA, IIROC and to the CSA) some of the underlying motivating factors that often lead to unsuitable recommendations which arise from the misalignment of the interests of financial intermediaries and the consumer, particularly the incentives in place that promote leveraged investing recommendations.
FAIR Canada continues to call for essential reforms to ensure that investors are better protected from unsuitable borrowing to invest recommendations. Our recommendations include:
- A presumption that a leveraged investing strategy is unsuitable for consumers, thus placing the onus on the salesperson and firm recommending leverage to prove that leverage is suitable for that particular consumer.
- Implementing minimum standards for registrants in assessing the suitability of leverage, which would include the following criteria: client investment knowledge; risk tolerance; net worth; gross income; employment status; and ability to withstand loss.
- Requiring independent legal advice be obtained when a home is to be used as security for leveraged investing.
- Requiring registrants and supervisors to certify that the risks have been explained and that the client understands the risks.
- More stringent rules on marketing or advertising of such a strategy and a review of the propriety of contractual relationships between investment fund companies, financing companies, and registrants in order to address the systemic problem of investors being unsuitably placed in leveraged investment strategies.
FAIR Canada has made a number of additional recommendations to IIROC and to the CSA, to help address this growing problem, which include:
- Any representation that the leveraged purchase of mutual funds, structured products or other high-fee investment products is suitable should be based on adequate and proper analysis;
- IIROC, the MFDA and members of the CSA (as appropriate) undertake a review of their member firms/registrants to determine:
- The extent and form (i.e. use of margin or off-book) of leveraged investing by the clients of dealer members/registrants;
- The particulars of the relationships regarding off-book loans, and the contractual arrangements between the registrant firms, the financial companies and the registered representatives;
- Whether the marketing and advertising materials that encourage investors to borrow to invest are fair, balanced and fully disclose the risks of such a strategy;
- The prevalence of unsuitable leverage recommendations;
- Whether clients who have leveraged investments were provided with sufficient information to properly understand the risks associated with such strategies or the details of the debt servicing obligations that they had taken on as a consequence of using leverage by canvassing a statistically relevant survey of leveraged clients; and
- The degree of compliance by dealer member firms/registrants with their existing supervisory obligations.