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Leverage and Misalignment of Interests

FAIR Canada’s executive director, Ermanno Pascutto, calls for increased investor protection from inappropriate use of leverage in a recent article entitled ‘To leverage, or not? in Investment Executive. He cites “a “systemic incentive”… that encourages advisors to recommend leverage, even in situations in which it is not suitable, because a larger asset base generates higher commission income and trailer fees for the advisor.” FAIR Canada has urged regulators to “institute a presumption that leverage is unsuitable for retail investors” which would require firms and advisors to demonstrate that leverage is an appropriate strategy for a given client. FAIR Canada has made several recommendations to address this problem, including its submission on mutual fund fees wherein we urged securities regulators to immediately address the risks of providing unsuitable recommendations to borrow to invest by precluding advisers and dealers from charging asset-based fees on monies that are borrowed for investment purposes and prohibiting the payment of a trailing commission in respect of amounts invested using borrowed funds. This reform has been adopted by the Australian Securities and Investments Commission.

An example of significant investors losses due to inappropriate leverage recommendations can be found in the class action against Investia Financial Services Inc., which involves some 760 clients “who collectively may have lost more than $40 million in investments bought with borrowed money.” This case was based on their alleged one-size-fits-all practice of recommending leverage to clients regardless of the suitability of such a strategy for each investor, which increased the fees earned by the advisors.

October 02, 2013