Leveraging: the pros weigh in

Recently, I wrote about the plight of a 62-year-old couple that had been persuaded to borrow $300,000 to invest in mutual funds. They had lost $10,000 in less than four months and the wife wanted to sell. Her husband, however, wanted to stick it out.

The story touched a nerve among some financial advisors who feel incidents like this give a black eye to their business and offered insider advice to the beleaguered couple on ways to mitigate their losses and perhaps even to get the whole transaction unwound.

I think this is an extremely important issue. Over the years, I have seen far too many examples of people being induced to mortgage their homes to the hilt to invest in mutual funds, lured by the prospect of big returns with interest deductibility tossed in as a sweetener. Often the only person who benefits in the end is the salesperson, who walks away with a fat commission.

Fortunately, responsible professionals are stepping forward to condemn these practices and to tell people how to strike back when they feel they have been misled into buying unsuitable securities. Two e-mails that I received in response to the original articleare examples.

The first came from Kurt Rosentreter, a senior financial advisor with Berkshire Securities Inc. in Ontario who has written several books about investing and tax strategy. Here are some excerpts:

“I saw the story about the 62-year-old couple who were convinced to leverage for $300,000. While you were kind in your response, I would suggest they may also want to explore a harder, harsher path to getting out of this leveraged portfolio.

“First, they could get a second opinion on their ‘know your client’ forms that they signed when they opened the accounts. A 62-year-old retired couple is usually not categorized as ‘high risk’ and ideal for a big investment loan. If the dealer’s applications were prepared wrong, or even interpreted wrong, they can then go to the branch manager or the compliance department for the dealer and start to build a case that they were ‘sold’ into an aggressive strategy that was never correct for them in the first place. If they are really serious and angry enough, engaging a lawyer to represent them will help. But I would start off with a face-to-face meeting with the branch manager.

“Second, it appears from the facts of the case that the broker sold them mutual funds on a rear load basis, as you mentioned there is 5.5 per cent redemption fee to sell now. That sounds like a rear load fee on a DSC mutual fund. This redemption fee will decline to zero over six years, meaning they will be close to 70 years old before this ordeal will be over completely. Again, they may want to go back to the dealer – branch manager or head office compliance, not the advisor – and request/negotiate to have the transactions changed to ‘front-end load zero commission’. Even at this late date, it is likely still possible to back-date the transaction to reverse the rear load, allowing them to remove the six-year chain on their leg. The advisor would have to give back the big commission he earned on the sale, but may not view this as too bad if it saves him from a lawsuit.

“I would strongly recommend they get a second opinion on their options by visiting another advisor at another dealer, who can review the exact situation and advise them accordingly. If in fact they were mishandled and if they are prepared to get nasty, they very well may be able to reverse the transaction or at least get the exit fees waived.”

The second e-mail was from Roy E. Adam, Vice-President and Calgary Branch Manager for Assante Capital Management Ltd. He wrote:

“I am an investment advisor with 20 years of experience. In 2002, I assumed responsibility for another advisor’s clients due to the fact that he recommended leveraging in the late 1990s, primarily into high growth (read ‘tech’) mutual funds. The ensuing damage done in the ‘tech wreck’ resulted in that advisor’s 15-year ban from the industry, lawsuits, marriage strain, delayed retirements, and obvious client losses. Those few that could hang on (if they had the personal risk profile, did not have margin calls forcing them out, and still had the stomach for it) are just now back to a slight profit.

“The couple in question sound like many of the clients whom I had to console and attempt to ‘repair’ their finances with what little was left. This task is made more difficult when these financial products are sold on a DSC basis, effectively creating ‘golden handcuffs’, which in this case are only golden for the salesperson.

“Your summary of the risks is quite clear and correct, however I think you have assumed that there is an ‘investment advisor’ who got these people into this. That’s a misnomer. As I’m sure you know, the investment industry has undergone a sea change in the past 30+ years whereby professionals giving technically knowledgeable and prudent advice are now outnumbered by those who may know just 10 per cent more than their client, but are enthusiastic marketers of mutual funds and ‘managed money’. They are purveyors of a portfolio manager’s investment competency, with little knowledge of their own and thus ‘salesperson’ is more correct than ‘investment advisor’.

“There are still many who are competent, however we face an uphill battle against those who are less so, but are much better salespeople. The mutual fund companies do nothing to dispel this, as they are the primary beneficiaries.

“The two-tiered regulatory structure further supports this regime, with mutual fund dealers and their relatively minor barriers to entry vs. investment dealers. The distinction is virtually unknown to the public as they assume all investment industry members must have similar credentials.

“This is not to say that IDA members who have completed the Canadian Securities Course are all wonderfully competent, but the IDA world does have a more demanding entry requirement and a more rigorous compliance regimen than most mutual fund dealers. And to be fair, there are many excellent members of the industry who have nothing more than a mutual fund salesperson’s license. They are good at what they do by their own choice, not because of rigorous supervision or any industry requirement to be competent.

“For this couple, there is no reason why they need to accept a loss and there are remedies. A few suggestions:

“1. Let’s keep in mind that this salesperson probably has many more clients who were advised to do the same thing and he/she and the firm were compensated handsomely. It is reasonable to assume that this incident is only the tip of the iceberg. Perhaps by bringing it to the light of the compliance department, other clients’ accounts will also be reviewed before another market decline, and losses mount. In this case, the appropriateness of such an investment is highly questionable for a near-retired couple and should be reviewed by the branch manager and/or someone higher in the firm with compliance authority. There are now numerous cases stemming from the 2001-2002 debacle where salespeople have been censured for failing to keep the client’s best interest at heart. Most compliance departments are sensitive to complaints about 62-year-olds having their life savings put at risk in this way. If that fails, the provincial securities commissions would be happy to intervene!

“2. About $15,000 in DSC income was paid to the salesperson and their firm but it is questionable if it was earned. If the review mentioned above is done, one result may be that all or part of those transactions are changed from DSC to 0 per cent FEL (front-end load) basis. The firm and the advisor would face a chargeback for the difference and in the future the salesperson would receive a higher trailer fee on the FEL funds. This does not reverse the market losses but does eliminate the mental hurdle of incurring a transaction loss just to get out of a bad deal. DSC charges are a significant deterrent to ‘doing the right thing’ at a time like this. I don’t think that I am being cynical by suggesting that they are, by design, very effective at holding the client to the (inappropriate) status quo, thereby impeding significant changes.”

The reaction of these two respected professionals to the plight of our 62-year-old couple is proof that there are many financial advisors who have the knowledge, skill, and integrity to look after clients’ money in a responsible manner. As Mr. Adam points out, one good way to find them is to seek out advisors who have bona fide financial planning and securities credentials as opposed to simply being sales people.

And, as both advisors point out, there are remedies available to people who feel they have been taken advantage of. If you are in that position, use them.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm