TORONTO - Most financial advisors don’t give much thought to how their livelihoods could be crippled or ended due to a compliance error, according to attorney John P. Huggard. In an advance copy of the speech he will give here today at the Million Dollar Round Table (MDRT) 2014 annual meeting, Huggard made a case for keeping that from happening.
The securities specialist laid out 10 areas that are currently on the federal regulatory radar, all of them with compliance implications for advisors. Several of the areas, such as assessing the mental capacity of older clients and adhering to suitability requirements, are hot buttons for state regulators, too. Here are a few highlights.
Selling financial products to older clients who may have reduced mental capacity that is not recognizable is “one of the major issues facing financial advisors today,” said the senior member of Huggard, Obiol & Blake in Raleigh, N.C.
To illustrate, he summarized a few details from the now famous case of Glenn Neasham, the annuity producer who ended up being convicted of larceny for selling an annuity to an older client. The charge against Neasham was that the annuity should not have been sold to the client because the client had reduced mental capacity, Huggard said. Neasham ending up losing essentially everything he owned, as well as his insurance license, because of that case.
The conviction was recently reversed in the California appellate courts, Huggard pointed out. But financial advisors “must still be vigilant when dealing with older clients or any client who might have reduced mental capacity.”
The best way to handle the issue of reduced mental capacity with older clients is to determine whether they have been involved in other transactions that would require mental capacity, the attorney said.
Such transactions would include using a computer, ATM machine or credit cards; refinancing a house, or purchasing an automobile, boat, or other major purchase, he said. In addition, he said, advisors should ask older clients if they have ever been involved in such activities.
This will help the advisor gauge the client’s mental capacity, Huggard said.
In addition, have the client “certify in writing that she or he has never had an issue concerning lack of mental capacity,” he said. For instance, ask the client to fill out and sign a form that has questions such as: 1) When was the last time you bought a car, boat or other major purchase? 2) When was the last time you purchased or refinanced real estate? 3) Have you ever been treated by a professional for any form of dementia or reduced mental capacity?
Huggard also suggested that at least one close family member (son, daughter, spouse) sign a form, too. This form essentially would be a certification by the family member that the older client has never had an issue with reduced mental capacity.
The family member statement might read like this: “My name is ______. I can attest that the above named individual is ___ years old and has never sought professional help relating to reduced mental capacity or dementia nor have I ever witnessed any symptoms or actions that would lead me to believe that the above named individual has dementia or reduced mental capacity. I am unaware of any health problems that might arise in the future involving the above named individual that are not covered by insurance.”
These signed forms will help protect advisors against a claim similar to the one in the Neasham case, Huggard predicted.
“The overwhelming majority of lawsuits and regulatory complaints filed with the Financial Industry Regulatory Authority (FINRA) involve the unsuitability of investments sold to clients,” the securities attorney said.
Suitability is also on the radar of many state regulators.
In financial practices, “the most common scenario involves a client who purchases an investment that later goes down in value,” the attorney said. In order to recover the investment, clients who have suffered losses tend to “come up with some way to claim the investment was unsuitable,” he continued.
Many law firms advertise on huge billboards that they will represent people who have lost money in the stock market, he noted. “What these attorneys normally do is to find some issue about the investment that was not discussed fully with the client. Their claim is usually based on an advisor’s failure to disclose an important piece of information.”
Huggard’s suggestion for advisors is to be sure to have documentation that such issues were discussed. As a general rule, he said, these claims are usually successful if the advisor does not have the documentation.
Never rely on the fact that the advisor provided a prospectus to the client, he stressed. “FINRA panel members are fully aware of the fact that clients do not read these overly technical documents and, for the most part, FINRA does not buy the fact that a financial advisor does not have any liability if the advisor has given the client a prospectus.”
It is important that a financial advisor is able to show that, at a minimum, the following issues were discussed with the client: Cost, risk, fee, potential tax liability, commissions and liquidity. Depending on the financial product being sold, there may be other issues that should be discussed with the client. The financial advisor should obtain documentation that such issues were discussed with the client.
Another caution: “The mere fact that an advisor can show a document signed by his client where the advisor has discussed the issues mentioned above does not fully protect the advisor,” Hubbard said. “FINRA requires that there is some proof that the client understood what was discussed.”
To show this, the advisor should have detailed disclosures explaining the major aspects of a financial product to the client, Huggard said. In addition, the advisor should have the client initial each topic and sign a disclosure form.
Also consider the possibility of recording the discussions with the client. Some financial advisors now do that, with the permission of the client, he said, so that “there is no misunderstanding in the future as to what was discussed and in what depth.”
Another idea is to give the client an exam. A few advisors are doing this, Hubbard said. They are “requiring clients to take short exams about the financial product the clients are purchasing.” The purpose is to enable the advisor to determine if the client really understands the product. “This also provides the financial advisor with something in his file indicating this,” he said.
Huggard also had a cautionary word about exotic investments. These products almost always have two characteristics, he said. “They are incredibly complex to understand, and they usually pay high commissions.” Examples include stranger-owned life insurance (STOLI), promissory notes (medical capital), private placements (Provident Royalties) and non-traded real estate investment trusts (REITs).
The advisors who sell exotics often do not understand them, Huggard said. That poses problems when the advisors are requested to explain to regulators why the product was sold to their clients.
His word to the wise: “Financial advisors who are approached to sell investments they have never heard of, especially if they are complex and offer enticingly high commissions, should be very careful about getting involved in the sale of these products.”
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