Canada: Brokers´ Report - October, 2009

Edited by David Di Paolo

Two recent cases, Mazzarolo v. BMO Nesbitt Burns ltée and Gale v. ScotiaMcLeod, are more examples of case law that emerged from the high tech crash. These cases illustrate the importance of knowing your client and keeping updated records of a client's investment objectives and risk tolerance. While this lesson is neither new nor groundbreaking, it is worth repeating.

Mazzarolo v. BMO Nesbitt Burns ltée

Mazzarolo v. BMO Nesbitt Burns ltée was decided in Quebec Superior Court on January 30, 2009. The plaintiffs, Mr. Mazzarolo and his three companies, sued the defendants, their former brokers, Michael Lazarus and Clifford Albert, and their employer, BMO Nesbitt Burns, after suffering substantial losses from the rapid decline in value of their portfolios. The plaintiffs claimed that the brokers failed to follow the plaintiffs' instructions and stated investment objectives. Moreover, the accounts were alleged to contain an unsuitable concentration in technology stocks.

Mr. Mazzarolo was an Italian immigrant who arrived in Canada in 1956 at the age of 20, having completed 8 years of formal education. In 1967, he started his own business which was sold in 1997. At that time the plaintiffs, opened accounts at various brokerage firms. Prior to opening an account with BMO, know your client (KYC) forms for the plaintiffs were completed in May of 2000. The KYC forms identified the plaintiffs' experience as limited, with aggressive growth as the investment objective. In addition, the brokerage accounts were non-discretionary. The forms, however, contained numerous errors regarding the plaintiffs' net worth and the parties disputed the source of the inaccurate information. The plaintiffs relied on Mr. Mazzarolo's limited education and the KYC form that indicated that he had limited investment experience as evidence in support of the allegations that the defendants provided unsuitable recommendations.

The Court, however, found that Mr. Mazzarolo was a sophisticated and knowledgeable investor. Mr. Mazzarolo had been investing for over thirty years with a variety of brokerage firms and was familiar with a large variety of financial instruments. KYCs from other brokerage firms listed the plaintiffs as sophisticated investors with investment objectives that were 50% speculative. The Court also found that the plaintiffs communicated frequently with the brokers regarding the trades made, and that it was the plaintiffs who pushed for a large concentration in technology stocks. The Court also concluded that the plaintiffs ratified the transactions when they failed to complain about the trades made, despite receiving a confirmation after every trade and a monthly statement of account.

As a result of the plaintiffs' investment knowledge, the non-discretionary nature of the accounts, and their ratification of the trades made, the Court found that the brokers were not responsible for the losses suffered. The plaintiffs' sophistication and investment knowledge reduced the duties owed by the brokers to the plaintiffs to the level of an agent. The court also found that "the investments made were appropriate and consistent with the investment objectives mentioned in each of the KYC forms" (pr 191).

Gale v. ScotiaMcLeod

Gale v. ScotiaMcLeod was decided in the Newfoundland and Labrador Supreme Court on September 19, 2008. The plaintiffs, Brian Gale and his wife, Cheryl Gale, sued the defendants, their former broker, James Rottball, and ScotiaMcLeod, after suffering large losses in options trading in the first half of 2000. The plaintiffs claimed that Mr. Rottball breached his fiduciary duty and his duty of care to the plaintiffs by inducing Mr. Gale to pursue an investment strategy which was unsuitably risky.

The plaintiffs, after selling their ownership stake in a local cable company, decided to invest with ScotiaMcLeod. In July 1999, the plaintiffs opened a non-discretionary trading account with Mr. Rottball. The KYC completed with the plaintiffs listed their combined knowledge as average with a medium risk tolerance. Mr. Gale was an experienced investor while Mrs. Gale was a complete novice. Shortly after the July meeting, Mrs. Gale signed a joint account agreement which gave Mr. Gale authority to deal with the account on her behalf. Mr. Rottball, in November of 1999, completed a second KYC after Mr. Gale signed an options trading agreement. The plaintiffs' risk tolerance was listed as 80% medium and 20% high.

The Court found that Mr. Rottball did not owe the plaintiffs a fiduciary duty and did not negligently handle their account. The Court determined that Mr. Gale was a sophisticated investor who had a history of undertaking risky trades with a penchant for technology and junior mining sectors. Further, a KYC from another brokerage firm listed his investment knowledge as good. As a result, the Court found Mr. Rottball fulfilled his obligations to know his clients and recommend suitable investments. Two factors led the Court to this conclusion. The first was the plaintiffs' investment knowledge and involvement in the development of the investment strategy. At their initial meeting, Mr. Gale rejected the initial investment strategy proposed by Mr. Rottball, which was to purchase a majority of mutual funds which had the motto of "buy, hold, and prosper". Mr. Gale also initiated the move from trading in securities to options trading. Further, Mr. Gale and Mr. Rottball's almost daily contact showed the broker was aware of the plaintiffs' investment objectives and risk tolerance even though he did not update the KYC form.

The second factor was Mr. Gale's investment history. The Court looked at his trading history in his discount brokerage account. Mr. Gale showed a tendency to perform trades with a high level of risk and look for short term profits. This displayed a pattern similar to the pattern of options trading which led to the losses.

Lessons Learned

Of note in these cases is that the Court used the plaintiffs' investment history to determine the scope of the duties owed by the broker to the clients. In particular, the Court used KYC forms completed with other brokers and the investment history of the clients to show that the brokers knew their clients. This allowed the defendants to demonstrate that they had recommended suitable investments although the defendants' own KYCs may have been inaccurate, as in Mazzarolo, or unconfirmed by the clients, as in Gale. Using external records to show that the broker knew the client is consistent with previous cases, such as Young Estate v. RBC Dominion Securities, where a broker's notes to file were accepted. Despite the acceptance by the Court of outside records, it is still prudent to diligently record changes in a client's risk tolerance and investment objectives through the completion of a new KYC form.

A developing story: A Rogue Broker

In a claim issued in August 2009, BMO Nesbitt Burns sued one of its former brokers, Gregory Rao, for, among other damages, ten million dollars he allegedly misappropriated from clients. In July of this year, Mr. Rao was terminated from BMO's branch in Woodbridge, Ontario after admitting to misappropriating 2.2 million dollars from clients and directing those funds to third parties and/or to himself. In its claim, BMO alleges that its own internal investigation has revealed that Rao misappropriated at least $6.4 million from at least 20 clients. Mr. Rao claims he stole the money, allegedly to pay off monies he owed regarding a condo project he was involved in, after receiving threats from other condo investors. Mr. Rao allegedly gave money to at least thirteen individuals, but has refused to name them and BMO's forensic accountants have not yet identified them. Shortly after commencing litigation, BMO obtained a court order freezing all of Mr. Rao's assets. We will continue to monitor this case as it heads to trial.

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