The Discretionary Account That Wasn't
An advisor manages a discretionary account for a client with a conservative profile and a 5% maximum equity allocation. Over two months, the advisor buys three small-cap biotech stocks, bringing equity exposure to 22%. Each trade is within the account's formal investment policy statement, which permits equities up to 25%, but the client's separately documented risk tolerance says 5%. The advisor's notes say the client 'seemed comfortable' after a phone call in which the advisor described the biotech sector as 'where the growth is.' The client did not initiate the call and did not give written approval. The advisor's compensation includes a trailing commission on the biotech positions. The client is 78 and relies on the account for monthly income, which has fallen because the biotech positions pay no dividend.
1. Identify the suitability and conflicts issues, distinguishing the IPS from the risk tolerance document.
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The central problem is a conflict between two governing documents. The IPS permits up to 25% equities; the risk tolerance document says 5%. When documents conflict, the firm cannot simply pick the more permissive one. It should reconcile them with the client, document the resolution, and update the IPS if the client genuinely wants more equity exposure.
Here the advisor effectively used the IPS as a permission slip while ignoring the more specific, client-stated limit. That is a suitability failure: the account was positioned at 22% equity for a client whose documented tolerance was 5%.
The conflict of interest is direct: the advisor earns trailing commissions on the biotech positions and described the sector positively in a call the client did not initiate. The advisor's compensation aligned with the trade, not with the client's income need. The drop in monthly income is a concrete, foreseeable harm that the advisor should have anticipated.
2. Was the phone call sufficient to establish client approval? Explain.
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No. Several features make the call inadequate.
First, the client did not initiate it, which shifts the burden to the advisor to show that the client affirmatively wanted the change. Second, the description of biotech as 'where the growth is' is a sales characterization, not a balanced discussion of risk - there is no record that the advisor explained the volatility, the lack of dividends, or the effect on income. Third, 'seemed comfortable' is the advisor's inference, not the client's instruction. Fourth, there is no written confirmation, and a change of this magnitude - quadrupling equity exposure against a documented 5% limit - warrants documentation.
The advisor's notes are the only record, and they record the advisor's impression rather than the client's decision. That is not informed consent.
3. What remediation and supervisory changes are appropriate?
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Client remediation: assess the loss to income and any capital loss attributable to the unsuitable positions; consider whether to unwind them, and whether to make the client whole. Reconcile the IPS and risk tolerance documents in writing with the client.
Supervisory changes: flag accounts where equity exposure exceeds the risk tolerance document even if within the IPS; require written client acknowledgment for changes that move an account materially away from its stated tolerance; review advisor compensation structures that reward concentration in commissioned products; and monitor income-dependent accounts for dividend-yield deterioration.
The firm should also review the advisor's other conservative-profile accounts for similar drift, since a single account exceeding tolerance by four times is rarely isolated.