The case of Charles and Marie
Charles and Marie worked hard all their lives. They have not managed to save much money. A financial adviser that they knew from church approached them with what seemed to be a great idea. They could borrow money against a mortgage on their home. They would invest the money in a mutual fund that would distribute 10% of its value in equal instalments each month. They could use the distributions to keep the mortgage up to date, and the balance to pay some nagging bills.
Better yet, the adviser told them that they would likely own the $100,000 mutual fund free and clear after 10 years. Because the mutual fund would go up in value, they could cash it in to pay off the mortgage and still have the $100,000.
The adviser helped them to borrow $100,000 at 5%, about $500 a month. Sure enough, they received a deposit into their account of $800 each month. They found the extra $300 cash very helpful. After three years, they looked at their bank statement. They only received $600 that month. This made them look at the semi-annual statement that they had recently received from the financial adviser. Something seemed odd to them. The mutual fund seemed to have gone down in value. It was now $15,000 less than the amount of the mortgage on their house. What did that mean? If this continued at the same rate, they would still owe $50,000 or more on their mortgage after 10 years, and the mutual fund would be worth nothing.
What was the scheme?
When a mutual fund pays more than its income from interest and dividends, this is known as a “return of capital”. It has to sell its investments to cover the distributions. If the value of the investments goes up, then the sale may not drop the value below the initial price. However, most ordinary equity mutual funds have embedded management expenses, often more than 2% per year. Add that to the 5% interest rate on the loan, and the market has to go up by 7% per year just for Charles and Marie to break even. In the their case, they withdrew 10% a year. This meant that the fund had to earn more than 12% per year to maintain its capital value: 2% for the expenses and 10% for the distributions.
Over a long period of time, the Canadian stock market increases at around 7% annually, with huge swings above and below that figure. Some years, such as 2008 and 2015, see substantial losses. If the fund pays out 10% in a year, this is money that it cannot keep invested to earn a profit and growth in the following years. Here is an excellent article by Finance Professor Milevsky of York University that explains this.
There is a very high chance that Charles and Marie will lose all of the $100,000 invested during the 10 years. The problem is that they would have to come up with the $500 a month to pay the mortgage even when the mutual fund reduced its monthly distributions. If the fund dropped to $50,000, for example, it would only be able to pay $416 per month at the same 10% rate.
But this is only how the clients suffer. What about their financial adviser? In this case, the adviser earned an immediate 5% commission, or $5,000. Each year, the adviser earned a further 0.5% on the value of the fund, or $500 if it stayed constant. If the adviser could find 10 families like Charles and Marie, the adviser could earn $55,000 per year at no risk. At least to the adviser.
What happened next?
Charles and Marie asked around for the name of a good financial planner. They found Diane, who has a CFA (chartered financial analyst) designation. Diane referred them to Christine, a lawyer who takes on investor loss cases. Diane recommended that Charles and Marie cash in the mutual fund to repay as much of the mortgage as they could. Christine started a lawsuit and negotiated a settlement for enough in damages to pay off the balance of the mortgage. It was a stressful time, but all’s well that ends well.
When a financial adviser makes a recommendation that is unsuitable for a client, that adviser can be held to account. Standards that are set by the regulators, the securities commissions, Mutual Fund Dealers Association and IIROC make schemes such as the leverage loan/return of capital strategy unsuitable for most clients.
If your client requires timely and effective legal advice from the experienced lawyers at MBC Law Professional Corporation, we are professionals who are already on your side. Contact Harold Geller or John Hollander toll-free at 1-888-288-2033 ext. 234 or by email.