Discount Stock Brokers: What Is The Extent Of Their Obligations To Know Their Clients?

The recent case of The Wish Group Inc. and Cianciulli v. De Vrij and Interactive Brokers Canada Inc. is an interesting review of the “know your client” obligations of a discount broker.

In this case, Mr. Cianciulli authorized Mr. De Vrij, a person claiming to have substantial experience as a trader in the financial industry, to open a corporate account for Cianciulli’s personal holding company, The Wish Group Inc., at Interactive Brokers Canada Inc.  Cianciulli signed a corporate resolution appointing De Vrij as an officer of The Wish Group and granted him sole trading authority over the account.  He then transferred $2,000,000 into the account.

De Vrij invested those funds in commodity futures and lost over $1.8 million over a period of 3 months.

Cianciulli and Wish Group then sued De Vrij and Interactive for the losses.  The matter went to trial against Interactive only.

Interactive is a discount broker.  It does not provide investment advice to clients.

Nevertheless, Cianciulli asserted a claim against Interactive in negligence.  He alleged that Interactive breached its “know your client” and “gatekeeper” obligations by failing to make necessary inquiries of Cianciulli before opening the account under De Vrij’s trading authority.  As a result, the plaintiffs wished to hold Interactive responsible for the investment losses arising from De Virj’s mismanagement of the funds.

The expert witness testifying on behalf of Cianciulli at the trial insisted that Interactive should have been alerted to a number of red flags both before and after the account was opened.  As all brokers, including discount brokers, are subject to a “know your client” obligation, it was required to “use due diligence to learn and remain informed of the essential facts relative to every customer and to every order or account accepted”, as set out in regulatory requirements and obligations imposed by the rules governing the behavior of stock brokers in Ontario.

Even though Interactive was not in the business of providing investment advice, so that it did not have the obligation to make sure that investments were suitable for its clients, it is still required to obtain certain information before opening a corporate account.  In particular, it must identify all beneficial owners of the company with an interest of 10% or more, verify the identity of the beneficial owners, obtain the names and occupations of its Directors, and obtain a certificate of corporate status.  It must also obtain a corporate resolution to ascertain who is authorize to trade in the account on behalf of the company, and must verify the identity of that individual.

In addition, investment dealers must act as gatekeepers, meaning that they must exercise diligence when faced with situations that raise a potential of illegal activity.  In particular they must respond to red flags, such as information known to the dealer that raises an issue respecting compliance with securities laws.

In this case, Interactive knew that The Wish Group was a holding company with a net worth of about $5,000,000.  De Vrij characterized himself as President and Chief Investment Officer.  According to the plaintiff’s expert, Interactive should have questioned why a relatively small company like The Wish Group would have required a full time Chief Investment Officer.  Furthermore, Interactive should have tried to understand better the relationship between De Vrij and The Wish Group.

The principal of Interactive had known De Vrij for years and knew that he had acted as a professional investment advisor in the past.  According to the plaintiff’s expert, he should have made further inquiries to determine if De Vrij was truly a corporate officer or was in fact acting as an investment advisor.

Interactive’s expert insisted that Interactive had complied with all “know your client” requirements.

The trial judge agreed with the position taken by Interactive.  It had to seek specific instructions from De Vrij to open a corporate account and De Vrij had the authority of Cianciulli to give those instructions.  It obtained the necessary corporate documentation and information about The Wish Group and its beneficial owner and it received duly authorized trading authority.  It had obtained the corporate resolution of The Wish Group setting out who had trading authority, signed by Cianciulli as sole director and beneficial owner.  It was under no obligation to contact Cianciulli to inquire about his relationship with De Vrij, the person being granted trading authority.  It was under no obligation to question why a small company would have a chief investment officer and it had no obligation to inquire into exactly what role was being played by De Vrij.  There were no red flags warranting further action.

There are number of cases that have held dealers liable for losses for having failed to comply with “know your client” obligations.  Generally speaking these cases involving dealers that provide investment advice.  That was not the case with Interactive, a discount broker.

In the result, the action against Interactive was dismissed.

There was one other fact which, although does not relate precisely to the obligations of Interactive in this case, may well have swayed the judge’s view.

It turns out that very shortly after De Vrij began trading on the account, it sustained a loss of about $500,000.  Cianciulli found out about it and was livid.  He emailed De Vrij and demanded that the money be replaced.  De Vrij responded by indicating that the losses were not abnormal and that they could be recouped.  Cianciulli decided to give De Vrij a second chance.

De Vrij went on to lose almost all of the balance of the funds.

The trial judge was not impressed by Cianciulli’s behavior.  While he was not required to calculate damages because he had decided to dismiss the action, he did say that if he was wrong, he would have concluded that Cianciulli’s damages would be limited to the $500,000 of which he had become aware fairly early on.  His decision to leave De Vrij in place constituted a failure to mitigate his damages.  Presumably in the sense that from that point forward, Cianciulli was taking his chances.  This suggests that the decision would have been different had Cianciulli pulled the plug on De Vrij’s authority on the spot.  The fact that he left De Vrij in place may well have played a role in the judge coming to the conclusion that Cianciulli was, as they say, the author of his own misfortune.

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