Covering Your Assets

If you're playing with the idea of forsaking your

Illustration By David Hughes

For more than 12 years, planner J. Michael Martin has gone bare. No, he doesn't greet clients in his birthday suit. Martin's four-person firm, Financial Advantage Inc. of Columbia, Maryland, has operated without professional liability insurance - "gone bare," in the lexicon of insurance.

Until recently, Martin believed that being picky about choosing clients minimized his chances of winding up across a courtroom from a dissatisfied client. But these days he's not so sure he'll get to know clients well enough.

"Some folks in our industry expect that Merrill Lynch might lose half of its brokers, voluntarily or involuntarily, over the next few years, so we'll probably see a lot of clients looking for new relationships. In that kind of turmoil, it becomes more difficult to be careful in your selection of clients," says Martin. "This year, I'm going to seriously consider E&O insurance."

Errors and omissions insurance for advisors has been around for years, and most observers agree it provides better coverage now than in the past. Still, many practitioners don't carry it, sometimes to their detriment. Katherine Vessenes, a compliance lawyer from Bloomington, Minnesota, who preaches against going bare, tells this tale of woe: "A big planner who was getting sued called a friend of mine, who said, 'Pull out your E&O policy. You should be covered.' And the planner goes, 'What policy?' He'll probably be shut down over this lawsuit."

Why would you not have one of these malpractice insurance policies, then? Cost, for one thing. They ain't cheap. For $1 million of coverage (with a $25,000 deductible, or "retention," as it's called in this insurance line) for an RIA managing less than $50 million, figure an annual premium of at least $5,000. "That's minimum," says one insurance executive. It'll cost more if your firm pursues aggressive investment objectives for clients, exercises discretionary authority over accounts, or puts clients in private placements, limited partnerships, hedge funds, or futures.

If premiums look pricey to those who go bare, they look a whole lot cheaper to those who have been scraped by an angry client. That's because E&O policies cover legal expenses in the event you're alleged of wrongful doing. "These cases are so complicated and paper-intensive that you'll have some silly case contesting $50,000, and if you can't settle it, the attorney's fees will cost you twice that," says Burton Wiand, a Tampa attorney who represents advisors when they are sued by clients. "Once a broker/dealer that works with independent contractors has a spate of litigation, they realize how beneficial it can be to have that insurance, so they get it."

The smart way to buy E&O is like any other insurance: Choose a high deductible, and avoid insuring against the nickel-and-dime stuff. To find a policy, you can engage an insurance broker; NAPFA has a short list of providers it gives to members interested in evaluating the marketplace themselves. When shopping for yourself, look for a policy that covers prior acts. "Prior acts coverage means that if you put coverage in force today and you've been in business for 10 years, you have coverage that goes back for that 10 years," Freitas explains. "You should be very leery if someone proposes a low premium but with a prior acts exclusion," Freitas says. Also avoid policies with a fee exclusion. They don't cover you against claims that you've charged excessive fees.

Maybe you're not worried about going bare because you're diligent, cautious, and you double-check your work. Do your partners? You're on the hook for their mistakes, under old-fashioned partnership law. "A partnership is responsible for all the partners' activities that relate to the partnership," says Vessenes. "You have to choose your partners carefully, but you can be a lot less worried about what they're doing if you've got E&O insurance."

Suppose you bring in an outside tax accountant or estate planning attorney for help. Are you at risk in the event that they screw up? "If there are no compensatory arrangements between the planner and the other professional, I don't think there is any liability back and forth," says Wiand. "But any sort of revenue-sharing gets everybody liable for everything - or at least it allows people to allege that that's the case." Keep referral relationships independent, Wiand advises.

Clients typically sue because their investments have gone south, even if they've executed an agreement promising to hold the RIA harmless for poor rates of return. "They'll say that you didn't follow the investment objective," says one malpractice insurance pro. (What do you think of style drift now?)

These days, Wiand is defending reps who have sold clients high-yielding fixed-income investments - the bonds of sub-prime auto lenders backed by receivables pools, equipment leasing companies' notes collateralized by packages of leases. "These investments have been recommended and sold to people who can't stand the risk. The idea that these things were secured was oversold by the planner as a guarantee of creditworthiness, and a lot of these things, where investors are stretching for yield, are failing," Wiand says. "I'm seeing many cases of that nature."

Another major source of current litigation is unregistered securities. "One thing that's popular now is unregistered nine-month notes," says Wiand, explaining that certain nine-month instruments are "exempt securities" under federal (and many states') securities law. Here's what's happening: Unscrupulous issuers are telling potential sellers - financial planners, reps, B/Ds - that their short-term notes are exempt from registration. Turns out, in the cases Wiand's seeing, that the securities actually don't qualify for the narrow exemption. You've been duped into selling unregistered securities.

Not good.

Claims executive Bill Jackson says, "If an unregistered security is sold when it should have been registered, that is an indefensible case - a slam dunk for the plaintiff's attorney." Plus, the customer can rescind the transaction and force you to buy back the security.

Really not good.

Another variation on the unregistered securities theme involves offerings that trumpet exemption from registration under Regulation D. This regulation stipulates, though, that the securities can't be sold to more than 35 non-accredited (i.e., unsophisticated) investors. Jackson says, "We've seen cases where financial planners and registered reps were told the investment was not going to be sold to more than 35 non-accredited investors, but it got sold to a whole bunch more than 35. That destroys the exemption. And saying you relied on the issuer's representations is not a defense," says Jackson, senior director at Lancer Claims Services in southern California. "In terms of magnitude of losses that we've experienced, No. 1 on the hit parade is unregistered securities - securities that are sold under Regulation D or investment products that are claimed not to be securities or otherwise exempt from registration."

It isn't any secret that the markets have become more volatile in recent years. What you may not know is that market volatility fuels claims due to mechanical trading errors, such as delays in executing orders, orders executed for the wrong security, and failing to mark orders as limit orders when they should be. "I'm currently dealing with a case where a customer wanted to put in a limit order for an IPO, but the rep forgot to mark it a limit order and the price skyrocketed on the first day of trading," says Jackson. "The customer had wanted to invest $8,000 and ended up with an order for $70,000. I'm sure these kinds of errors are made all the time," Jackson concedes, "but in more normal markets, the consequences are probably so small that they don't manifest in claims."

If technical snafus don't land you in court, rebalancing the portfolio of a sick or elderly client might. When heirs find that a portfolio underwent sweeping change not long before death, they're moved to sue for two reasons: significant capital gains taxes on the decedent's final return, and the missed opportunity to inherit securities with a step up in basis. If your customer is in seriously deteriorating health, or is elderly, you need to talk to him, and document that you've talked to him about these issues.

In the final analysis, E&O insurance is "what allows you to sleep at night," says Vessenes. Practice bare, and the legal fees to defend yourself, even against a non-meritorious claim, could wipe you out. "And if you lose, you've got the legal fees plus what you owe the investor," she says. "You wouldn't go without health insurance or auto insurance. It's the same thing. You just have to protect your business."

Reprints Discuss this story
This is where the comments go.