More On Legal & Compliancefrom The Advisor's Professional Library
- Using Solicitors to Attract Clients Rule 206(4)-3 under the Investment Advisors Act establishes requirements governing cash payments to solicitors. The rule permits payment of cash referral fees to individuals and companies recommending clients to an RIA, but requires four conditions are first satisfied.
- Updating Form ADV and Form U4 When it comes to disclosure on Form ADV, RIAs should assume information would be material to investors. When in doubt, RIAs should disclose information rather than arguing later with securities regulators that it was not material.
When something goes wrong in our society, there seems to be a knee-jerk reaction that requires finding someone or something to blame, and we hope that somebody or something has deep pockets. If you get fat, sue McDonald's. If you're grossed out by what you see on television, sue the producers of "Fear Factor." If you lose money in the stock market, sue your investment advisor. The legal process has long served a legitimate purpose by forcing businesses or individuals that have caused physical or economic damage to another to make good. But in today's litigious climate, lawsuits seem to be viewed as a panacea for every inconvenience, and even minor tragedies are turned into bonanzas akin to winning a lottery jackpot. In such circumstances, investment advisors are as vulnerable as any other professionals to the whims of disgruntled customers.
Unfortunately, just because an advisor has always exercised the highest professional standards doesn't mean she isn't going to be sued by a client whose investments didn't turn out the way they both had hoped. For many advisors, the first line of defense against such a situation is an errors and omissions insurance policy.
The reasons for insurance are blatantly obvious. As Katherine Vessenes, an attorney and CFP with Vestment Advisors in Shorewood, Minnesota, points out, "The question is not 'Can they sue us?' since you can always get sued, but rather, 'Can they win?' The arbitration studies show, and this varies from year to year, that roughly 50% of the time investors do win, and they get a little bit more than 50% of what they ask for, on average."
Going up against such odds, it's not surprising that errors and omissions insurance is as common among investment professionals as malpractice insurance is for doctors and dram shop liability coverage is for bar and restaurant owners. "I think it's incredibly important to be insured," says Vessenes. "It's not a bullet-proof vest, but I've had a couple of client firms that had no coverage at all and that can be a horrifying thing." She adds that over the years she's come across a common fallacy among fee-only advisors that they don't need coverage, citing reasons ranging from their ethical purity to the fact that their clients love them. "Nothing could be further from the truth. When you get into a down market, investors look to go after whomever they can, including their investment advisors, whether they're insured or not. One case can just completely wipe out a firm. It's not unusual to see cases that have large settlements, $500,000 or $1 million, and if you're a small firm it can bankrupt you."
A Fee-Only Advisor's View
"We went without it for years," says Ricky Grunden, a fee-only advisor in Denton, Texas. "We went to a fee-only base in 1992. We were always under the impression that we were doing the best job for our clients, we were doing the right thing, they knew us, and they knew we were not going to cheat them. Well, if you step away and look, that's kind of arrogant. It's also presumptuous to put your clients in that position."
When he split off from his previous partnership to open Grunden Financial Advisory in 2001, Grunden bought E&O coverage for the first time. "I got it and I hate to pay for it, but it gives me a great deal of comfort to know that we've tried to protect our clients. It's a substantial financial commitment, but I felt like I owed it to my clients," he explains. "To me it's about a certain level of professionalism. It has less to do with protecting myself. If we really messed up, I don't think I could have faced the client and said, 'I lost your money and we don't even have insurance.'"
Grunden hasn't had to make a claim on his coverage to date, but he sleeps better at night knowing he has it. He's never been sued, nor, he says, has the possibility even been raised in conversation, but that's doesn't mean there haven't been mistakes or misunderstandings. During a volatile period in the market, he recalls a client who lost $33,000 in two days, when the client thought he had instructed Grunden to keep him out of the market. In the end, Grunden decided doing right by the client was more important than any other consideration, so he "felt compelled to make it up, " and did so, paying the money to the client out of his own pocket. "I thought, what if this was a really big mistake. If I couldn't make good for it, how would that affect my clients? That really compelled me to go ahead and get the insurance."
He estimates that he currently pays between $6,000 and $7,000 a year for his coverage.
A Crisis Averted
A year ago, as the scandals in the mutual fund world erupted and Eliot Spitzer was investigating just about everything under the financial services sun, there was a veritable panic regarding potential lawsuits and a perception that errors and omissions insurance was becoming increasingly expensive and hard to find. The good news for advisors is that the climate for litigation doesn't appear to have worsened since then. "I don't think there is a litigation crisis," observes Rich Hunter, chief financial officer for the independent broker/dealer Commonwealth Financial Network in Waltham, Massachusetts. "I don't believe there are any more cases today than there have been over the past five to 10 years, but it's always been essential and critical for the rep to have errors and omissions insurance. We've had that insurance here since the early 1990s, and I believe that most broker/dealers have had it around since that time as well."
In the current market, it seems that while most professionals would rather not have to pay for the coverage, policies are available and costs for many advisors have stabilized. "There are fewer carriers for the smaller investment advisors, for those folks with $200 million or less under management," admits Andy Fotopulos, executive VP of Theodore Liftman Insurance, a Boston-based independent insurance broker with more than 4,000 E&O clients, ranging from one-man-shop independent RIAs to advisors to mutual funds and hedge managers. "For anybody above $200 million, there's a whole slew of insurance carriers out there."
Despite how the market may have looked 12 short months ago, except for the smallest firms, cost seems to have plateaued. "Overall, this past year I've seen the premiums stabilize," says Fotopulos. "I just did three renewals with no increase in premiums, but there is a catch."
The broker explains that different insurance carriers focus on accounts of various magnitudes. Most of the carriers who underwrite smaller accounts have traditionally had lower minimum premiums. "Those carriers are still increasing their minimums by 20% a year right now," he explains. "They had some bad years that they're trying to make up by trying to get their minimum levels up to what everyone else charges. Most carriers will charge a minimum premium of $6,000 for a $1 million limit of liability."
Fotopulos points out that an advisor may be able to find a policy under which the premiums are lower, but it won't be as comprehensive. While the annual premium may be a couple of thousand dollars less, the deductible is likely to be higher, and some alternative investments, such as hedge funds, are likely to be excluded.
He also has a piece of advice for advisors who may be shopping for coverage: Know what you're buying. An important distinction is whether the seller of the policy is a broker, representing multiple insurance carriers, or a plan manager, who offers policies from a single carrier. Fotopulos says that plans offered by professional associations such as the FPA or AICPA tend to be from a single insurer and don't allow the buyer to comparison shop.
A B/D Tries Do-It-Yourself
For many broker/dealer reps, one of the primary advantages that come from their affiliation is coverage under the B/D's errors and omissions policy. While even for large firms it's important to monitor the costs of coverage, that was only one of the factors behind a decision that led Commonwealth Financial Network to become essentially self-insured. "The third-party insurance market was just getting out of control," explains Commonwealth CFO Hunter. "We were being charged excessive premiums for the amount of benefit that we received. We also wanted to get better control of the litigation process. When you have a third party, they pick the attorneys, and control the process a little more, so we formed a captive insurance agency in the state of Vermont."
As Hunter explains the process, Commonwealth collects the premiums from reps and then the captive writes the insurance. Although the program has been in place only for about a year, Hunter is very pleased with the result. It's also been well received by the company's reps for two important reasons--it gives them the same, or greater coverage, and the cost has remained the same.
"Another reason that we went to the captive is that the third party started to strip away some basic coverages," says Hunter. "It wouldn't cover some of the alternative investments--limited partnerships, REITs, or hedge funds. Through the captive, we insure any product authorized to be sold through the broker/dealer. So the coverage is broader than through a third-party carrier."
Under Commonwealth's previous third-party policy, coverage limits were $1 million per incident with a $10 million aggregate. Under the new coverage, limits are the same, the deductible has been reduced to $10,000 across the board (it used to be $25,000 on trading errors), and more products are covered. According to Hunter, the premium for Commonwealth reps is just under $2,000, an amount that did not increase this year. He also points out that although the captive insurer is underwriting the policies, it's Commonwealth's deep pockets that are the ultimate backup. "The anomaly there is that even with the third party, Commonwealth was exposed on claims over $1 million."
For just about anyone serving the public in an advisory capacity, errors and omissions insurance is no longer an optional purchase. As Ricky Grunden points out, having such coverage is indicative of a level of professionalism that advisors really owe their clients. It's also something that can make both advisors and their clients sleep a little better at night.
Staff editor Robert F. Keane can be reached at email@example.com.