More On Legal & Compliancefrom The Advisor's Professional Library
- Where Are We Headed? The ultimate compliance goal is to help ensure that everyone associated with an advisory firm acts ethically at all times. Advisors and RIAs should do the right thing, even when regulators are not looking over their shoulders.
- Trading Practices and Errors When SEC-registered investment advisors conduct annual audits of firm policies and procedures, they should pay close attention to trading practices. Though usually not required to, state-registered advisors should look at their trading practices and revise policies that do not fully protect clients.
As I sit on my return flight to the United States from Italy, it saddens me to report that I was not successful in becoming the securities commissioner of Positano or Venice, the Italians insisting that no such position exists. Thus, I must devote my energies to the many challenges that continue to face U.S. advisors. One such challenge is E&O insurance: Should I have it and, if yes, how much?
There is no regulatory requirement that an investment advisor maintain E&O. So, should an advisor purchase E&O insurance? My answer is absolutely yes. I have heard many reasons not to purchase, including that it makes the firm more susceptible to claims or it doesn’t cover claims for client-alleged negligence. Nonsense! Over the past 25 years, I can point to far too many examples of such errant judgment, the unfortunate result of which is an advisor facing a claim (regardless of the merits thereof) without any coverage. It is at this point the advisor realizes how mistaken he or she was to not obtain coverage. Legal defense fees can be substantial, even in cases where the advisor insists that the claim is spurious. Having been engaged by advisors and their insurance carriers for many years, I can assure you that it is emotionally difficult enough for an advisor to defend him- or herself against a claim (especially a meritless claim), without compounding the situation by having to fund the defense and potential settlement and judgment costs.
I often review insurance policies to determine if the scope of coverage is appropriate for an advisor. Who should it cover, and how much coverage should the advisor have? In general, the policy should cover the firm and all of its employees and representatives. As for how much coverage an advisor should have, unfortunately there is no specific benchmark to point to. Generally, most standard policies will cover claims for at least $1 million during any coverage year (although some may cover less, depending upon the carrier and advisor). I strongly recommend that the advisor annually review and adjust such coverage amounts as the advisor increases his or her assets under management and scope of services. I also often recommend that an advisor consider using insurance dollars to obtain more coverage with a higher deductible, recognizing that a claim in excess of the advisor’s coverage can be potentially disastrous (for example, $2 million of coverage with a $25,000 deductible versus $1 million of coverage with a $5,000 deductible).
One often overlooked issue is coverage for financial planning errors. Unlike claims for investment losses, which generally can be self-correcting over time as markets and investments rebound, financial planning errors generally do not have such opportunity (for example, a client passing without an estate plan or having inadequate insurance coverage, especially for those advisors—and there are far too many—who indicate in marketing materials or their written disclosure statement that all of their clients receive such proactive advice).
Finally, read the policy, especially the exclusions, to make sure that it covers claims germane to your business. For example, many polices have eliminated coverage for claims arising from advice pertaining to private investments (hedge funds). If such is the case with your policy, think twice about recommending any such product without having the client execute a plain-English acknowledgment of the risks associated with the investment. Remember, the offering memorandum and subscription agreement protects the fund sponsor and not the advisor.
There are far too many investors willing to bring cases claiming lack of suitability (generally, in these cases, investment losses are equated to lack of investment suitability). It is critical for an advisor to adopt a written and client-executed investment objective confirmation to confirm investment suitability, objectives and restrictions, continuously putting the onus on the client to notify the advisor if there are ever any changes thereto.