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- How to Avoid Sabotaging Your Compliance Exam There is much more to compliance examination survival than knowing all of the rules. It helps to understand why the rules were put in placeand to recognize that examiners are not the enemy.
The days of $1,500 errors and omissions insurance with a $5,000 deductible are quickly coming to an end.
Today, it’s more typical to see annual policy costs in the $3,000-$4,000 range, with deductibles running as high as $350,000. Reasons for the increases vary, as Jim Eccleston, president of Eccleston Law Offices, explains.
“Regulatory actions and arbitration claim filings are increasing,” Eccleston argues. “Arbitrations claims may be ‘group’ type claims involving multiple investors and may involve products sold to numerous investors. And product-based class-action filings alleging lack of due diligence are increasing as well.”
Jodee Rager, chief compliance officer at Geneos Wealth Management, believes that securities attorneys are a primary cause of the current E&O insurance dilemma.
“Attorneys are making a lot of money with their boilerplate statement of claims and in my opinion, are a major factor in the number of claims that result in the E&O increases,” according to Rager. “These law firms are going after insurance money and perhaps don’t realize that insurance coverage is dwindling thanks in part to the investors they’ve convinced to file a claim. It’s true that not all attorneys are banking on insurance money, but we do know that one of the selling points in getting investors to sue is that it won’t cost the advisor any money."
Rager adds that clients who are still doing business with their advisor are filing arbitrations through these law firms who solicit complaints because they are led to believe there will be no splashback to the advisor as they won’t be named in the complaint, which is simply not true — the advisor doesn’t need to be a named party for the complaint to be reportable.
Another development in this Dodd-Frank era of reform is how E&O deductibles are being determined — based on product, compliance history and outside business activities.
Alternative investments: It’s getting tougher to find coverage
If you have alternative investments as part of your product mix, you may see your deductible at a much higher threshold and/or a higher premium. As deductibles go up, you may also see coverage being cut back to levels as low as $50,000, while other product coverage remains at normal levels of $1 million to $2 million per incident. We are hearing from many firms how difficult it is becoming to get coverage for alternative investments, especially for direct participation programs and hedge funds.
Dodd-Frank suitability rules have made oftentimes frivolous claims proliferate over liquidity and risk level issues, especially when senior citizens are involved in a claim. Broker-dealers have been quick to settle such claims through their E&O insurance, resulting in more carriers less willing to offer coverage and much higher rates for those that do. Fraudulent alternative investment products such as Provident Royalties, Medical Capital and DBSI originally drove the rate increases. Now, suitability litigation from securities attorneys capitalizing on products they perceive as an easy target is exacerbating the problem.
Fixed insurance: It may cost you to go outside the BD network
If you do fixed insurance through an outside insurance marketing organization rather than an IMO networked through your broker-dealer, you may incur a higher deductible. The reasoning is this: doing fixed insurance as an outside business activity is harder to supervise and exposes the firm to more liability, hence the higher deductible.
“Why should we offer freebie insurance on something that is outside of our supervision and profit center?” commented one compliance staffer.
Compliance: One mark can drive rates up
Having only one mark on your compliance history, or being terminated for cause, could result in you paying a substantially higher deductible. Another deductible variant we’ve seen is to have, as an example, a $25,000 deductible on your first claim and then increasingly higher deductibles for each additional claim. If you are the victim of a mass mediation from an aggressive securities attorney, you can quickly find yourself bankrupt.
Adding to the variables on deductibles, some firms are now implementing a policy where if the rep is the only one named in a claim, the deductible will be the base deductible. However, if the rep and the broker dealer are both named, the rep will be liable for a substantially higher deductible, typically $50,000 or more. The problem with this reasoning is that when a claim is submitted, both parties (rep and broker-dealer) are nearly always named — it’s misleading. Why not just say, "if you have a claim, we have a higher deductible"?
Your own RIA: Going outside your BD’s RIA may get you penalized
If you have your own registered investment advisory, you may find your deductible higher than if you were under your broker-dealer’s corporate RIA, or needing to purchase separate insurance to cover your RIA. As with fixed insurance done as an OBA, your RIA is perceived as harder to supervise and less profitable for the broker-dealer, so you are penalized with a higher deductible than if you were under the broker dealer’s corporate RIA or if you needed to buy your own coverage for your RIA business.
Broker-dealer recruitment quality: Increasingly E&O insurance-driven
Broker-dealer management is becoming very sensitive to how their E&O carrier perceives their reps. One broker-dealer president commented to me recently, “We have to be careful who we bring on because our E&O carrier is keeping a checklist on our reps.” Poor credit histories, tax liens, recent bankruptcies or having numerous reps under heightened supervision are fair game for E&O carriers to raise rates on coverage.
Insurance policies commonly exclude coverage altogether for reps with three or more complaints in three years. Broker-dealers need to carefully read and understand the coverage and exclusions so they can operate accordingly to mitigate risk that could arise from activity that has specifically been excluded from coverage.
Paying $3,000 to $4,000 for coverage doesn’t sound like much when compared to malpractice insurance for an OB/GYN that can run as high as $300,000 annually for those that have had numerous lawsuits and $50,000 for those with a clean record. However, being saddled with a $100,000 deductible will push many advisors into bankruptcy.
We are at the tipping point. We now have reps changing broker-dealers over E&O insurance coverage, seeking out lower rates and deductibles. And reps are seeking firms with fewer compliance issues in order to not only have more reasonable E&O rates and deductibles but more importantly, fewer restrictive policies and compliance bureaucracy hassles that have resulted from large fines paid in arbitrations. This tipping point is also evident in the growing number of firms curtailing their alternative investment offerings as part of their risk management to survive the onslaught of litigation.
Returning to securities authority Eccelston, he brings to light the myriad of factors perpetuating our litigation problem, noting that state and federal regulators are focusing on the problems of alternative investments, hedge funds and the like, such as nontraded REITs, private placements and complex derivative products. State and federal regulators, as well as FINRA, are becoming more aggressive as they bring well-publicized complaints and are reaching well publicized settlements with significant fines. Those activities prompt additional civil litigation and arbitration filings, and give investors’ counsel a roadmap to success.
Again, according to Eccelston, FINRA continues to reiterate in its notices to members that two often-employed defenses won’t prevail as a suitability defense. First, with complex products, wealth and sophistication of a customer won’t matter given the complicated nature of the product (and often misunderstood by the reps selling them). Second, and more importantly, risk disclosure contained in a prospectus won’t be a defense against a suitability claim by a customer.
Writer and theologian C.S. Lewis made the point that well-meaning tyrants are much more dangerous than purely selfish ones. “Those who torment us for our good will torment us without end,” Lewis wrote. The tyrants he describes and our regulatory community have much in common. Under the guise of Wall Street reform and consumer protection, fines are being assessed left and right. FINRA defines its mode of operation as one of sticks and carrots, though we’re hard pressed to find the carrots. State regulators are increasingly getting into the act so as not to seem heedless or risk “having one pulled over on them.”
Between state and federal regulators, FINRA and securities attorneys, the torment continues.