Protect Yourself

When it comes to protecting themselves from disgruntled clients and the long arm of regulators, advisors and their broker/dealers have to be on the ball. Granted, shielding one’s practice from the Securities and Exchange Commission and NASD, it can be argued, is easier in many ways than staving off lawsuits from peeved clients. After all, the regulators are generally clear on what they expect, and when they expect it (even though meeting those expectations can often be time consuming and costly). But predicting if, and when, a client will sue you is next to impossible. That begs the question: why aren’t more advisors carrying errors and omissions (E&O) insurance?

Advisors and their B/Ds are faced with a number of harsh realities these days when it comes to complying with regulation–and either doing their best to thwart, or deal directly with, lawsuits filed against them. The regulatory bugaboo these days is the death of the broker/dealer exemption rule, which has forced B/Ds to transition within a four-month timeframe (they have until October 1) their fee-based accounts to either a commission account, or an investment advisory account that charges fees. Some industry observers predict the U.S. Court of Appeals for the D.C. Circuit’s March 30 ruling will spark on onslaught of brokerage firms converting to registered investment advisory firms (see sidebar).

While advisors have enjoyed a few years of a steady bull market, which has indeed helped keep clients from running to the courthouse (see sidebar, Up the Down Staircase), the sobering fact is that while the number of “arbitration filings are down, as a percentage of the actual filings, claims against investment advisors have been on the rise,” says Steven Caruso, president of the Public Investors Arbitration Bar Association (PIABA). Interestingly, more claims are being filed against advisors on the basis of “whether they are complying with their fiduciary duties,” says Caruso, who’s also a partner at the New York law firm of Maddox Hargett & Caruso.

Why No E&O?

Given this reality, why it is that so few advisors carry E&O insurance? Such coverage provides legal defense in the event an advisor is sued and also pays damages up to a certain amount if an advisor loses a lawsuit or chooses to settle to avoid litigation. Only one state, Hawaii, requires advisors to carry E&O insurance. But Caruso points out that even if all states mandated such coverage, “E&O insurance does not protect against fraud–it’s a negligence policy,” adding that fraud could include an advisor’s derelection of her fiduciary duties, depending upon the violation that’s been alleged. Since arbitration hearings are held under the cloak of confidentiality at the NASD, it’s hard to say exactly what the majority of claims allege. However, as president of PIABA, Caruso can render an educated guess that the claims “are all across the board; some are for intentional misconduct and some negligence.”

Ironically, while advisors do their utmost to protect themselves from investor lawsuits, many industry officials and lawmakers believe that the mandatory arbitration system that was christened by the SEC–and that investors must use–ultimately works against investors. Members of Congress and industry groups are once again pressuring the SEC to end mandatory arbitration of securities-related disputes for public investors. Mandatory arbitration requires investors to give up their right to a jury trial if they bring a claim against a brokerage firm or other financial professional. Critics of mandatory arbitration, like Caruso, say it’s unfair that investors are being forced to submit their disputes to an arbitration system that’s owned and operated by the securities industry. Senators Patrick Leahy (D-Vermont), chairman of the Senate Judiciary Committee, and Russ Feingold (D-Wisconsin), a member of the panel, sent a letter to SEC Chairman Christopher Cox in early May urging the SEC to rewrite its rule so that arbitration is voluntary.

Stacked in Brokerage Firms’ Favor?

A new study supports the belief that mandatory arbitration does indeed work in favor of brokerage firms. The study, Mandatory Arbitration of Securities Disputes: A Statistical Analysis of How Claimants Fare, was conducted and authored by Edward O’Neal, a faculty member with the Babcock Graduate School of Management at Wake Forest University when the study was compiled, and now a principal with Securities Litigation and Consulting Group, Inc. (SLCG), and Daniel Solin who is a securities arbitration attorney and RIA.

After collecting data on 14,000 NASD and NYSE arbitrations that occurred between January 1995 and December 2004, O’Neal and Solin found that investors recovered just 22 cents on the dollar in 2004, which was down from 38 cents in 1998. The win rate for investors in arbitration dropped from a high of 59% in 1999 to 44% in 2004, and investors fared particularly poorly in cases against large brokerage firms. The study says that “claimants in arbitrations against top 20 brokerage firms face an expected recovery percentage that is approximately 28% in claims under $10,000, and the expected recovery percentage plunges to approximately 12% in claims over $250,000.”

During a conference call with reporters in mid-June announcing the release of the study and its findings, Solin said the study “paints an alarming picture of a steadily worsening situation for investors who have no alternative to securities arbitration administered by the very industry that they are suing.” While there may be “innocent explanations for the fact that the chances of an investor recovering significant damages from a major brokerage firm are statistically small in mandatory arbitration,” he continued, “our data clearly indicates a decline in both the overall ‘win’ rate and the expected recovery percentage against major brokerage firms, at a time when the misconduct of these firms reached its apex with the analyst fraud scandal.”

But critics of O’Neal and Solin’s study, like Terry Weiss, head of the broker/dealer practice of Sutherland Asbill & Brennan in Atlanta, say the study lacks credibility because it wasn’t commissioned by a regulator or other government agency, and because Solin “is a lawyer who represents investors and [O'Neal] is a professor who is regularly paid as an expert to testify on behalf of investors in these cases.” Thus, says Weiss–who is also an arbitrator for the NASD, NYSE, and National Futures Association–this study “should be viewed as an advocacy piece representing only one side of the coin.”

Weiss argues that fairness of arbitration “cannot be determined by whether one side wins or not, just like whether an investment is appropriate can’t be determined by whether the investor made money or not.” All forms of dispute resolution, he says, “(court and arbitration) have risks, costs (time and money), and potential rewards. As an example, you can take the same case with identical facts and take it to trial multiple times with different juries and judges and get remarkably different results. That is part of the risk of the process, but that does not make it unfair.”

There’s also the survivorship bias issue. O’Neal and Solin’s study “necessarily will exclude cases that were settled–i.e., cases that the respondent broker/dealer might have felt had merit and that money should be paid to resolve them,” Weiss says. “If so, the cases that remain are those that the broker/dealers feel they have a better chance of winning. The results of O’Neal’s study probably support that conclusion and, at least in part, underscore why the win rate has dropped for investors.” Weiss adds, too, that the Supreme Court has ruled that the mandatory arbitration system, as overseen by the SEC, is fair.