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Protect Yourself

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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.

The Cost of a Good Defense

While a large number of the disputes brought against advisors are frivolous, it’s still important for advisors to have E&O coverage, asserts Bud Bigelow, president and CEO of Cambridge Alliance, a managing general agent for E&O insurance, because the cases still need to be defended. Some defense costs can reach into the hundreds of thousands of dollars, Bigelow says. The average cost to defend one’s practice against a claim is $42,000, adds Glen Clark, president of Rockwood Programs Inc. in Wilmington, Delaware, which is a managing general agent for life, accident, and health insurance agents. Clark is also president of Fox Point Programs Inc., which provides E&O coverage for financial services and healthcare providers ( In January, Fox Point became the exclusive distributor of E&O insurance for the newly founded Financial Advisors Assurance Select, which is a risk retention group launched by Jerry Reiter, founder of FA Legal. The risk retention group is domiciled in Nevada, but is registered to sell insurance in all 50 states. Clark says Reiter launched the group because more than half of the advisor population lacks E&O insurance, and because he saw gaps in the coverage of advisors who carry it–some have good coverage, others don’t.

With the risk retention group, the policyholders are the owners of the company, he says. Most buyers of E&O insurance are broker/dealers, he says, as opposed to individual advisors. “B/Ds will buy a group [E&O] policy and they will force those who do business with them to buy from their group policy.” Clark says this type of arrangement is loaded with problems, however. First, the policy is written to protect the B/D, not the rep. Second, the policy is written at a “group aggregate rate,” which means a few advisors affiliated with the B/D could use up the coverage and leave others without insurance. Also, the insurance is not portable, so if the advisor left the B/D, she couldn’t take it with her. In addition, if both the B/D and advisor get sued, the B/D can settle on its own and leave the advisor to handle her suit alone. Fox Point’s mission through the risk retention group is to sell advisors an E&O “policy that they can use forever–and for whatever products they [deal with],” Clark says.

“This jump to advisors is a natural next step” for Fox Point, he adds. However, because there are so many iterations of advisors, he says, and so many advisors lack coverage, it will take a while to penetrate the market.

First, Know Your Client

Mark Brown, a CFP with Brown & Tedstrom in Denver, says he gets E&O insurance via his B/D, but he’s never had to use it. “The best way to avoid a dispute is to make sure that you know your client,” he says. “A lot of knowing your client is taking on new business consistent with your philosophy–if you can’t do what a client wants, that means you may not be a good” fit for them. If an advisor senses there is a problem in a relationship, he adds, address it immediately. Bedda D’Angelo, a CFP with Fiduciary Solutions in Durham, North Carolina, argues that “the best protection from disgruntled clients is to fire unhappy clients at their annual review.” But when speaking to advisors at conferences and other occasions, Bigelow says he gives them a wake-up call when he tells them that it’s usually their “rock-solid clients” who are the ones most likely to sue.

Advisors should also take note that a number of economic and market troubles are brewing now that could spark an increase in claims filed against them, Bigelow says. While the number of claims has dropped in the last year, he says, business fundamentals aren’t faring well these days. “Housing starts aren’t good, the dollar is falling [in value], and the auto industry” is in trouble, he says. Plus, the U.S. has a trade deficit, a balance of payment deficit, and the Fed is “making noises” about worries on inflation, he adds. What’s more, there’s no end in sight for the war in Iraq, and “the S&P 500 has started to head south in the last few weeks,” Bigelow says–”so fundamentals aren’t good.” He says that “it isn’t a question of when we have a correction [in the market], but how deep [the correction] is; that will determine what the claims will look like.”

Rates in Flux

E&O rates are also in a state of flux because of insurance marketplace shifts, Bigelow says, which means the capacity of insurers to underwrite E&O business. However, he notes, E&O premiums in the advisory industry have been stable for 15 years, with no huge rate increases taking place. Advisors should be buying E&O because of “the uncertainty in the investment market,” Bigelow says, “and there should be a flight to quality because that’s what happens when there is uncertainty in the insurance and investment markets.”

Getting back to the demise of the broker/dealer exemption rule. The U.S. Court of Appeals for the D.C. Circuit’s decision on March 30 exempted brokers from being subject to regulation as investment advisors in fee-based brokerage accounts, on the basis that the SEC had exceeded its authority under the Investment Advisers Act of 1940. The SEC has said it will consider whether “further rulemaking or interpretations are necessary regarding the application of the Advisers Act to these fee-based accounts and the issues resulting from the court’s decision.” SEC Chairman Cox has also said that he has approved additional emergency funding to accelerate the previously commissioned study being conducted by the Rand Corporation, which seeks to assess whether investors are confused about the different roles and responsibilities of investment advisors and brokers. The study is to be delivered to the Commission no later than December 2007, several months ahead of schedule.

The SEC has publicly announced that it’s not going to seek a rehearing of the ruling by the Supreme Court. However, Congress can rewrite the Investment Advisers Act of 1940, which is what the Securities Industry and Financial Markets Association (SIFMA) is urging lawmakers to do.

The Financial Planning Association (FPA) told the U.S. Court of Appeals for the D.C. Circuit June 1 that while it does not oppose the SEC’s request that it give broker/dealers four months to convert their fee-based brokerage accounts under the court’s ruling, the court should deny the SEC’s request to grant further extensions if a B/D runs into unforeseen problems when converting those accounts.

Caruso of PIABA says a lot of folks in the industry and in the media mistakenly believe that the ruling ends fee-based accounts for B/Ds. The ruling states that if a B/D is going to offer fee-based accounts, they have to “take on a fiduciary role and put the interest of clients first,” he explains. Because brokerage firms are already RIAs, the onus really falls on the broker/dealer rep to register. “Everybody is saying this is the death of fee-based accounts and the court has prohibited them, but they really haven’t,” Caruso says. “All the court said was that if you’re going to offer a fee-based account, you have to agree that you are a fiduciary. Brokerage firms offering fee-based services could be dually registered, and all of them pretty much are; it’s a question of whether the sales rep is registered as an investment advisor rep.” Like others in the industry, Caruso says he still doesn’t “understand why brokerage firms are having such tremendous difficulty living up to a standard of putting their clients first–that’s what they’ve supposed to have been doing all along.”

Washington Bureau Chief Melanie Waddell can be reached at [email protected].


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