Financial advisors are the Number 1 litigious target in America today, according to Robert S. Mills, president of Financial Advisors Legal Association, Las Vegas.

The current economic crisis, with the resulting stock market losses, will undoubtedly spawn a huge increase in litigation against financial advisors. With the assistance of plaintiff’s counsel, clients will look for someone to blame for their losses in stocks, mutual funds and variable annuities.

The attitude of many filing such lawsuits is that the stock market should only go up. When it does not, it is the fault of the financial advisor.

We understand that the Financial Industry Regulatory Authority, Washington, D.C., is gearing up its arbitration resources to handle the expansion of litigation that is expected to result from the meltdown.

It is difficult for financial advisors to defend against clients’ claims that “unsuitable” investments were recommended. After all, “suitability” is largely in the eye of the beholder. There are really few objective standards that measure what is “suitable” and what is not. “Suitability” is almost totally subjective.

Therefore, the only way to demonstrate that an investment was suitable is in the words of the clients themselves. The only way to show what the client was thinking is through detailed documentation at all stages of the relationship.

The attitude of many clients who resort to litigation against financial advisors is that if the investment lost value, then it was per se unsuitable and that the resultant loss is somehow the fault of the financial advisor.

The fact that there has been a broad-based financial meltdown resulting in the loss of trillions of dollars to the American economy is never brought to light. Instead, the claim is that the client should never have been exposed to any risk–even though there would have been no way to reach the client’s goals without exposure to market risk.

As expert witnesses, we have had the opportunity to observe a number of FINRA arbitrations where the client claims that he or she should have never been sold a variable annuity and that the VA’s underlying investments were too speculative for the client’s financial sophistication and risk tolerance. Whether or not the financial advisor (and broker-dealer) prevails in such litigation is related not only to defense lawyer skill, but more importantly to the extent of financial advisor’s documentation.

Any lawyer will tell you that “selective memory” is a hallmark of all litigation. People remember what they think will support their legal theories. It is too late when litigation is already in the works to do the documentation to support the fact that the client had the necessary risk tolerances and understood what he was acquiring.

Moreover, the financial advisory process is an ongoing one, where contact with the client occurs over what is often a substantial period of time. Documentation of these ongoing contacts is essential to demonstrate that the client understood what was happening and took part in the decisions relating to the investments made.

Detailed notes of meetings and telephone conversations, as well as any written communications, will go a long way to prove that the client understood what she was acquiring. If it can be proved that the client understood the investment and understood the risks involved, then it is hard to sustain the burden of proving that such an investment was “unsuitable.”

VAs offer a unique challenge to advisors. Not only does FINRA Rule 2821 apply a different standard of suitability screening to VAs (and to no other form of investment), but it is easy to misunderstand the duality of suitability screening as applies to VAs. A VA sale really involves 2 securities. The first is the VA itself; the second, the VA’s underlying assets. Both must pass suitability screening standards.

Frequently, in FINRA arbitrations, the claimant’s counsel concentrates on the VA and, if he can convince the panel that the VA was unsuitable, never inquires into the suitability of the underlying investments.

But, claimant’s counsel always wants damages equal to the total market loss, not just for the costs resulting from the VA purchase. We have seen cases where an investor converted a mutual fund portfolio into a VA with almost identical underlying assets insofar as risks are concerned. Then in a market downturn, a claim is made that since the VA was unsuitable, the measure of damages should be the entire portfolio loss instead of only the extra costs imposed by the VA. This, even though the client would have suffered almost identical market losses if she had retained the mutual funds that were converted to the VA!

Detailed documentation will go a long way to prevent unjust claims that financial advisors have let clients purchase unsuitable investments. Preparation for the storm of litigation that is on the horizon is a smart course of action.

Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are attorneys in the Pompano Beach, Fla., office of Blazzard & Hasenauer, P.C. Their email address is: norse.blazzard@blazzardlaw.com