Good business practices alone don’t provide adequate protection for investment firms from litigation. Here are three concepts why insurance is important.
Published on September 19, 2022
By Deb Chamian, Executive Underwriter, Commercial Financial Institutions, Markel Specialty
When big-name custodians announced that they were requiring registered investment advisors (RIAs) using their platforms to purchase certain types of insurance, it soon became clear that a number of smaller investment advisors and financial planners had not already done so. Many if not most of these smaller firms likely believed that their probity, professionalism, and adherence to sound business practices were adequate protection against potential lawsuits and similar risks.
The reality, however, is that good business practices by themselves don’t provide adequate assurance that a firm in this industry will fail to be sued. A firm’s clients may simply be unhappy because of financial losses that occur due to larger market forces. In addition to alleging an actual breach of fiduciary duty, clients may also allege that their investment advisor made inappropriate investments, or that their portfolio suffered as the result of a lack of diversification.
Here’s a quick summary of these three concepts and how they underscore the need for registered investment advisors to take insurance seriously.
Breach of fiduciary duty
A number of laws and regulations spell out the meaning of the concept of “fiduciary duty,” with potential implications for registered investment advisors. These laws range from the Investment Advisors Act of 1940, to state common law, to the recently enacted Regulation Best Interest of the US Securities and Exchange Commission (SEC), sometimes referred to as Regulation BI.
In general, these laws stipulate that investment professionals must:
a) perform their duties with the highest level of professionalism, care, and skill;
b) act in the best interests of their clients; and
c) put their client’s interests above their own.
Attorneys working for investors often advise their clients that if a broker or financial advisor breaches any of these duties, the client may have a right to receive compensation for their financial loss.
This is likewise an evolving area of risk. Before June 30, 2020, the “suitability rule” established by the Financial Industry Regulatory Authority (FINRA) required that investments be “suitable” for each client, given the client’s unique profile. After that date, the SEC’s Regulation BI required that investment advice be made with the investor’s best interests first and foremost.
The general concept here is that financial advisors and brokers should recommend securities that align with their client’s investment objectives, as well as their risk tolerance, their tax status, and other factors unique to each client. If a client loses money because investments made by an advisor are not appropriately linked to these criteria, then the client may be owed compensation. Further, in addition to claims made by clients, regulators may also be the source of allegations against RIAs.
Lack of diversification
Diversification is another concept frequently cited by plaintiff’s attorneys. The idea is that a diversified portfolio is less likely to suffer wild swings in value. And while there may be valid reasons why an investor’s account is concentrated in a single security or type of security, the registered investment advisor must discuss with their client the avoidable risks associated with such concentration.
Once again, plaintiff’s attorneys may argue that a client’s broker or financial advisor may be held liable if the client loses money due to a lack of diversification.
Types of insurance coverage
There are two types of insurance that are frequently cited as necessary for RIAs to protect themselves against the risks posed by these terms: errors and omissions (E&O) insurance and directors and officers (D&O) insurance.
- E&O insurance provides advisors with insurance protection against any actual or alleged error, misstatement, negligent act or omission, neglect, or breach of duty while conducting their practice. It typically provides insurance protection from liability, as well as the costs associated with legal protection.
- D&O insurance provides coverage for the registered investment advisor as an owner of their business. It can cover negligence in business decisions that have adverse financial consequences and helps provide insurance protection from regulatory events or claims brought by shareholders, employees, competitors, or the government, related to business decisions made by the firm.
Both types of insurance provide coverages for loss of a covered claim for a wrongful act.
While the evolving risks we’ve discussed pose challenges for a wide range of registered investment advisors, it’s also true that each individual firm has a unique risk profile, and therefore different insurance requirements. Consultation with an insurance professional is a wise first step.