From the NAIP: Losing Green and Seeing Red

Years ago both firms and investment professionals discovered the advantage of fee-based accounts they offered a steady revenue stream and promised to reduce compliance problems. Instead of dreaming up new reasons to trade and generate commissions, brokers would maximize their incomes by maximizing the value of their clients' assets. So, over the past 10 years, we've seen an explosion in the number

Years ago both firms and investment professionals discovered the advantage of fee-based accounts — they offered a steady revenue stream and promised to reduce compliance problems. Instead of dreaming up new reasons to trade and generate commissions, brokers would maximize their incomes by maximizing the value of their clients' assets. So, over the past 10 years, we've seen an explosion in the number of fee-based accounts — and a relatively small number of clients filing claims against their brokers/advisors.

That has changed as the market has soured. I found out just how much on a recent Sunday, when the phone rang at 6:30 a.m. The caller was Jim, an active NAIP member who is a 20-year veteran of the securities industry and the owner of a successful New York-area RIA practice with several employees and $150 million under management.

His voice was full of anxiety. “I've got a client who is threatening to sue me,” he said. “He has been a client of mine for many years. I considered him a friend. In fact, he recently helped me get into his exclusive country club.”

The client, an 80-year-old retired doctor is one of many discretionary managed accounts at Jim's firm. “Over the last few years, I've had him in large-cap growth stocks like Dell, Cisco, and Microsoft, but I also have a portion in fixed income,” Jim continued. “The last couple of years, I've been trying to convince him that he should lighten up on equities and go more into cash or bonds. He refused. Now, his account is down 40 percent to $600,000.”

Jim told me how he had gone to great lengths to make the client happy — even offering to suspend fees for a few quarters. “He, of course, accepted,” Jim said. “But, last week, I received a letter from his attorney stating that he was going to sue me on the grounds that I improperly allocated his portfolio and that the securities I purchased for him were unsuitable.”

Shocked, Jim called the retired doctor, who blithely explained: “Jim, this isn't personal, this is business. You do have some kind of malpractice insurance don't you? They will pay for this — you won't have to worry about it.”

With a last strained breath Jim asked, “What am I going to do? I do have errors and omissions insurance but it is only for $250,000 and he is suing me for a total of $600,000.”

Jim, unfortunately, is in good company. Since the bull market began to sputter in the spring of 2000, we have seen investor claims rise 20 percent a year. Many involve managed accounts. It is easy to see why: Clients whose accounts are down 20 percent to 40 percent think their advisors should have done something to earn the fee (like getting them out when the getting was good). In some cases, advisors tried to do something to protect the client — but the client wouldn't listen. That, as my friend Jim now knows, doesn't stop them from suing later.

There are steps you can take to reduce the chances of getting sued for failing to keep a client from losing money — and to protect yourself, just in case.

Make sure the client's account application is updated according to firm policy. This is usually done yearly.

If you are an independent contractor or an RIA, make sure you have at least $1 million worth of errors and omissions insurance. It is better if you own the policy, rather than the firm. There are many reasons for this, but it is best you read it on our Web site at www.naip.com.

Keep constant and detailed records of all client meetings and telephone calls. Invest in a good contact management system like ACT! or GoldMine. An advisor who can show when client meetings took place and what was discussed and decided on will have a better chance of winning arbitration.

Follow the financial planning process with each client as closely as possible and get the client to sign off on decisions made regarding asset allocation and choice of securities.

Finally, don't panic. The market shows signs of stabilizing, and a client like Jim's may decide a lawsuit isn't worth it. On the other hand, this is a good time for Jim to fire the client: In the investment business, lightning can indeed strike twice.

Writer's BIO:
T. Sheridan O'Keefe

President of the National Association

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