Investment Advisor Interests   December 5, 2017

Do I Really Need E&O If I Just Became A Registered Investment Advisor

By Harry Lew

Are you a new registered investment advisor (RIA)? Then you know the process of setting up an investment-advisory firm is no simple matter. Whether you’re licensed with the Securities and Exchange Commission (SEC) or with a state securities administrator, establishing a firm that complies with federal or state regulations can be a daunting challenge. Then there are the tasks of deciding on the legal entity of your firm as well as designing its operational procedures.  And let’s not forget the crucial chore of purchasing investment-planning software, along with other financial applications, and the hardware necessary to run all these tools.

Given all this, it’s understandable that some new RIAs put E&O insurance at the bottom of their task list . . . or maybe even decide not to buy it.

As a new RIA, you might rightly assume your assets under management (AUM) will be limited for the first few years as your client list grows, creating only nominal E&O exposures. You might also be doing business with friends, relatives, and other people who you believe would be unlikely to sue you (at least, in theory). And you might take comfort from the fact that your regulatory agency does not require you to buy E&O insurance. How crucial can it be if it’s not required? Finally, you might decide that the cost/benefit ratio of buying E&O insurance is skewed too far toward the cost side of the equation.

Reasonable points, all. But we’d encourage you to consider these counter-points:

  • First, purchasers of financial- and investment-planning services today are not the same as those who purchased these services 15 or 20 years ago. They are much more knowledgeable about financial matters. They expect their advisors to know what they’re talking about and are much less forgiving when their advisors make mistakes.

  • Second, depending on your target market, you may quickly find yourself bringing on clients with seven-figure investment portfolios. They’ve been working for decades and now as baby-boomers are looking to move into retirement. Consequently, they can be sitting on substantial investment portfolios. Make a mistake in how you manage their hard-earned money or forget to do something important, and you will likely face an unhappy, litigious client.

  • Third, as baby-boomer portfolios have increased over the decades, a cottage industry of lawyers and law firms has formed to seek out financial-advisor clients who believe they’ve been wronged. In fact, a common marketing strategy of such firms is to get the names of advisors that FINRA or  the SEC have sanctioned and then blast them all over the Internet to recruit potential plaintiffs. Bottom line: the RIA marketplace has become much more legally treacherous over the last decade.

  • Fourth, RIAs often assume lawsuits will never happen to them because they’ve never been sued before. This is a cognitive bias called “the gambler’s fallacy.” Here, RIAs falsely believe the odds that something happened (or didn’t happen) in the past will determine the odds of it happening (or not happening) in the future. So if they never got sued, they never will. Clearly, this is a serious cognitive error that can have devastating financial consequences for a new RIA.

  • Fifth, as a new registered investment advisor, you may not be fully aware of the many ways an RIA can make mistakes, harming a client who then brings suit. You might breach your fiduciary duty, which is among the most frequent causes of RIA lawsuits, or recommend what turns out to be an unsuitable investment. Or you might innocently misrepresent the features or impact of an investment strategy or transaction, creating losses for your client. Then there are a host of negligence-related errors that can harm your new RIA firm. They might range from incorrectly executing a trade or falling for an Internet fraudster who wants you to wire your client’s money to him (who’s operating unbeknownst to you from an office in Nigeria). Then, as often happens, you might get sued just because a client is angry the stock market tanked, reducing her portfolio’s value.

Finally, depending on the nature of an RIA’s business, it’s not unlikely for clients to file six- and even seven-figure lawsuits against them. Being on the receiving end of a large legal action will quickly transform an RIA’s views on the costs vs. benefits of having errors-and-omissions insurance.

In short, even though you may be new to the RIA business, you’ll want to mitigate the financial risks of becoming embroiled in a client dispute. By putting a financial backstop in place before you get sued, you’ll be able to focus on working with your insurer-provided attorney and claims adjuster to mount a defense and hopefully achieve a positive outcome as quickly as possible. With your legal dispute behind you, you can then turn your attention to adding new clients and serving your existing ones, secure in the knowledge that if a problem arises with one of them in the future, your E&O insurance will be there for you.