Protecting the Business
Advisers need to shield themselves legally more than ever, with Congress, the U.S. Department of Labor (DoL), and courts all looking more closely into possible wrongdoings in retirement plans. An adviser who helps select a 401(k) plan’s investment lineup, for instance, subsequently could get sued by participants who experience losses and believe they stem from inadequate due diligence done upfront. When searching for professional-services insurance coverage, keep these six things in mind:
1. Do not assume you already have ERISA-claims protection. Sponsors’ fiduciary insurance generally does not cover advisers. “Very rarely do we see a plan asking for coverage for an investment adviser,” says Brian Smith, a Senior Vice President at consultant Segal Co. in New York.
Advisers working for a broker/dealer as an employee generally are covered by that company’s insurance, while registered investment advisers (RIAs) typically buy their own insurance policy, says Tom Clark, Executive Vice President at Theodore Liftman Insurance, Inc., in Boston. “A common misunderstanding is that an adviser is covered adequately because the adviser has E&O (errors and omissions) or D&O (directors and officers) coverage,” says Steve Saxon, a Principal at Groom Law Group in Washington. “Lots of those policies have ERISA exclusions.”
2. Look closely at a policy’s definitions. “These E&O policies are generic, and they are intended to cover a broad range of financial firms. You have to look at the definitions to make sure they are hitting on all the services you are providing to your clients and, if not, the policy may need to be amended,” Clark says.
For an adviser, Smith says, a key definition is exactly what constitutes “professional services” in the policy. A policy may not cover an adviser’s work on certain plan investments such as hedge funds or oil-and-gas partnerships, for instance. “Ideally, the policy’s definition is nice and broad, and therefore they are covered,” he says, “but a lot of carriers do not want to be that broad.” What constitutes a “claim” that triggers coverage: just a lawsuit, or also other situations such as a criminal investigation or an investigation by the DoL or U.S. Securities and Exchange Commission?
A key related element: Does the policy cover defense costs and, if so, how does it define those costs? Does it include expenses like experts who testify at trial, appeals, and surety bonds? “The most important thing in the policy is making sure that attorneys’ fees are covered,” says Jerry Kalish, President of Chicago-based National Benefit Services, Inc., adding that those costs can total hundreds of thousands of dollars.
3. Scrutinize the policy’s exclusions. “Depending on the complexity, you can have dozens of exclusions under some of these policies,” Smith says. Adviser-policy exclusions often revolve around work with particular investments within retirement plans. For example, some insurance carriers will not cover advisory services that involve ETFs with heavily leveraged underlying investments, or any alternative investments.
Advisers also need to know what a policy’s ERISA exclusion says. A policy typically excludes coverage for ERISA issues involving the advisory firm’s benefit plans for its own employees (as opposed to the benefit plans of the advisory firm’s clients), but some policies may not cover claims for some or all ERISA-related work an adviser does for clients.
A policy should make explicitly clear that the ERISA exclusion does not apply to any professional services covered. “If it says it excludes anything dealing with ERISA violations [with clients and participants], then effectively there is no coverage,” Smith says.
4. Get the right price/coverage tradeoff for your business. Price drives many advisers’ decisions on which policy to buy, Clark says. The cost varies based on factors such as the advisory practice’s total plan assets, types of customers (such as individuals versus institutions), and investment strategies employed. For instance, a policy that costs $10,000 annually may not cover any advisory work involving alternative investments, he says, while one that costs $15,000 may.
“It is difficult for us to pinpoint the right level of liability coverage,” Clark says, given the price/coverage tradeoff. “Some advisers may say they want a policy that protects them as close to the first dollar as possible, so a person may buy a $1 million policy with a $10,000 deductible. Somebody else may want catastrophic coverage, so he buys a $5 million policy with a $100,000 deductible.”
5. Remember that just having insurance is not enough. Think of it like jumping out of a plane, Smith suggests, which most skydivers do with two parachutes so they have a backup. For advisers, he says, the primary chute is “doing the job with attention to detail,” he says. “That is their best defense.” Insurance is the backup chute.
“[Advisers] need to have risk-management processes in place, because just having the insurance is really false comfort,” Kalish says. “Since 2008, things have changed drastically,” as the market turmoil brought a greater threat of lawsuits. “If you are not adapting to that, if you are doing business in the same old ways, there are going to be issues,” he adds.
Following the right processes goes a long way toward preventing legal trouble. “Most cases involve allegations of breach of fiduciary duty because of imprudence,” Saxon says. “If you can demonstrate you followed a prudent process properly, courts will say almost universally that a mere indication of a loss [on investments] is not a breach of fiduciary duty.”
6. Understand the support you have at your back office. Look for a broker/dealer or custodian that provides access to trained and licensed legal and other staff who can answer technical questions from advisers, recommends Ken Pardue, a Senior Vice President at St. Louis-based Wells Fargo Advisors.
Getting the right help on compliance services ultimately means going with a broker/dealer that has a good staff-to-adviser ratio across all staff, says Bill Chetney, National Retirement Partners CEO. “I would look for a ratio of three to four advisers to one broker/dealer staff member,” he says. Compliance services “really is paperwork processing,” he adds. “It is not rocket science. It is just having adequate staff to process the paperwork tidal wave that is coming.”
Kalish sums up the practical bottom line of an adviser’s risk-management focus. “Most of it is tightened-up processes, and documentation and communication,” he says. “Have procedures in place and then document, document, document. A lot of this has to do with managing expectations.”