Increasing Litigation Against Advisers

By Fred Reish

We are seeing an increasing number of claims filed against advisers . . . both as civil lawsuits and FINRA arbitrations. While the increase in claims undoubtedly reflects the recent stock market losses, it is also the result of at least three other factors. Those are: an increasing awareness of the fiduciary standard; the growing focus on retirement savings, including rollovers to IRAs; and heightened expectations about the performance of advisers. Of course, there is always that fourth category . . . crooks who steal money.

For those who are honorable, but may be caught up in controversies, there is an increasing need to insure against those claims. For example, there is errors and omissions insurance for professional negligence and fiduciary liability insurance for claims related to investment advice.

Some of the claims that we have seen or heard of are:

• encouraging employees to take early retirement or in-service distributions from retirement plans, and then investing the money in alternatives that are significantly more expensive than the investment expense in the plan;

• encouraging elderly people to invest, either individually or through their IRAs, in illiquid and expensive investments, some of which have become worthless;

• recommending in investments that are “guaranteed” to return unrealistic amounts, for example, 10% per year or more in annual distributions from income;

• the negligent recommendation of providers who subsequently embezzle funds from the plan, or otherwise cause avoidable losses to the plan;

• recommending heavy equity allocations in defined benefit plans, resulting in substantial losses in 2008 and underfunded status;

• allegedly refusing to follow the investment guidelines established by the plan or instructions from the plan sponsor or fiduciaries;

• investment advice that causes the adviser to receive additional income if the advice is accepted (which results in prohibited transactions under section 406(b) of ERISA for retirement plans and section 4975 of the Internal Revenue Code for IRAs).

The DOL has also warned that, where an adviser is serving as a fiduciary for a plan, the adviser may commit fiduciary breaches and/or prohibited transactions where they encourage participants to take distributions and rollover to IRAs to which the adviser will provide services. That is a significant issue where the compensation is variable, e.g., where the services are compensated by commissions, rather than a level fee and where the costs are higher in the IRA than in the plan.

In addition to purchasing the appropriate types of insurance, advisers (and their broker-dealers or RIA firms) can manage many of those risks in a number of ways.

The first is through a service agreement which adequately describes the services to be rendered. In our experience, in many cases the allegations are that the adviser should have taken some steps in addition to what he did. In other words, the investor felt that the adviser had significant responsibilities in areas where the adviser had not committed—at least from the adviser’s perspective—to perform those duties.

A second, and fairly obvious, recommendation is that all investment recommendations related to investors near or during retirement satisfy the following four criteria. The investments should be liquid and, thus, marketable on short notice. The investments should be internally diversified, that is, the risk of large losses should be mitigated by diversification. The investment strategy should be consistent with modern portfolio theory, that is, the investment portfolio should be diversified by asset classes, so that the risk of losses is limited. The investments should be age appropriate, that is, the risk of the portfolio should be consistent with the needs for a person of that age to manage risk and to earn a reasonable return.

In addition, most older investors do not have enough money to be comfortable so that, no matter what the future holds, they will have an adequate and sustainable income. In those cases, the damage caused by investment losses is usually greater than the benefit awarded by additional gains. In developing investment programs for those older workers and retirees, advisers—at least from a risk management perspective—need to focus on an annual income for the investor which, when combined with social security and other investment income, is sustainable for life.

Finally, advisers should make sure that, when they refer other service providers, they have a reasonable basis for doing so. If an adviser doesn’t know enough to make a unqualified referral, the best alternative is to refuse to do so. Alternatively, the adviser can investigate...probably by obtaining the opinions of several other people in the benefits community. If that is not possible, then the adviser should specify in writing to the client that he has not worked with the service provider and cannot make an unqualified referral. That is, it is up to the client to determine whether or not to use the service provider.

These are straightforward steps that can substantially reduce an adviser’s exposure to liability. Obviously, more can be done, but these steps are a good starting point.

© 2009 Reish & Reicher, A Professional Corporation. All rights reserved. THE ERISA CONTROVERSY REPORT is published as a general informational source. Articles are general in nature and are not intended to constitute legal advice in any particular matter. Transmission of this report does not create an attorney-client relationship. Reish & Reicher does not warrant and is not responsible for errors or omissions in the content of this report.

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