The slumping markets of 2022 may seem a distant memory among the recent records set by
But a rise in insurance claims paid out to aggrieved investors last year shows the pain remains.
Golsan Scruggs, a Lake Oswego, Oregon-based insurance broker for financial services firms, reported on Friday a 500% increase in the number of claims clients filed in 2023 alleging their advisors had placed them in unsuitable investments the previous year.
That, in turn, led to a 213% rise in the number of errors and omissions claims the advisory firms' insurers paid out. And because unsuitability claims tend to lead to relatively high penalties, RIA insurers paid out roughly 85% more than in the previous year, according to the Golsan Scruggs data.
Brian Francetich, the director of the firm's RIA division, said increases of this sort can eventually result in higher premium costs for all RIAs over time. In this case, though, insurers were fairly well prepared for the coming litigation storm.
"I would say that the underwriter world was not overly shocked by this number," Francetich said. "And I think a big, big driver of that is that we all know we're going to go through market cycles."
Costly coverage
Francetich cited a recent Charles Schwab benchmarking study that found that $1 million in errors and omissions coverage can run firms about $7,500 a year, although the figure can go up or down for various reasons. Insureon, another insurance brokerage,
Francetich noted that companies like Charles Schwab and Fidelity started insisting about three years ago that the RIAs they work with for custody purposes carry at least $1 million in E&O insurance. Those firms, along with Pershing and LPL Financial,
READ MORE:
These firms' new custody requirements mean most RIAs have some sort of coverage these days.
"So then we're at least starting at that base level with most of our clients," Francetich said. "And the question becomes: How are you different, or how are you bigger, or what do you need that's different?"
Buyer's remorse?
Investors who sue their advisors after their portfolios turn sour are often accused of suffering from "buyer's remorse."
Most advisors are no doubt aware that even their best-intentioned attempts to put their clients in suitable and carefully planned investments can come back to haunt them if things don't turn out as planned. That's especially true in years like 2022, when investors struggled to find safe harbors in
At the end of that year, the S&P 500 was down nearly 20% and the Nasdaq more than 30%. On the fixed-income side, the Total Bond Index, which tracks U.S. investment-grade bonds, was down more than 13%.
The claims cited by Golsan Scruggs all arise from registered investment advisors' obligation under the fiduciary standard to look out for their clients' best interests. That conduct standard includes what's known as the duty of care, which calls on wealth managers to make sure they've taken investors' goals and appetite for risk into account before making recommendations.
But if you were told of the risks …
Leila Shaver, the founder of Alpharetta, Georgia-based My RIA Lawyer, said that at least some of the rise in RIA insurers' payout can no doubt be traced to buyer's remorse. Investors who were fully apprised of the risks of the investing strategy they authorized their advisor to pursue nonetheless want someone to blame when things don't turn out as planned.
But there are also plenty of instances in which wealth managers are guilty — if not of outright fraud — of at least not taking the time and care needed to understand their clients' goals and needs, Shaver said. For one, some investors are extremely averse to the idea of losing money. For them, especially during times of volatility, investments in supposedly safe vehicles like bonds may not be enough.
"If they tell you they are really that nervous about losing money, maybe you just put that client into cash for the short term to get through the volatility," Shaver said. "Then you really are putting the interests of your client ahead of your own, because some advisors don't get paid for managing cash and some do."
Shaver said she also thinks advisors need to get better at playing defense. When markets are going through wide swings, many planners' instinct seems to be to hide out until stability returns.
Shaver said they should be doing the opposite: Regularly checking in with clients to make sure they're still comfortable with investment plans and goals they last adjusted years ago.
"And then sign disclosure documents saying, 'We have gone over these risks,'" Shaver said.
Playing defense
Of course, if clients want to sue, they'll find a reason to. But certain defensive measures can at least improve an advisor's chances of prevailing before the arbitration panels that hear many of these cases alleging unsuitability.
Max Schatzow, a founder and partner of
Schatzow said he's found that most cases that are successful before arbitrators usually arise from more than simple buyer's remorse. To win, investors usually have to show that their advisors were neglectful or careless in carrying out their fiduciary duties.
"My gut is that claims of this sort are fairly unsuccessful if the advisors were otherwise prudent," he said.
Both Shaver and Schatzow said the vast majority of their clients have some sort of insurance offering protection against legal liability. Shaver said she has noticed that insurers are becoming more likely to exclude certain investment products from their contracts. Many have carved out exemptions in their coverage for advisors' recommendations of riskier products like private credit and cryptocurrencies, she said.
Bonds not a safe harbor
Francetich said the increase in payouts seems to have stemmed primarily from disappointment about the bond market. Bonds, he noted, are often seen as a way to hedge against riskier stock bets. But that wasn't the case in 2022, when rising interest rates hit both equity and
"It was the worst one in 30-some years for bonds," Francetich said. "And so, what we had was this large uptick in claims for investors bringing suits because they lost money in investments that they thought were a lot safer than they turned out to be in 2022."
Advisors who could find a shelter in that storm for their clients were small in number. The result - fair or not - was a lot of aggrieved clients and lawsuits.
"I think this is part of the maturing of the industry and is a cost of doing business," Francetich said. "We're in a litigious society."
'Rare snapshot'
Golsan Scruggs noted that most RIAs have contract clauses with clients requiring that disputes go before arbitration panels rather than judges in the regular court system. Since those proceedings usually play out in private, insurance claims data provide "a rare snapshot" into what's happening on the legal front in the industry.
Francetich said Golsan Scruggs arrived at its results by looking at 2,042 RIA firms that had an average of $400 million under management. He acknowledged that's only a small fraction of the 30,000 registered advisories in the U.S., roughly half of which are registered at the state level and half with the Securities and Exchange Commission.
But he said the survey takes in a fairly comprehensive swath of the industry. The respondents ranged from firms with $15 million under management to those with up to roughly $30 billion.
Suitability claims not advisors' top concern
Beyond unsuitable investments, the second most common complaint brought against RIAs in 2023 concerned accusations of wire fraud. Francetich explained this often happens when an unscrupulous third-party impersonates a client or uses other underhanded means to trick an advisor into moving money into a fraudulent account. These claims were up by 400% in 2023.
Meanwhile, other sorts of claims remained largely unchanged in number. These included allegations over trading errors, regulatory violations and cyber-breaches or ransomware attacks.
Next on the list of worries were possible regulatory and compliance violations, followed by errors in trade execution. The results were compiled using a survey sent to roughly 8,000 RIAs between August and October last year.
Golsan Scruggs noted that most advisors placed cybersecurity risks over client dissatisfaction in their list of top worries.
"Yet, the experience as shown in claims data shows that the breakdown in trust between advisors and their clients about their investments remains the greatest threat," according to the release.
