Every Day Risk Avoidance Techniques (Securities Law360)

December 30, 2008 Securities Law360

Over the past 11 years that I have defended financial advisors and their employers, it has become readily apparent that many customer-initiated arbitrations are not necessarily the result of malfeasance or even negligence. Instead, the seeds of many potential problems are sown at the initiation of the relationship or innocent missteps in client management.

All too often I hear the rhetorical question of: “I worked so hard, and went out of my way for this client, so why I am being sued.” In most instances the work ethic of the advisor has nothing to do with the commencement of an arbitration. Rather, customer selection and long-term client management are the root cause of most arbitrations. This article focuses on common pitfalls, problematic client conduct and simple techniques financial advisors can use to minimize their risk of being sued and, if sued, provide a strong defense.

Initiation Of The Relationship

As a result of the most recent bear market, the industry has vastly improved the client intake process by requiring, among other things, greater fact gathering from new clients to ensure that the “know your customer” requirements of New York Stock Exchange Rule 405 are met. The best and most detailed-oriented client intake process will do nothing if the financial advisors employing them do not take a more discerning approach regarding who they want as clients. In this highly competitive industry, all too often financial advisors give in to the desire to build their client-base while ignoring certain red flags of potential trouble.

The biggest pitfall is what I characterize as the free agent client. This is the type of client who has worked with a number of different advisors over short period of time before coming to you. These are clients that are typically shopping for returns and the promise of a better day. Although there are instances where it is necessary to change an advisor (e.g., personality conflicts or advisor retirement), repeated changes in a short period of time is indicative of a person who can never be satisfied and, in all likelihood, will be the first to initiate a lawsuit. To think that you may have the answer to this client’s past problems is to set yourself up for potential disaster.

The second pitfall involves an advisor trying to shoehorn the client in to the advisor’s personal investing style rather than recommending investments best suited for the client. A former financial advisor that I represented was self-characterized as a long-term buy and hold investor who only recommended investments in individual equities. Many of his clients became very wealthy in the bull market, but those same investors suffered in the bear market. This type of financial advisor is only for the more affluent who can withstand wide fluctuations in the value of their accounts, not for widows living off of a life insurance policy or an unemployed individual living off a small family trust; the latter brought claims against the advisor for their bear market losses. If the advisor is not willing to modify his approach to meet a client’s situational profile, then the best move is to refer the client to someone else.

The third pitfall involves the advisor who gives in to the potential client with unrealistic expectations. For example, a client in her 40s, with $500,000.00 in liquid assets, a self-characterized moderate investment style, who wants to retire early, is a potential disaster waiting to happen. No matter how much initial “know your customer” analysis you perform, this client has unrealistic expectations. In short, this person cannot afford to retire early without taking substantial risk to grow her assets. If the client does not take substantial risk, the assets will not last through retirement. If the client takes substantial market risk, the assets are at risk of another market downturn. In either scenario, the financial advisor who takes on this client is unwittingly becoming a likely target of a lawsuit.

Whether or not an advisor decides to take on one of the potential problem clients noted above, there are simple tools that all advisors can employ to better protect themselves. The next section discusses what I characterize as a common-sense approach to minimize risk throughout the advisor/client relationship. The two hallmarks to this approach are communication and documentation.

The Long-Term Relationship

The simplest way to avoid problems in the future is to have open and ongoing communication with your clients. This is rather self-evident in as much as financial advisors who do not communicate with their clients become financial advisors without any clients. When the markets are performing well, it is easy to share good news. Communication after the markets go down is the key to survival. But there is more to this approach; communication must be followed with documentation.

All too often I have seen a lack of communication in a down market. The most common omission is where a client calls to express her concern, but does not receive a prompt return call, or receives a return call where the advisor comes across as unsympathetic. Like the practice of law, clients are your lifeblood and they, at times, require some hand-holding. By failing to respond at all, a financial advisor can make a rather innocent issue fester into a major problem. Similarly, an inappropriate response can, in many ways, be worse than no response at all. The simplest approach to take is to return all phone calls every day and to treat each client like you would want to be treated by your own financial advisor. If you find yourself speaking to your client in a way that would upset you, then you are not communicating properly with your clients.

As important to the open line of communication is documenting that communication. The only way to explain the importance of documenting phone calls is with a short true story. Some years ago, a widow claimed that her husband’s advisor improperly allowed him to cash out a life insurance policy. The facts revealed that the husband wanted the cash to buy real estate in Florida. The advisor recommended against doing so until the husband cleared underwriting for a new policy, but the husband ignored this advice and cashed out the policy. Before completion of underwriting on the new policy, a bee stung the husband who then died of anaphylaxis. Fortunately, the advisor had detailed contemporaneous notes of all of his communications with the husband, including the warning against cashing out the first policy before completion of underwriting on the second. The simple act of taking detailed notes insulated the financial advisor and his employer from substantial liability.

It is also incumbent on advisors to do a better job documenting recommended investments. In a customer-initiated arbitration, I am often faced with two divergent stories; the advisor claims full disclosure and the customer claims no disclosure. The best way to avoid this “he said, she said” credibility debate is for the advisor to follow-up all oral investment recommendations with a written confirmation. The advisor should not simply rely upon the fact that the client will receive a prospectus in the mail (after the investment is made) that the client will, in all likelihood, discard and never read. In the follow-up written communication, the advisor can simply recap the recommendation and highlight the risks and rewards inherent in the investment. The letter should be concluded with a standard admonition such as, “If you have any questions or need any further information about these investments, please contact me.” By doing so, you are not only protecting the client against making a mistake, but you are establishing written support of full disclosure.

It is equally important to document when a client disregards your advice. If an advisor prepared a financial plan and the client deviates from that plan, the advisor should caution the client about the impact that this may have on their financial goals and objectives. The most common example is where the client takes substantial and unexplained cash withdrawals. In this scenario, the advisor should caution the client (in writing) against taking significant withdrawals and highlight the impact of continued high withdrawals. When this very client then initiates a complaint, the stack of letters/emails cautioning the client against the suspect conduct becomes the best defense.

All of the techniques identified above may appear to be rather simple. Nevertheless, they are effective tools to minimize the risk of a customer-initiated arbitrations and to better defend yourself in the event of a claim. It is critical to take the time needed for open communication and substantial documentation because, in the end, your most marketable asset is your reputation; nothing is worth more time to protect than that.