INVESTMENT ADVISORS' PERCEPTIONS AND REACTIONS TO LIABILITY EXPOSURE by Bill Scroggins, Jr., Louise J. Clark, Gail Jones, and Elise Gantt

Bill Scroggins, Jr. scroggin@jsucc.jsu.edu is a Professor of Finance and Acting Head of the Finance, Economics, and Accounting Department, College of Commerce and Business Administration, Jacksonville State University. Louise J. Clark  lclark@jsucc.jsu.edu  is a Professor of Statistics and Associate Dean, College of Commerce and Business Administration, Jacksonville State University. Gail Jones gjones@jsucc.jsu.edu is a Professor of Finance, College of Commerce and Business Administration, Jacksonville State University. Elise Gantt egantt@jsucc.jsu.edu is an Assistant Professor of Accounting, College of Commerce and Business Administration, Jacksonville State University.

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Introduction

The term "investment advisor" is not specific; rather, it refers to an amorphous group including accountants, attorneys, financial planners, insurance underwriters, stockbrokers--anyone whose stock in trade is financial advice. Generally, oversight of these investment professionals is minimal, and the field has been considered "wide open," but due to practitioners' perceptions of increasing liability, i.e., fear of lawsuits, the profession may be less attractive to new entrants. The recent change from Securities Exchange Commission (SEC) regulation to state regulation of firms managing less than $25 million in assets should make SEC oversight of the larger firms tougher, as they will have fewer firms to regulate. Oversight of smaller firms will, of course, vary from state to state.

The purpose of this paper is to describe the conduct most likely to give rise to complaints and/or litigation and to address the research question, "Is there a relationship between conduct and the threat of liability exposure?" The results of a survey sent to1500 investment advisors around the country serve as the basis for this research. The survey was concerned with investment management practices, client communication, new clients, tools/aids, safeguards, conflicts of interest/ethics, and documentation, as well as prior complaints/litigation.

Literature Review

Fein [1996] examined activities resulting in conflicts of interest when commercial banks serve as investment advisors in mutual fund activities. Banks participating in mutual fund activities can follow certain actions to avoid turning conflicts of interest into improper or illegal acts. In a similar paper, Gentile [1998] examined actions by mutual fund directors in response to a growing shareholder activism movement. According to Gentile, "due to the growing competition among mutual funds, many dissatisfied investors have voted with their feet, selling off shares in one fund to invest in another. However, over the past few years, some investors have decided to stand their ground, challenging the actions or inactions of fund directors." Insurance agents frequently serve as investment advisors. In "Legal Liability of Agents and Banks," Ziomek and McCahill [1999] examine some of the actions and problems that may result in claims asserted against insurance agents. In a related paper, Harris [1998] examined actions in one of Canada's largest independent financial planning firms, Fortune Financial Management, Inc. that resulted in lawsuits against the firm.

Other prior research has focused on actions of directors and officers of U.S. firms in response to liability exposure. A study of CEO's of 1000 Business Week firms by Scroggins and Fielding [1995] found that liability exposure has resulted in a variety of actions to reduce exposure to potential liability from lawsuits.  In a similar study of 1000 U.S. commercial banks, Scroggins, Fielding, and Clark [1995] found that bank managers have taken actions to reduce liability exposure. Liability exposure from lawsuits and the potential financial leverage serves as a disciplining device because it forces top bank management to undertake value-enhancing strategic changes. Most of the value-enhancing actions translate into an increased operating focus that results from more effective monitoring by directors and officers. Such actions should result in better monitoring by directors and officers with no significant increase in monitoring costs but instead a decrease in agency costs, consistent with maximization of shareholder wealth. To date, no studies specifically concerning the effect of liability exposure on the actions of investment advisors exists in the literature.

Sources of Liability

While the nature of client complaints varies widely, most can be grouped into common categories: misrepresentation/omission, unsuitable products, churning, breach of fiduciary duty, fraud, conflict of interest, and others. The following is a brief description of these commonly complained of misfeasances.

• Misrepresentation/Omission: Rule 10b-5 of the SEC makes it unlawful for any person, in connection with the sale or purchase of any security, directly or indirectly, to make any untrue statement of material fact or to fail to disclose material facts [17 CFR Ch 11, 1996]. States have evolved similar statutory prohibitions. This means that for investment advisors, the doctrine of caveat emptor is dead. Full disclosure of investment risks as well as benefits are required, and both state and federal courts have held that violations of securities fraud laws may be willful irrespective of the violator's knowledge. Proof of unlawful motive is not a requisite to conviction. [US v. Brown, 578 F2d 1280,1284], [Buffo v. Alabama, 415 So2d 1158].
  
• Unsuitable Products: The concept of suitability precludes a securities broker from recommending a securities transaction that is not appropriate for a customer's particular investment needs and objectives; i.e., the test of suitability is subjective, and brokers must obtain information about each customer's financial circumstances and goals before recommending investments [Markham, 1995]. Commission compensation policies of the larger brokerage firms tend to encourage brokers, who work almost entirely for commissions, to put their own interests ahead of their customers'. Existence of sales contests and the prospect of higher commissions for in-house products can lead brokers to sell customers unsuitable products. In-house investments produce higher profit margins and brokers receive financial incentives to promote them without regard to performance records. The system is skewed toward selling products which pay the greatest commissions, not dispensing disinterested financial advice tailored to suit each individual customer [Spiro and Schroeder, 1995].
  
• Churning: The more commissions brokers generate, the larger the share they're allowed to keep. This in turn encourages churning, or excessive trading of customers' accounts [Spiro and Schroeder, 1995]. In prior years, the practice has been associated with stock accounts, but recently the SEC has turned its attention to variable annuity exchanges. Under the tax code, annuities can be exchanged for other annuities without losing tax-deferred status and there is additional concern that brokers are churning accounts to generate new commissions [Hansard, 1997].
  
• Breach of Fiduciary Duty: A fiduciary is a person in a confidential relationship who owes a duty of trust, utmost loyalty and good faith to another. When one person places their trust and confidence in another, the law imposes a fiduciary obligation to act in the best interests of the party to whom the duty is owed; i.e., if a fiduciary relationship exists, self-interest must be subordinated to the interests of the other party. Investment advisors do not always act as fiduciaries in their relationships with clients. If the client simply orders a broker-advisor to buy a certain number of shares of stock in a specified company, the client is clearly not relying on the advisor's professional skills and knowledge and no fiduciary duty exists. But if the client says that he has money to invest and asks for the advisor's recommendation, a legal duty arises to put the client's interest above his own and to act with a high degree of care, skill, diligence and prudence.
  
• Fraud, Conflict of Interest, Others: While misrepresentation, unsuitability, churning, and violating fiduciary obligations are probably the most common client complaints, there are, of course, others. Fraud (intentional lying/deception), conflict of interest (putting one's own well-being ahead of the clients' when no confidential relationship exists), untrue or misleading advertising, and professional negligence (failure to use due care under the circumstances) are also common grounds for liability. An SEC official recently cited problem areas to be scrutinized and included in the list were misleading advertising and inadequate disclosure of fee arrangements [Daniels, 1997].

Survey Methodology

In November and December 1996, 1500 questionnaires were mailed to brokerage firms, investment advisors, and financial planners in all 50 states. The mailing list was compiled with the assistance of the International Association for Financial Planning, National Association of Securities Dealers (NASD), and other professional associations. Two hundred and five responses from 40 states were received--a rate of 13.7%, respondent size ranged from very large firms to sole proprietorships. 

Part I of the questionnaire, which consisted of 30 questions, was designed to gather information concerning the influence of liability exposure on investment advisors' actions. More specifically, this issue was investigated relative to practices which we subdivided into eight action categories: management practices, client communication, new clients, tools/aids, safeguards, conflict of interest/ethics, protective contractual provisions, and documentation.

The actions in question were identified as those most likely prospects to reduce the exposure to lawsuits. No prior studies were identified that could be used for possible replication. Respondents were asked whether they or others in their firm had taken the specific actions stated and, if so, to indicate their opinions of the degree of influence exposure to legal liability had on the particular actions taken. A four-point semantic differential scale was used to allow the respondents to indicate their opinions of the degree of influence (significant, moderate, little, or no) attributable to liability exposure. 

Chi-square analyses were performed on each of the 30 identified actions to test the null hypothesis of no significant relationship between action taken and threat of liability exposure vs. the alternate hypothesis that a relationship does indeed exist between action and threat of liability exposure. The four-point "degree of influence" variable was collapsed into two categories, the first including the "significant/moderate" categories and the second, the "little/no" categories. This was necessary due to the lack of sufficient cell counts in some cases. 

Survey Results

Respondent Profile

Summary statistics that profile the survey respondents are presented in Table 1 (below). Results indicate that the largest number fall into the category consisting of CEO's, CFO's, owners, and partners who have been in that position between 6 and 13 years. The majority have backgrounds in finance, financial planning, and/or consulting; slightly over one-fourth of the respondents have a bachelor's degree in finance, and 10 percent have earned the MBA degree. Regarding professional certification and credentials, the majority are Certified Financial Planners (CFP). Most are compensated either by commission only or some combination of commission and fee.

Table 1

Respondent Profile

Part I: Actions/Omissions Which Could Give Rise To Complaints/Litigation

Management Practices: Questions 1-4 in Table 2 (below) were designed to demonstrate the effect of liability exposure on investment management practices. Survey responses indicate that practitioners are acutely aware of the possibility of legal liability and that their awareness affects day-to-day practices. Seventy-six percent of the respondents reported that they had recommended investments with lower risk levels to clients, and 78% of those said that exposure to liability had a significant or moderate degree of influence on that recommendation. Ninety-six percent said they tried to determine if clients were sophisticated investors, of which 89% said that liability exposure played a moderate-to-significant role in such efforts. Ninety-two percent said that services were based on clients' personal goals, with 81% saying that liability exposure moderately-to-significantly influenced such orientation. Seventy-six percent said they had not stepped up monitoring of recommended investments, 15% did not respond, and 24% said they had stepped up monitoring; of those increasing monitoring, 61% said the increase was due in moderate-to-significant degree to liability exposure.

Client Communication: Survey results clearly show that advisors view client communication as a vital matter. The vast majority reported that they tried to enhance communication, kept good records of client communications, avoided giving opinions and/or unrealistic forecasts, responded quickly to complaints and criticisms, and encouraged clients to become more pro-active in investment management and decision-making. Ninety-five percent indicated that they were careful about making unrealistic forecasts/projections, with only 14% saying it was not attributable to liability, i.e., 14% said liability had little or no influence on their actions. Ninety-six percent also reported prompt response to client criticisms or disputes, with 89% of those attributing their action to liability exposure. According to NASD, 20-30% of all complaints involve failure to communicate [Vessenes, 1997], and survey results indicate that practitioners are acutely aware of that fact.

New Clients: As in the case of prior classifications, the survey demonstrates that respondent advisors are greatly concerned about potential liability. Eighty-five percent reported that they had become more selective with respect to potential clients, and 83% said they evaluated new clients more carefully; 86% and 87%, respectively, said liability exposure had a moderate-to-significant influence. This does not imply that practitioners are afraid of new, unknown clients; clearly, though, they are doing whatever they can to familiarize themselves with potential clients and evaluating them more selectively. Few indicated that this increased care was liability exposure-related.

Tools and Aids: Respondents use checklists (75%), risk-tolerance tests (65%), and computer programs (78%) to avoid problems and generate/evaluate financial plans. The percentages of those respondents citing liability exposure as a moderate-to-significant influence were 78%, 80%, and 64%, respectively. Whereas 78% reported using computer programs, a substantial number (33.3%) indicated their reasons were other than liability--probably the same reasons other professionals use computer programs. Use of risk-tolerance tests and checklists are more clearly associated with liability minimization.

Safeguards: Overall, this category polled a smaller percentage of positive responses than any other: only 38% said they had increased their professional liability insurance; 20% increased bond assurances; and 42% had an internal system to process clients' claims quickly. Why? Perhaps they have adequate safeguards in place and feel it unnecessary to increase them. Of those who responded positively, most cited potential liability as a moderate-to-significant influence. Note that within the category "Client Communication," 96% reported that they responded promptly to any client criticisms or disputes. (How does that correlate to the fact that only 42% report internal systems to process claims quickly)? Responses to questions in other categories imply that practitioners are definitely concerned about potential liability. No explanation was discovered as to why they do not utilize these particular safeguards.

Conflict of Interest/Ethics: Seventy-seven percent of respondents exercised a greater degree of care to avoid conflicts of interest, which correlates with 78% finding potential liability to have a significant-to-moderate influence on their actions. Ninety percent said they had increased review of professional codes of ethics and standards, and 91% were careful to avoid outlandish claims when advertising. Avoidance of liability was cited in moderate-to-significant degree by 75% relative to review of ethics codes and 83% relative to outlandish claims.

Protective Contractual Provisions: While respondents do use disclaimers where appropriate in client contracts, most do not limit arbitration awards to compensatory damages, nor do they contractually waive clients' rights to trial by jury. Eighty-two percent reported using disclaimers, but only 31% limited damages, and 36% required waiver of jury trial. Of those who do limit damages and/or waive jury trial, most designated liability exposure as a moderate-to-significant factor.

Documentation: Positive responses dominated in this category. Ninety-five percent said they had established and monitored adherence to required policies/procedures. Ninety-seven percent,, the highest response of the entire survey, reported maintenance of records to support reasonableness of investments. Eighty-four percent  said they used greater care to ensure accuracy of required documents; and 81% reported that they updated required information regularly. The lowest positive response rate in this category was the 59% who reported using greater care to fulfill duties required by the Employment Retirement Insurance Security Act (ERISA); perhaps, some (or many) of them do not come within the scope of ERISA or are not responsible for reporting to ERISA. Overall, this category elicited the greatest percent of positive responses. Obviously, investment advisors take documentation seriously. 

Table 2

Summary of Responses to Questions Concerning Actions Taken by Investment Advisors to Minimize Liability Exposure

* Represents the number responding to the survey question.

Part II, Prior Disputes

Part II of the survey, "Prior Disputes," consisted of three questions: (1) if the survey respondent had been sued or involved in arbitration in the past five years; (2) if disciplinary action had been initiated by regulators within the past five years; and (3) if there had been accusations of enumerated types of wrongful conduct.

Lawsuits/Arbitration: Twenty-five respondents (12%) reported that lawsuits/arbitration actions had been filed against them since January 1991. Of those, four indicated that the bone of contention involved the sale of limited partnerships--poor performance of the partnerships, return of 100% of capital, overselling of the limited partnerships, and theft of funds by a partner. Three alleged unsuitability (including one such claim by a sophisticated investor) and three were based on poor performance of investments. Various other grounds were cited, including failure to fully explain investment choices. Two respondents said the suits were groundless, i.e., frivolous suits filed by "hungry lawyers" seeking "deep pockets. One response was that the advisor had filed an arbitration against a client, not vice versa--no explanation was given. The vast majority reported no suits/arbitrations filed.

Disciplinary Actions: Nine respondents (4%) reported that disciplinary actions by regulators had been taken against them; 127 (62%) said no disciplinary actions had been taken; and 69 (34%) failed to answer the question. These results indicate that disciplinary actions are rare. 

Accusations of Wrongful Conduct: Although there may have been no resultant lawsuit or arbitration, respondents reported that they had been accused of the following:

Unsuitable investments--50 respondents (24%)

Inadequate disclosure--19 respondents (9%)

Misrepresentation of facts--18 respondents (9%)

Failure to explain risks--18 respondents (9%)

Violation of fiduciary duty--7 respondents (3%)

Fraud--6 respondents (3%)

Silence (failure to disclose facts)--4 respondents (2%)

Conflict of interest--4 respondents (2%)

Unauthorized trades--2 respondents (1%)

Churning--2 respondents (1%)

Misappropriation--1 respondent (2%)

Falsifying documents--1 respondent (2%)

In all, 132 responses indicated that there had been accusations of misfeasance: out of 205 responses, 132 accusations (64%). The message is clear: investors do not accept losses easily. Someone must bear the blame and that someone is--who else? Investment advisors.

Chi-Square Results

The results of the chi-square analyses revealed a number of significant relationships between actions taken by investment advisors and their possible fear of legal liability exposure. Table 3 (below) provides these results. 

Table 3

Chi-Square Results For Actions vs. Degree of Influence of Liability Exposure

(df = 1 in every case)

* Chi-square invalid due to low expected counts in some cells.

Revealed by this survey is that investment advisors have been significantly influenced (level of significance = .05) by the threat of liability exposure with regard to the following actions:

ACTION CATEGORY: MANAGEMENT PRACTICES

• Recommended investment with lower levels of risk
• Stepped up monitoring of financial performance of investments recommended for clients

ACTION CATEGORY: CLIENT COMMUNICATION

• Encouraged clients to become more pro-active in decision making and managing their own financial affairs

ACTION CATEGORY: TOOLS/AIDS

• Administered a risk-tolerance test to clients
• Utilized computer programs to evaluate/generate client financial plan

ACTION CATEGORY: SAFEGUARDS

• Increased use of bonding assurances
• Utilized an internal system to process clients' claims quickly and consistently

ACTION CATEGORY: CONFLICT OF INTEREST/ETHICS

• Exercised a greater degree of care to avoid conflicts of interest

ACTION CATEGORY: PROTECTIVE CONTRACTUAL PROVISIONS

• Utilized an agreement that limits arbitration awards to compensatory damages only
• Utilized an agreement with a waiver of client's right to a jury trial
• Used disclaimers where appropriate in contracts with clients

ACTION CATEGORY: DOCUMENTATION

• Exercised greater care to see that annual and interim reports/statements are accurate
• Exercised a greater degree of care in fulfilling duties required by ERISA

As reported in this survey, 13 of the 30 actions are significantly influenced by the threat of possible litigation. In fact, these 13 actions included practices from seven of the eight action categories. The only area in which none of the actions were significantly related to the threat of possible litigation was the category "New Clients." The three action categories: 1) Tools/Aids, 2) Safeguards, and 3) Protective Contractual Provisions include a total of nine individual actions. The analyses revealed that seven of these nine actions are significantly related to the threat of possible litigation (See Table 3.) This could be due to the fact that the actions included in these three categories are characteristically tangible actions that enable advisors to be especially proactive in dealing with liability exposure.

Only six of the 19 actions in the remaining four categories: "Management Practices," "Client Communication," "Conflict of Interests," and "Documentation" were found to be significantly related to the threat of possible litigation (See Table 3.) The lower frequency of statistical significance in these four categories could be due to the fact that these actions tend to be more general, less tangible and, consequently, more difficult to adopt and apply than actions in the former categories.

Summary and Conclusions

In Part I, "actions taken by investment advisors," at least 90% of respondents reported that they:

1. attempt to determine if clients are sophisticated investors;
2. base services on clients' personal goals;
3. actively try to enhance client communication;
4. guard against unrealistic forecasts/projections;
5. respond promptly to client criticisms/disputes; 6. review professional codes of conduct;
6. establish and monitor required policies/procedures;
7. maintain records to support reasonableness of investments. 

At least 80% reported that they:

1. keep comprehensive records of client communications;
2. avoid giving opinions;
3. are more selective with respect to potential clients;
4. evaluate new clients more carefully;
5. are careful to avoid outlandish claims in ads;
6. use disclaimers where appropriate in contracts;
7. update information required by regulatory authorities;
8. exercise greater care to ensure accuracy of required documents.

Over half the questions in Part I (16 of 30) were answered affirmatively by 80-97% of respondents. Given the nature of the questions, such high percentages indicate that practitioners are acutely aware of and concerned about their liability exposure.

The three action categories: 1) Tools/Aids, 2) Safeguards, and 3) Protective Contractual Provisions included seven of nine individual actions significantly related to the threat of possible litigation. These are characteristically tangible actions that enable advisors to be especially proactive in dealing with liability exposure.

Few actions in the remaining four categories: "Management Practices," "Client Communication," "Conflict of Interests," and "Documentation" were found to be significantly related to the threat of possible litigation. These actions tend to be more general, less tangible and, consequently, more difficult to adopt and apply than actions in the former categories.

Only one action category, "New Clients," contained no specific actions taken by management that were significantly related to the threat of possible litigation.

Part II, "prior disputes, disciplinary actions, etc.," revealed that lawsuits/arbitration actions are relatively rare, but that less formal accusations are more common, especially complaints of unsuitability of investments and failure to disclose investment risks/facts.

Twelve percent of respondents reported that formal legal complaints (lawsuits or arbitration actions) have been brought against them in the last five years. This is, of course, a significant percentage. Practitioners are very much aware of their liability to clients; furthermore, they are nervous about it and many of their daily practices are predicated on this awareness/tension.

Safeguards (to avoid liability) may not be adequate, as there were fewer positive responses in this category than any other. Though respondents indicated awareness of liability-fraught situations, such as poor client communication, failure to explain investment risks, etc., most (60%) do not have internal systems to process client claims. They should. They should also review errors and omissions insurance coverage on a regular basis.

While it is better to be safe than sorry, fears of increasing liability may not be substantiated by the facts. All professionals may be held liable for losses caused by breaches of duty, but this is nothing new. Across the spectrum of professions, more lawsuits are filed against professionals each year, not necessarily because liability has increased, but, perhaps, because people take legal action more readily today than in the past. According to the National Center for State Courts, new case filings are increasing at a much faster rate than the nation's population--in some states, three to five times as fast. The number of civil suits increased 34 percent from 1984 to 1996. Our society has simply become more litigious, and investment advisors, as well as other professionals, must bear this in mind and employ whatever safeguards available. Ignoring a situation will not make it go away.

Note: During the preparation of this paper, Elise Gantt, a CPA and a co-author of this article who is also a Certified Financial Planner, was asked why she does not actively pursue a career in financial planning. Her response: the liability is too great!

Sources

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