RIA Liability Claim: Define “Alternative Investments”

By Kenneth Golsan
Proverbs 4:13 informs us to “Hold on to instruction, do not let it go; guard it well, for it is your life.” In navigating a successful investment advisory practice, we are wise to learn from other firms and their fiduciary claim nightmares. Once again, when it comes to purchasing E&O (errors and omissions) insurance, “Details, details, details!”, or your firm’s primary risk-transfer mechanism (insurance) may reveal itself an ineffective strategy.

How do E&O and/or fiduciary liability underwriters handle the subject of “Alternative or Exotic Investments”? How do they (key word – as they get to craft the master and unendorsed insurance contract) define those terms? Might it be good to grasp the subject prior to receiving a Breach of Fiduciary Duty claim? Might it be wise to ascertain before the binding of coverage that is hopefully available to aid in such affairs?

Though a heartbreaking manner in which to acquire customers, approximately two years ago a $150MM (AUM) firm approached our company (a) to secure improved E&O coverage, yet, additionally, (b) seeking advice and support in their battle to obtain legal defense and/or settlement dollars from their existing E&O carrier due, at the time, to experiencing a “trade systems error”. Here’s what happened…

The advisory firm had received notifications from a handful of clients to temporarily cease trading activities on a discretionary basis due to the clients’ anxiety toward the volatile market. Whether such communication was done verbally or in writing, this RIA acknowledged the clients’ notifications. However, proper instruction of such to the staff in total was incomplete and/or proper alteration of the firm’s in-house automated trading system failed to transpire.

Moving forward without their automation adjustment, the firm placed a leveraged ETF block-trade applicable to several clients, several accounts, and, unfortunately, to those previously mentioned. Had the security appreciated, while negligence to the clients’ requests would stand, the legal claims would not have materialized. Unfortunately, the security quickly and drastically moved in a direction contrary to the Senior Advisor’s portfolio management projections. Three clients, within days, submitted letters to the advisor requesting indemnification (to make whole) and/or reversal of the trades, as the activities were in violation of the clients’ earlier notifications, to the total sum of approximately $170,000.

Now, this scenario could open discussion on several interesting and challenging E&O fronts. One could discuss how the insurance contract (1) treats the “failure to supervise”, (2) defines “error”, (3) defines or excludes “trade errors”, (4) defines “claim”, (5) handles “computer and/or electronic system breaches”, or (6) defines “Alternative or Exotic Investments”? For this ia360 Risk Tip we are focusing on the latter.

At first, the client-written letters, once submitted to the E&O carrier in question, were insufficient to trigger any defense allocation to the RIA (a subject for another time!). As time progressed, the client-written letters were followed-up by formal legal claims drafted by various client-appointed counsel demanding indemnification plus expenses based on, chiefly, (1) Negligence, (2) Failure to Supervise, (3) Unsuitability, and (4) Breach of Fiduciary Duty. The second submission of these legal claims triggered the E&O underwriter’s attention, yet the advisory firm in turn received a “Notice of Denial of Defense and Coverage” based upon the underwriter’s definition of “Exotic Investments”. In the underwriter’s viewpoint (key point), and they backed-up their argument based on previous cases in their claim denial history arsenal, the security in question – the leveraged ETF – clearly met the definition. However one argues what is and is not an “Alternative” or “Exotic” investment is immaterial. Such debate will continue ad infinitum. The key is in how we allow an underwriter to issue a contract-of-insurance (it’s not simply a policy) with language that is subjective in nature and, therefore, could allow for confusion and negative interpretation. Here is the particular underwriter’s language on the subject:

Exclusions: “Exotic Investments. We do not cover claims which arise out of or are in any way related to actual or alleged arbitrage, short sales, trading or failure to trade derivatives, including, without limitation, interest rate swaps, collateralized mortgage obligations, structured notes, commodities, commodities futures contracts or any type of option, or future, or futures option contract or similar investments or investment products including, without limitation, commodity pools or partnerships engaged in the investment in or trading of such “securities”…We do not cover claims arising out of the actual or alleged trading or failure to trade hedge funds…” (words in bold and underlined my emphasis).

Now, while this exclusion with its securities or investments clearly specified might be acceptable to some individual RIA practices and its particular asset exposures – it is the catch-all “or similar investments or investment products” that is obviously unacceptable. In protecting clients – as agent on their behalf placing, modifying and securing appropriate coverage – it is best to structure an insured-insurer relationship where, in the case of defining “securities and investment” classes, the list of items are plain and specific or no such exclusion exists at all.

In this legal case, the investment advisory firm had to carry the bulk of the load. Our office – and in partnership with legal counsel – assisted to, at least, obtain some minor reimbursement for legal costs from the E&O carrier. But, unfortunately, the advisor will finance the final arbitration settlement over several years through its firm’s operating income. Let us heed the words of King Solomon!

Golsan Scruggs is an insurance brokerage firm operating throughout the United States specializing in investment advisor E&O errors & omissions insurance (aka professional liability insurance) for RIA registered investment advisors.. As one of the largest insurers of RIA firms in the U.S., we have a dedicated staff that understands the risks of the financial services industry and delivers superior results.  We make the underwriting process painless.