Golsan Scruggs RIASure Risk Guide

I

RIA RISK & INSURANCE GUIDE

GOLSAN SCRUGGS

Investment Management E&O Specialists

In Association With

Golsan Scruggs RIA Risk & Insurance Guide

TABLE OF CONTENTS

I. THE BASIS FOR RISK

Legal Duties of Investment Advisers

Risk Categories & Case Law

II. CLAIM ILLUSTRATIONS

III. RISK SUMMATION

IV. INSURANCE (RISK-TRANSFER) MECHANISMS

V. DISCLAIMER & CORPORATE INFORMATION

VI. REFERENCE INDEX


The Investment

Advisers Act of 1940

(“IAA”) is itself a

Congressional

recognition of an

adviser’s status as a

fiduciary.

The SEC has

implicitly

acknowledged that

an adviser’s

fiduciary

obligations contain

a suitability rule…

component.

THE BASIS FOR RISK

Investment Advisers face risks associated with rendering investment advice to their clients, managing

their clients’ assets, publishing written materials related to investment advice, and, from regulators, for

violations of Federal and State law governing their practices. The discussion below highlights the sources of the

risks that Investment Advisers encounter in their practices.

A. LEGAL DUTIES OF INVESTMENT ADVISERS

1. Sources of the Fiduciary Duty

An investment adviser’s duties as a fiduciary derive from various sources,

including state and federal statutes, as well as longstanding common law (legal

principles developed by courts independent of statute). The Investment Advisers

Act of 1940 (“IAA”) is itself a Congressional recognition of an adviser’s status as a

fiduciary.i Section 206 of that Act, commonly referred to as the “anti-fraud”

provision of the IAA, establishes “federal fiduciary standards” that govern advisers’

conduct.ii The SEC has also looked to common law principles of fiduciaries and

agents to clarify the standards of conduct of investment advisers. Just some of the

duties that flow from that fiduciary status include:

(1) Acting in good faith solely for the benefit of the principal;

(2) Disclosing all actual and potential conflicts of interest;

(3) Avoiding deals in which the adviser is adverse to the client, except where the client has given informed consent;

(4) Disclosing all material facts concerning the cost at which securities were sold and the current market price;

(5) Executing trades at the best price discoverable in the exercise of reasonable diligence.iii

The nature of the particular duty of any adviser will depend upon the services rendered. An adviser who

has total discretion has a different duty than one who makes investment recommendations. An adviser who takes

custody of assets has yet another duty. Nevertheless, the duty of any adviser is a duty of the highest loyalty and

care and it is owed to every client.

The investment adviser fiduciary role shares some similarity with the FINRA

suitability rule and usually imposes a higher standard than the FINRA “suitability”

obligation. However, the suitability rule (FINRA Rule 2111) is often incorporated in

claims against advisers, and can be relevant to determining compliance with

fiduciary obligations,iv and the SEC has implicitly acknowledged that an adviser’s

fiduciary obligations contain a suitability component.v The suitability rule requires

that securities professionals have a reasonable basis to believe that a security

product is suitable to be offered to at least some investors and that it is suitable for

the customer, based upon reasonable diligence of the customer’s financial situation,

needs and objectives. This applies to an investment product and an investment strategy, which may or may not

involve specific products. A professional must also perform reasonable diligence to understand the benefits and

risks of a transaction or investment or strategy, which must be explained to the customer. The suitability rule also


Section 202 of the

IAA defines an

“investment

adviser” as any

natural person or

entity.

includes a “quantitative suitability” requirement which requires that all transactions, taken together, not be

excessive or unsuitable for the customer’s investment profile. In recent years the broker-dealer suitability

obligation has been enhanced to make it more consistent with the adviser’s obligations as a fiduciary.

2. Definition of an “Investment Adviser” Under Federal Law

Section 202 of the IAA defines an “investment adviser” as any natural person

or entity who: (1) for compensation, (2) is engaged in the business, (3) of providing

advice to others or issuing reports or analyses regarding securities. Note the law’s

inclusion of the word “person”. Such clarification within the law clarifies the intent and

magnitude of our society’s congregational unity on the role of a fiduciary, of the

inability for the corporate entity to act as the commonly used traditional barrier and

legal protector to the individual, and for the confirmation of an adviser’s personal

liability to the public for the adviser’s actions or inactions.

3. The Advisers Act Does Not Create Privately-Enforceable Causes of Action

The U.S. Supreme Court has held that the Investment Advisers Act does not create private causes of

action to enforce its various provisions, with the exception of a section rendering void contracts that run afoul of

the act, which gives rise for a suit for rescission of the contract and restitution of fees paid.vi Consequently, only

the SEC may bring actions for violations of the Advisers Act. Most private litigation against advisers therefore takes

the form of other causes of action, mostly under state law. It is generally accepted that federal securities laws,

including the Investment Advisers Act, does not preempt state securities laws or causes of action.vii

However, the Investment Advisers Act does empower the SEC to enforce the terms of the Act, including

imposing financial penalties, such as fines and restitution against advisers. Its provisions can also be relevant in

determining an adviser’s duties and are pled as industry standard rules in claims involving purported negligence or

breaches of fiduciary duty. Especially in arbitrations were the arbitrators are not bound to follow the law,

standards under the Act may be significant factors in the outcome of the case.

B. RISK CATEGORIES & CASE LAW

1. Common Law Liabilities Negligence/Professional Malpractice

Definition: Failure to act with the same degree of care as a typical investment adviser under the same or similar standards. Legal Applicability: Longstanding duty imposed by courts at common law (i.e., independent of any statute). Plaintiffs may establish the standard of care through practices in the community, according to testimony of experienced practitioners (usually paid experts), articles and texts on investment adviser practices, securities training materials, regulations, and, especially where the adviser uses specific credentials, standards set forth by accrediting organizations (e.g. CFP designations). Potential Defenses: Advisers may defend themselves by establishing (also usually with expert testimony) that their conduct was consistent with industry standards including disclosing potential risks and


problems to the investor. This is a very case-specific analysis, and the nature of the standard applied will depend upon the relationship between the client and the adviser and the services that were rendered. Written investment policy statements and clear records or communications with clients regarding the risks and potential benefits of strategies are key components of defending against these claims. Statutes of limitations vary state-by-state, but California’s statute of limitations for professional negligence actions is two years.

viii

Negligent Misrepresentation Definition: Investor suffers loss by reasonably relying on material, false misrepresentation or omission by adviser who was compensated for providing such advice, when the adviser honestly believes the truth of the statement but without reasonable grounds for that belief. Legal Applicability: Although negligent misrepresentation is a form of fraud, plaintiff does not need to prove that there was an intent to deceive, just that the statement was made without a reasonable basis. Potential Defenses: Like a negligence action, a negligent misrepresentation claim is typically subject to a two-year statute of limitations (or in some cases, depending on the circumstances of the misrepresentation, possibly the longer statute of limitations for fraud). Adviser-defendants may attempt to prove the statement was true; that it was no misleading in light of the various risk disclosures, including written disclosures and the investment policy statement; that the adviser did have reasonable grounds for making the statement on the basis of research, investigation, or due diligence; or that disclosures rendered any alleged reliance on a misrepresentation unreasonable. Fraud Definition: Causing damaging reliance by a customer on a material misstatement or omission, with both knowledge of falsity and specific intent to cause customer to rely. Legal Applicability: The elements of fraud are (1) misrepresentation or omission, (2) knowledge of falsity, (3) intent to defraud by inducing reliance, (4) justifiable reliance on the misrepresentation by the investor, and (5) resulting damage. Potential Defenses: California imposes a three-year statute of limitation on fraud claims.

ixThe most

difficult aspect for potential plaintiffs will be proving intent to defraud, and many of the adviser’s due diligence and suitability efforts can serve to corroborate an adviser’s non-fraudulent, good faith intent. Breach of Fiduciary Duty Definition: Failure to act loyally, in good faith, and in the absolute best interest of the client with full disclosure of all possible material information including potential conflicts of interest. Most common breaches include failure to disclose compensation from third parties and conflicts of interest such as the impact of recommended transaction on adviser’s own holdings or those of other clients. Legal Applicability: The Supreme Court, the SEC, most state regulators, and financial planner associations have affirmed that generally a financial adviser is a fiduciary. A fiduciary’s standard imposes a higher duty than just to avoid negligence or misrepresentations. Many charges often alleged against advisers, including the failure to properly execute the wishes of their clients, conflict of interest, suitability, or mistake, are often pleaded as breaches of the broad fiduciary duty. Such alleged violations are also often


pleaded as independent causes of action, when in fact it is the breach of fiduciary duty that creates the causes of action.

x

Potential Defenses: California grants one of the longest statute of limitations of four years for breaches of fiduciary duty.

xi Although it is typically not possible to deny that an adviser had a fiduciary relationship

to the customer, an adviser may attempt to show that alleged damages were not linked to that relationship (i.e., the alleged losses stemmed from an investment choice that the adviser did not assume fiduciary duties over), or that the adviser complied with his or her fiduciary duties by acting diligently, loyally, and in good faith. Breach of Contract Definition of Risk: Failure or alleged failure to honor and/or fulfill the trust, faith or promise made as described within your client agreements, investment policy statements or trust documents. Legal Applicability: Breach of contract is a legal cause of action at common law. In addition, Section 205 of the Investment Advisers Act of 1940, affirms that an adviser’s responsibilities to adhere to “prudent practices” includes adherence to client plans.

xii

Potential Defenses: Alleged breach of a written contract must be brought within four years, and on an oral contract within two.

xiii. It can often be difficult for plaintiffs to identify what provision of a contract

that was allegedly violated, or that the value of the services provided (the investment advice) was not worth the fees paid. Agency Liability—Acts of Another Definition of Risk: Liability for the acts of another, independent securities professional. Legal Applicability: Under common law agency principles, an adviser is the agent of the investor, who is the principal; the adviser may, under certain circumstances, create a situation where he is the principal, and another person is his sub-agent. For example, when an adviser has discretionary authority over a client account and selects the broker-dealer who will execute the transactions, the broker-dealer may be deemed the adviser’s agent.

xiv In such cases the adviser may be liable for the sub-agent’s violations, and

also for his own conduct such as negligent hiring or supervision or failure to disclose known information to the principal-investor, including information about the sub-agent’s possible legal violations. Alternatively, even in the absence of an agency relationship, a plaintiff could argue that an adviser’s fiduciary duty extends to performing adequate due diligence on persons he recommends or refers the client to. Potential Defenses: The statute of limitations for the underlying violation provides the time limit for agency liability based on that original violation. An adviser could argue that the other investment professional is not his or her agent, but rather that they are both co-agents of the investor, independent of each other. The adviser could also argue that he had no knowledge of, or reason to know of or suspect, the wrongful acts of another. Employee Dishonesty/Fidelity Definition of Risk: Theft by RIA employees of RIA in house assets or from client accounts.


Legal Applicability: Principles of agency law dictate that advisory firms have a duty of care to make prudent hires within the firm and to properly safeguard funds. Registered investment advisers are required to adopt a code of ethics

xv (setting forth the standards of business conduct expected of

“supervised persons” (i.e., employees, officers, directors and other people who are required to be supervised), and it must address personal securities trading by these people. Potential Defenses: The statute of limitations for the underlying violation provides the time limit for agency liability based on that original violation. Adoption and adherence to sufficient supervisory and compliance procedures provides the main line of defense against such liability.

2. Statutory Liabilities Involvement in Sale of Security (Federal Securities Statutes) Definition: Making a false statement or omission in connection with purchase or sale of security. Legal Applicability: Section 12(2) of the 1933 Securities Act imposes liability to persons who successfully solicited a sale, motivated by a desire for pecuniary gain on the sale. Proof of actual reliance is not required, but only a causal connection between the purchase and the misrepresentation or omission. The exact applicability differs somewhat depending on what federal circuit suit is brought in, but liability generally does not attach unless the adviser receives compensation from the actual seller of the security. Rule 10b-5 of the SEC imposes liability on all persons who knowingly make a false or misleading statement or omission in connection with the purchase or sale of security. Plaintiff must, however, prove that the adviser knew that the representations were false or misleading, or acted with reckless disregard for their truth or falsity. Potential Defenses: Federal statute imposes a two-year limitations period from the date that the investor should have suspected or discovered the allegedly fraudulent conduct.

xvi The securities statutes also

codify the “good faith” defense absolving persons from fraud liability if they can prove that did not know, and could not have discovered in the exercise of reasonable diligence, the untruth or omission.

xvii

Uniform State Securities Act (2002) Definition: Engaging in a deceptive or fraudulent act or scheme when rendering investment advice. Uniform Act (2002), Section 509(b). The client may sue to recover the consideration paid for such advice, any actual damages “caused by” such advice, plus interest, costs and attorney’s fees, less the income received from such advice. This remedy is cumulative with those provided by other remedies at law or equity. Legal Applicability: A 10b-5-like private cause of action is available against any person who directly or indirectly receives consideration for providing investment advice and violates the Act’s anti-fraud provision. Also jointly and severally liable are control persons, managing partners, executive officers, directors, and employees and other advisers who materially aid in the conduct, unless they can prove an affirmative defense of reasonable lack of knowledge. Section 509(f). The 2002 Act has so far been adopted by 17 states and has been endorsed by the American Bar Association and FINRA; the prior 1956 also contains a similar provision. 1956 Uniform Securities Act, Section 410(b).


Potential Defenses: The Uniform State Securities Act, versions of which have been adopted by most state, is similar to the federal securities laws in both its limitations period as well as the existence of a good faith defense. Uniform Act (2002) Section 509. Liability as a Broker-Dealer Definition of Risk: Engaging in activities of a broker-dealer, subjecting adviser to possible enforcement action or civil litigation for failure to register as a broker-dealer or for violation of laws applicable to broker-dealers. Legal Applicability: Under Section 401 and 509 the 2002 Uniform Securities Act, failure to register as a broker-dealer gives rise to a private cause of action for recovery of actual damages, including costs and attorney’s fees, less income received. The SEC has advised that it would not recommend registration as a broker-dealer or enforcement even when an adviser exercises discretion over client accounts, when the adviser did not directly purchase or sell securities (but submitted orders through another entity for execution) and did not receive additional compensation for participating in such transactions.

xviii

However, activities such as soliciting investments in connection with a brokerage firm in exchange for a fee will require registration as a broker-dealer.

xix Solicitation of private placements, even without

transaction-based fees, may also be deemed an activity requiring registration as a broker-dealer.xx

Potential Defenses: Advisers may argue that they do not fall under the definition of broker-dealers and are not properly subject to registration requirements. The federal securities laws also contain numerous exemptions to the registration requirements for certain finders, banking-related functions, private placement servicing platforms, certain persons associated with the issuer, etc.

xxi The USAA also imposes a

shorter statute of limitations for this action of one year after the violation. Section 509(j)(1). Unlike other securities statutes or other parts of the USAA, the limitations period runs from the date of the violation and is not tolled (or paused) for late discovery. Elder Abuse Definition of Risk: State statutes provide for punitive or multiple damages involving persons over a certain age, plus attorney’s fees, where there is proof of recklessness, oppression, fraud, or malice. Certain states require a “taking” of property in order to assert such claims. Legal Applicability: Elder abuse claims are often used by investor attorney’s to “beef up” damages and attempt to secure attorney’s fees. The evidentiary burden varies according to the state’s elder abuse statute, but California has recently reduced the proof burden from “clear and convincing” down to a “preponderance of the evidence” standard.

xxii

Potential Defenses: Elder abuse claims can come into play when an aggrieved investor is of a certain age and an adviser has received some assets of the elder or dependent adult through the form of fees.

xxiii But,

like allegations of fraud, they are often difficult to prove absent genuine wrongdoing rising to the level of recklessness, oppression, fraud, or malice. ERISA Definition of Risk: Employee Retirement Income Security Act of 1974 imposes heightened fiduciary responsibilities over advisers with certain levels or kinds of discretion or control over retirement plans.


Legal Standards: ERISA’S fiduciary standard is the “highest known to law”, Donovan v. Beirwith, 680 F.2d 263, 272, n.8 (2d Cir. 1985), and makes ERISA fiduciaries personally liable for any plan losses incurred because of breaches of that duty. ERISA Section 409(a). Section 404 of ERISA imposes four types of duties on fiduciaries: (1) act for the “exclusive benefit” of the plan; (2) comply with the statute’s “prudent man rule” requiring a fiduciary to oversee the investment under an objectively prudent standard, (3) diversify assets to avoid large losses, and (4) comply with the plan documents.

xxiv Section 406 of the

statute also contains various prohibitions, including keeping a fiduciary from entering into transactions which he “knows or should know” is with a party in interest, dealing with plan assets in his own account, acting on behalf of a party with interests adverse to the plan, or receiving compensation from any party dealing with the plan (with an exception for “reasonable compensation” that is adequately disclosed).

xxv

A fiduciary must both avoid prohibited transactions as well as comply with the fiduciary duties set forth by Section 404. Possible Defenses: An adviser may not necessarily be an ERISA fiduciary, for example, if advice were just provided on a one-time basis. ERISA’s prohibitions are also subject to certain exemptions according to the statute and guidance issued by the Department of Labor for many common transactions. Finally, courts have determined that, like other fiduciary relationships, a plan fiduciary is only a fiduciary “to the extent” he performs one of the defined fiduciary functions; taking on a fiduciary rule in a limited capacity does not create full responsibility of all aspects of the plan.

xxvi Similarly, one is not responsible for acts before

becoming a fiduciary or after ceasing to be one.xxvii

3. Investment Adviser Act Violations Relevant To Other Causes Of Action As explained above, standards applicable to investment advisers can be relevant to determining the existence of negligence or other breach of duty, even if they do not give rise to a private cause of action. They may also form the basis of an award by arbitrators acting in equity, or enforcement actions by the SEC. In most situations such violations are specific instances of broader general legal principles, and are subject to the same defenses.

Arbitrator-Created Causes of Action Definition of Risk: An arbitration panel holding an adviser civilly liable for a regulatory or statutory violation that does not, at law, create a private cause of action. Legal Applicability: Arbitrators have equitable authority to impose the relief they deem just. They are not technically bound by rules of law, including those holding that many regulations and the Investment Advisers Act do not create private causes of action. Therefore arbitrators could properly award relief to a complaining investor on the basis of such violations, even if such an award could not occur in a court of law.

Trade Execution/Error Definition: Failure and/or alleged failure to execute a securities trade-transaction as intended or preferred. Legal Applicability: Pursuant to Sections 203(f), 203(k), 206(1), 206(2), and 211 of the Investment Advisers Act of 1940, advisers must execute trades as intended. Execution errors may also be treated as negligence, failure to supervise, and breach of common law and/or ERISA fiduciary duties.

xxviii


Regulatory Compliance/Audit Definition: Failure and/or alleged failure to meet regulatory requirements of the SEC, DOL & various

State Regulators.

Legal Applicability: A registered investment adviser’s books and records are subject to compliance

examinations by the SEC staff (under Section 204 of the Advisers Act) and state regulatory agencies. The

purpose of SEC examinations is to protect investors by determining whether registered firms are

complying with the law, adhering to the disclosures that they have provided to their clients, and

maintaining appropriate compliance programs to ensure compliance with the law. The Department of

Labor enforces ERISA and the Pension Protection Act and holds the power to conduct examinations of books

and records.

Conflicts of Interest Definition of Risk: Placing or alleged to have placed one’s own interest above a client’s. Legal Applicability: The Investment Advisers Act of 1940 (as well as ERISA) imposes a duty on advisers to act as fiduciaries in dealings with their clients, meaning the adviser must hold the client’s interest above its own in all matters.

xxix .

“Best Execution” (Trading) Practices Definition of Risk: Inability or alleged breach of obligation to execute transactions in such a manner that the clients’ total cost or proceeds in each transaction is the most favorable under the circumstances; failure or alleged failure to exercise reasonable care to obtain the most advantageous terms for a customer/client. Legal Applicability: As a fiduciary, an adviser has an obligation to obtain "best execution" of clients' transactions. This stems from the fiduciary duty and crates an obligation to execute transactions where the clients’ costs in such transactions are the most favorable under the circumstances. An adviser must consider the full range of a broker’s services and quality of services in making brokerage decisions.

xxx

These practices are the subject of increasing regulatory scrutiny and the SEC has made these a point of emphasis in examinations. Suitability of Investments Definition of Risk: Breach or alleged breach of the fiduciary duty owed to client to determine, provide and transact investment management concurrent and suitable to the client’s financial situation, investment objectives and risk tolerance. Legal Applicability: The fiduciary standard of the Investment Advisers Act and ERISA imposes a higher standard of care which incorporates the “suitability” requirements discussed above.

xxxi


Client Information Privacy Breach Definition of Risk: Clients’ private information improperly disclosed to, or used by, third parties or employees. Legal Applicability: Effective November 13, 2000, the SEC adopted Regulation S-P, the privacy rules promulgated under Section 504 of the Gramm-Leach-Bliley Act (GLBA). Section 504 of the GLBA required the SEC and other federal agencies to adopt rules implementing notice requirements and restrictions on a financial institution’s ability to disclose nonpublic personal information about consumers. Under the GLBA, a financial institution must provide its customers with a notice of its privacy policies and practices. Furthermore, it must not disclose nonpublic personal information about a consumer to nonaffiliated third parties, unless the institution provides certain information to the consumer and the consumer has not elected to opt out of the disclosure. California’s Financial Information Privacy Act also provides mandatory notice and choice provisions for sharing nonpublic personal information by financial institutions, and provides for a $2,500 maximum penalty per individual violation.

xxxii

II. CLAIM ILLUSTRATIONS

The following describes various claim examples experienced by various Golsan Scruggs’ insured

investment adviser clientele:

Claim Example #1

Allegation(s): Unsuitable Trading, Breach of Fiduciary Duty

Claimant: Private Individual

An advisory client with an IRA invested in traditional equities and bonds decided to invest a portion of the funds in

a private hedge fund. The adviser prepared the documents with the custodian to invest about $1MM into the

private hedge fund. As tax documents were being prepared the following year, it was discovered that the

previously completed transaction was in fact a withdrawal and reinvestment of the funds resulting in an

immediate tax bill of $250,000 to $300,000 for the client. In short, the adviser had prepared the wrong document.

The client alleged damages of $300,000 and demanded indemnification.

Third-Party Settlement: $50,000

Defense Expenses: $50,000

Claim Example #2

Allegation(s): Failure to Disclose & Conflict of Interest

Claimant: Securities Exchange Commission

An SEC investigation into separate, commonly owned RIA firms and a mutual fund managed by one of the firms

resulted in allegations that the RIA failed to disclose multiple conflicts of interest in three areas: (1) receipt of


undisclosed compensation, (2) misleading information regarding fee structure and (3) voting proxies in their own

favor. The SEC called for disgorgement of previously charged fees as well as civil money penalties; disgorgement of

$900,000 and SEC levied fines of $150,000.

Third-Party Settlement: $1,150,000


Claim Example #3

Allegation(s): Breach of Contract; Failure to Supervise

Claimant: Three Separate Individual Clients

Advisory staff failed to properly modify trade instruction software. The firm incorrectly included all firm accounts

within a block trade in leveraged funds. However, three specific clients had given special communication and

instructions for their cash balances in all accounts to remain as cash. The market moved rapidly down

(exponentially so due to a leveraged investment product) resulting in losses to the three clients. The Clients

brought suits against the adviser for breach of contract and failure to supervise.



Claim Example #4

Allegation(s): Erroneous Trade

Claimants: Multiple Third Party RIAs

An RIA firm functioning as a back-office service provider and model portfolio manager to outside, unaffiliated RIA

firms routinely completed significant block trades. It was agreed that in order to rebalance mutual fund portfolios,

a roughly $7,000,000 rebalance from one fund to another was needed. The RIA reported to their clients (other

RIAs) that the rebalance occurred on a specific date. It was found days later that the trade did not, in fact, occur.

The market moved by the time this was discovered resulting in an approximate $200,000+ loss to the underlying

accounts.

Third-Party Indemnification: $200,000

Defense Expenses: None

Claim Example #5

Allegation(s): Unsuitable & Risky Investment Recommendations

Claimants: Private Individuals

An RIA was engaged by clients as their discretionary asset manager to manage the clients’ assets in accordance

with their specific investment needs, goals and objectives. The clients noted that their primary goals were “Capital

Preservation” and a “Low Level” of volatility. Clients alleged that the actual portfolio constructed by the RIA was


High Risk and Unsuitable. The claim noted that the average standard deviation of the initial asset allocation was

near 20 and that this was not consistent with the “Capital Preservation” goal. The claim alleged that the gain of a

“suitable portfolio” would have produced substantial gains over the time period. Claimants not only requested the

amount they had lost during the adviser’s management, but also the amount they would have gained should they

have been invested differently. Adviser ultimately found to have properly executed their fiduciary role.

Third-Party Indemnification: None


Claim Example #6

Allegation(s): Unauthorized Transaction & Unsuitable Investment


An Investment Adviser Representative (IAR) presented the opportunity to a client to purchase pre-IPO shares of a

social media company which were held within a private partnership. The claimant alleged that the IAR invested

funds in the private partnership without final approval of the claimant. The claimant did sign forms to move

forward with the investment, but alleged that they were rushed through the process and did not receive complete

explanation. The claimant alleged the IAR promised to call to further explain, yet did not call and purchased the

investment regardless. The claimant also alleged that the investment was unsuitable due to his limited

understanding of investments and his modest net worth. The written demand requested the client be made whole

by the advisory firm. Due to specific security market correction, claimant’s financial position improved and,

therefore, claim was withdrawn.

Third-Party Indemnification: None


Claim Example #7

Allegation(s): Unsuitable Trading, Breach of Fiduciary Duty


The claimant was unhappy with the minimal returns which her funds were generating within a fixed annuity

product. On the adviser’s advice, the claimant liquidated the annuities and deposited cash into the adviser’s

custodial account. The adviser managed the claimants account on a discretionary basis from mid-2007 through

the first quarter of 2009 (a period over which the S&P fell by about 40%). The claimant’s approximately $750,000

account fell from market losses as well as significant client withdrawals. The claimant alleged damages of

$750,000 (the entire account) on the basis of unsuitable trading and breach of fiduciary duty. Ultimate breach

unclear. All parties agreed to minor settlement.




III. RISK SUMMATION

Pursuant to the above sections expanding upon the legal duties, risk categories, case

law and claim examples – What have we learned?

There is no higher professional standard than that of a

fiduciary (“duty of care”).

Cases brought against advisers can be groundless or

unwarranted but trigger and demand attention

(defense) regardless (i.e. alleged vs. actual) of

circumstances.

The legal framework (IAA – the Act) imposes liability to

an Adviser (IAR) personally as an Individual – as well as

to the IA entity. The definition of “adviser” includes

“personal”. The corporate entity may not necessarily

act as a shield of protection.

Categories of risk are wide and multiple.

Monetary exposures can be deep and catastrophic. The

occurrence of an “action” against an adviser should be

expected, based on success and longevity. The degree

of severity is somewhat unknown.

1

2

3

4

5


IV. INSURANCE (RISK-TRANSFER) MECHANISMS

What are the primary insurance coverage forms available in the insurance marketplace to wholly or

partially insure (transfer) the risks of operating as an Investment Adviser?

COVERAGE LINE DESCRIPTION

Errors & Omissions Liability

(aka Professional or Investment

Management Liability)

Coverage for actual or alleged mistakes or misconduct, claims or suits for

Breach of Fiduciary Duty, client suitability, not meeting client expectations,

violation of regulations, accountability imposed under the Investment

Advisers Act of 1940, and related matters.

Directors & Officers Liability

(aka D&O)

Covers management liability suits for Directors, Officer, and Managers in

their roles as such. Unfair competition, breach of duty, slander, violation of

trade practices, and regulatory proceedings are examples of types of

complaints covered.

Employee Dishonesty

(aka Crime or Fidelity) Covers loss of property due to theft by employees and/or third-parties.

ERISA Bond (In-House) Covers loss of company plan assets due to theft/fraud of the plan sponsor.

ERISA Bond (Client/3rd

Party Plans) Covers loss of clients plan assets due to theft/fraud of the investment

manager/adviser.

Cyber/Data Breach Liability

Coverage for third-party (cyber liability) and first-party (cyber crime

expense) to address risks associated with technology/cyber risks. Failure to

properly manage cyber exposure can trigger Breach of Fiduciary Duty claim.

CAUTIONARY NOTE: The Insurance Services Office (ISO), the governing body for the property/casualty insurance

industry, to which all insurance companies are members, customarily issues recommended forms (contract language)

for most commonly purchased commercial insurance (property, general liability, auto, etc.). However, ISO has decided

against recommending any commoditized standard form for the above specialty coverage. Each underwriter

independently issues their own unique contract forms with differing terms, conditions, exclusions, limitations,

conditions, etc. Caution is recommended to the RIA community to recognize the specialty of the RIA underwriting

marketplace and to solicit advice from qualified and experienced professionals possessing superior knowledge of

fiduciary exposures and risk-transfer solutions.


IV. DISCLAIMER & CORPORATE INFORMATION

Legal Notice

Golsan Scruggs is an insurance and risk-management company specializing in serving U.S. based Registered Investment Advisers

and practicing under the name Golsan Scruggs. Golsan Scruggs is a registered trade name of K.R. Golsan, Inc., in jurisdictions in

which it practices.

Copyright Notice

All copyrightable text and graphics, the selection, arrangement, and presentation of all materials (including information in the

public domain), and the overall design of this report are ©2014 Golsan Scruggs. All rights reserved. Permission is granted to

download and print materials from Golsan Scruggs’ website, www.gsRIA.com, for the purpose of viewing, reading, and retaining

for reference. Any other copying, distribution, retransmission, or modification of this report and its information or materials on

or from our web site, whether in electronic or hard copy form, without the express prior written permission of Golsan Scruggs,

is strictly prohibited.

Joint Publication

This report has been produced through a joint effort of both Golsan Scruggs and Markun Zusman Freniere Compton LLP,

Attorneys At Law. All notations within this report’s Disclaimer & Corporate Information apply completely and equally to

Markun Zusman Freniere Compton LLP.

Disclaimer

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VI. REFERENCE INDEX

i SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963). ii Transamerica Mortg. Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979).

iii In re Hughes, SEC Release No. 4048 (February 18, 1948).

iv E.g., In re Fregien, 2013 WL 1364297 (Wisconsin Com. Sec. March 21, 2013).

v Investment Advisers Release No. IA-1406.

vi Transamerica Mortgage Advisers, Inc. v. Lewis, 444 U.S. 11 (1979).

vii 69A Am. Jur. 2d Securities Regulation—State, Section 13; 15 U.S.C. § 80b-18a.

viii CCP § 339.

ix . CCP § 338.

x SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963); In re Rizzo, Inv. Advisors Act Release No. 897 (Jan.

11, 1984); Nat’l Ass’n of Personal Financial Planners, Code of Ethics (Oct. 1989). xi CCP § 343. When more than one cause of action is pleaded, each with different causes of action, California

courts will look to the “gravamen,” or essence of the suit, to determine which applicable statute of limitations should govern the entire action. Hydro-Mill Co. v. Hayward, Tilton & Rolapp Ins. Assoc., 115 Cal. App. 4th 1145, 1154 (Cal. Ct. App. 2004). xii

See also ERISA sections 3(38)(C), 104, 402, 403, and 404; Dardaganis v. Grace Capital, Inc., 664 F. Supp. 105, (S.D.N.Y. 1987). xiii

CCP §§ 337, 339. xiv

Suh v. Dong Won Securities Co., 2004 WL 1843276 (Cal. Ct. App. 2004). xv

The “Code of Ethics Rule” is Rule 204A-1 under the Advisers Act. xvi

28 U.S.C. §1658. xvii

15 U.S.C. § 77k. xviii

In re First Atlantic Investment Advisory Corp., Fed. Sec. L. Rep. P 79,746, 1974 WL 10170 (SEC No-Action Letter March 22, 1974); In re McGovern Advisory Group, Inc. 1984 WL 45930 (SEC No-Action Letter). xix

In re Boston Advisory Group, 1980 WL 14910 (SEC No-Action Letter October 2, 1980). xx

In re PRA Securities Advisors, LP, Fed. Sec. L. Rep. P. 76,603, 1993 WL 67873 (SEC No-Action Letter, March 3, 1993). xxi

See Thomas Lee Hazen, “Broker-Dealer Registration; Definitions and Exemptions,” Treatise on the Law of Securities Regulation § 14.4. xxii

Cal. Wel. & Inst. Code Section 15657.5. xxiii

Wood v. Jamison, 167 Cal. App. 4th 156 (Cal. Ct. App. 2008); Zimmer v. Nawabi, 566 F. Supp. 2d 1025 (E.D. Cal. 2008). xxiv

See William Campbell Ries, 1 Regulation of Invest. Mgmt. & Fiduciary Serv., §§ 13.21-.24. xxv

See ALI-ABA Course of Study, “Fiduciary Litigation Under ERISA,” SN080 ALI-ABA 243 (April 2008). xxvi

Pegram v. Hedrich, 530 U.S. 211 (2000). xxvii

See supra, note xxv. xxviii

In re Michael T. Jackson, Advisers Act Release No. 2374 (April 6, 2005). xxix

SEC v. Capital Gains Research Bureau, Inc. 375 U.S. 180 (1963); see also ERISA sections 3(14), 404 and 406. xxx

See Exchange Act Release No. 23170 (April 23, 1986); Investment Adviser Act of 1940, Section 211(g)(1); Herman v. NationsBank Trust Co.,126 F.3d 1354 (11th Cir. 1997). xxxi

Investment Advisers Act Release No. 1406 (March 16, 1994)l Laborers National Pension Fund v. Northern Trust Quantitative Advisors, Inc. 173 F.3d 313 (5th Cir.). xxxii

Cal. Fin. Code. §§ 4051-4057.

Golsan Scruggs RIASure Risk Guide

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