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With attorneys and disgruntled investors setting their sights on financial advisors, can lawsuits against them be far behind? The answer, say plaintiff attorneys, depends on the advisor.

It’s not a growing number of lawsuits that are plaguing investment advisors. At least not yet. What’s troubling them and their errors-and-omissions insurers these days is the uptick in mistakes advisors are making and then are trying to rectify in a highly expensive manner.

In fact, in some cases, advisors are fixing mistakes even before investors realize they’ve been made. "It’s good for investors, but it’s an interesting phenomenon," says John M. Gannon, deputy director of the Securities and Exchange Commission’s Office of Investor Education & Assistance.

The people feeling the most heat for mistakes aren’t investors, regulators or even advisors. It’s the errors-and-omissions (E&O) insurers, who write coverage for advisors and are beginning to see red. "Advisors live and die by their reputations, and the last thing they want is a trial, so they want to correct errors in an effort to stem lawsuits," says Evan Rosenberg, senior vice president of Chubb & Son in Warren, N.J.

The concern for insurers is that advisors are tapping their "cost of corrections" riders—coverage that is no more than three or four years old—to pay for their mistakes. That, in turn, is blowing a hole in insurers’ profits and may be driving up deductibles and premiums for errors-and-omissions insurance. The riders don’t cover bad judgment or investment decisions, but they do cover errors.

"Say an advisor buys a block of stock and distributes it among clients, and a significant number of shares are deposited in a client account, where the client has given specific instructions that they don’t want that stock," Rosenberg explains. "Then suppose the error isn’t discovered for six months, until the stock tanks. That type of error has been happening a lot in the past year or so."

Rosenberg says the tremendous growth in the advisor industry and the assets it manages has taxed its infrastructure and its back-office capacity, causing more things to fall between the cracks. To pay for such errors, advisors are making an increasing number of "cost of correction" claims. Both Chubb and AIG say such claims have increased 50% in the past 12 months.

The claims Chubb is seeing "run between $200,000 to $2 million," Rosenberg says. A smaller investment-advisory firm with about $25 million in assets is paying about $8,000 to $10,000 in annual premiums for $1 million in errors-and-omissions coverage. Deductibles on such policies run between $25,000 and $50,000 a claim.

The problem for insurers is that advisor policies historically have been a relatively profitable business with few claims. Now, the increase in cost-of-collection claims is standing insurers’ economics on its head and could make these policies pricier.

Still, it’s not surprising that advisors try to correct problems or settle claims before they become lawsuits or, at the least, lead to lost clients. Whether or not an advisor is guilty, say experts, a lawsuit typically can cost more than $100,000 in legal fees and take five years to resolve.

Although Chubb hasn’t been hit with huge claims, Rosenberg has heard of insurers that have. In effect, the industry’s remarkable and quick growth has become a bit of a costly liability in itself.

Expansion problems "could happen to a car manufacturer. Rapid and top-end growth is difficult for any firm to absorb. After a claim, we go out to a firm, and almost every time, everything we’d want to see in terms of procedures is there. It’s just a matter of human error. Someone goes on vacation, for example, and no one is cross-trained, and someone forgets something," says Rosenberg.

Advisors are fixing a significant number of problems and settling those they can’t. Is this trend a precursor to a rising tide of lawsuits against advisors? If it is, should more advisors buy errors-and-omissions insurance? Should more include arbitration clauses in their client agreements?

While those monitoring lawsuits haven’t seen an increase in those filed against advisors to date, they are watching events carefully. And the fact that some plaintiffs’ attorneys have begun including investment advisors in ads soliciting the business of wronged investors isn’t lost on those experts.

"Investment advisors and financial planners are more subject to litigation than they have been in the past," says Rick Ryder, president of the Securities Arbitration Commentator and its vast arbitration databases.

Moreover, Ryder says advisors are finally on the map in a big way, and thus have more exposure because of a number of trends. Not the least of them is the attention from lawmakers and regulators on investment advisors since 1996.

With the market downturn bringing some dicey sales practices to light, complaints against brokers and registered representatives are up 20%, and arbitration claims are up 22% this year as of mid-May. Will advisors confront the same fate? While advisors typically have engaged in needs-based marketing and advice and have developed relationships with their clients that do not translate easily into lawsuits, that doesn’t mean advisors are immune from legal action.

On May 4, the SEC filed a civil fraud action against Stevin R. Hoover and his Boston-based advisory firm for allegedly misappropriating client funds of more than $475,000 and violating disclosure rules. Hoover was an investment manager celebrated by Worth magazine from 1998 to 2000.

The SEC, which supervises 22,000 investment advisors, reported 397 complaints against advisors last year. The National Association of Securities Dealers oversees 677,000 registered representatives and received nearly 6,400 complaints against such individuals in 2000.

The SEC’s Gannon says he’s expecting to see a slight increase in 2001 complaints against advisors. The NASD already has released year-to-date data that shows complaints, many of them related to shady sales practices or incompetence, are up more than 20%.

Who’s to blame? NASD Dispute Resolution Inc. President Linda Fienberg chalks up the increase in complaints to a spate of events. "The market turned down precipitously, there are more investors than ever before, and more people bought on margin," Fienberg says. "I haven’t said to brokers, ‘You’re doing something wrong.’ All I’ve said is there’s a 22% increase in claims. My speculation is that claims are caused by a number of things."

Fienberg says the most prevalent allegations in complaints against brokers include breach of fiduciary duty, negligence, misrepresentation, churning and lack of suitability. The new entry at both the NASD and SEC is margin account-related complaints. Brokers and investors caught in the euphoria of what seemed like a forever-rising stock market borrowed heavily to invest more and possibly make more.

"That’s a shift we’re seeing. The allegations may be the same, but some of the facts are different," Fienberg adds. "For instance, an investor may now claim unsuitability because they believe they shouldn’t have been on margin."

Plaintiffs’ attorneys are seeing a crush of investor complaints roll in the door. Complaints about technology losses and margin accounts top the list, they say.

"I’m inundated with investor complaints, especially against brokers," says Melanie Cherdack, of counsel at the Miami-based law firm of Genovese Lichtman Joblove & Battista. "Mostly, I’m hearing from investors who have true unsuitability claims. They were put in high-tech positions and then had their total accounts margined." Some complainants lost as much as 100% of their assets and are now having to pay back their margin losses and costs.

"It’s particularly tough for those investors who are on fixed incomes. In order to buy more stock and make more money, brokers margined entire accounts," Cherdack says. The recent phenomena has earned its own moniker among attorneys, who call it "margin blowout."

While it’s hard to say how often advisors margined clients’ accounts, the problem is seen more often at brokerages. "I tend to think this was done by brokers in the business less than four or five years who, like investors, believed that they couldn’t lose money," Cherdack says. She adds that she hasn’t seen the volume of complaints against investment advisors that she sees against brokers.

But that doesn’t mean advisors’ honeymoon from liability is over. "I think it’s still early to say anything definitively," Cherdack says. "It usually takes a good year before complaints shake out. We have people coming in weekly whose losses happened in the middle or end of last year."