David R. Evanson

On Wall Street, Summer, 2004

The numbers keep going up, up, up. Unfortunately, wezzre not talking about the market; wezzre talking about arbitrations. Based on activity through April, about 12,000 arbitration filings can be expected this year, an increase of more than 100 percent since 2000. And with the upswing in arbitrations has come a crisis in the insurance designed to protect brokers and their firms from such claims: errors and omissions (E&O) coverage.

“With a large number of groundless claims coming in, underwriters are thinking they could get in real trouble, so they react by increasing rates, lowering the limits of coverage and raising deductibles,” says Jack Frawley, an insurance broker for New York City-based First City Resources.

Carriers have abandoned the business, leaving just a handful including AIG, Quanta Specialty Lines Insurance and Arch Insurance Group. According to John Iannotti of AIG, “Itzzs been a very tough market, and we have not made money in it for some time. We only offer this insurance because we want to offer our clients a full menu of products.”

For brokers, the impact of the E&O crisis depends on where you work. If you work at a large firm, many of which self-insure, the crisis may not affect you until you run into an arbitration. In such cases, firms may rush to settle and leave you holding the bag in terms of reputation and future employment opportunities.

If you work at a regional firm, you are seeing the increasing costs of insurance being passed on to you and a heightening of recordkeeping requirements.

If youzzre at a small firm or an independent where youzzre responsible for your own coverage, you may be facing a crisis of monumental proportions. You face escalating premiums, an intense focus on compliance in order to satisfy the requirements of your policy or, worse, the unavailability of coverage at any price.

Consider the case of Westfield Bakerink Brozak LLC in San Diego, which paid $10,000 in 2002 for E&O coverage for 15 registered representatives. According to principal LaRae Bakerink, premiums jumped to $33,000 in 2003 despite the firmzzs never having made a single claim or having a lawsuit filed against it. Based on a 20-basis-point trailer, every broker in the firm would have to raise another $110,000 in new mutual fund assets just to pay for the insurance.

But the real costs extended far beyond the premiums. If a negotiated settlement were to come in below the deductible of the coverage, the settlement would come out of the brokerzzs pocket. Therefore, despite the $25,000 deductible Bakerink was quoted, the true cost to the broker was the $2,200 they paid for coverage, plus the up to $25,000 they would have to pay if involved in an arbitration settlement.

Firms are as much at risk as brokers. According to First Cityzzs Frawley, “Years ago, firms could have purchased a $10 million policy. Today, it would be very difficult to put that together.” Most firms top out at $5 million in coverage, meaning a really large claim could put them out of business.

With economics like that, why even bother with E&O coverage? Bakerink and others simply have no choice.

“Because we sell insurance and variable annuities in California,” she says, “itzzs required.”

Many states mandate coverage, especially to sell life and variable annuity products, and many carriers require E&O insurance of the firms that sell their products.

E&O coverage for Bakerinkzzs firm for 2004 was a big question mark until a program she had been working on with the National Association of Independent Broker Dealers (NAIBD) came through. Specifically, the NAIBD — which Bakerink chairs — now offers members E&O insurance from Quanta. In that way, Bakerink picked up coverage at a more reasonable premium of $24,000, which is about 140 percent of her old premium, despite a history of not a single claim. The increase, of course, was passed along to the firmzzs brokers.

“I spent a lot of time tracking down insurance,” Bakerink says. “Then we spent even more time rewriting our new account applications and revamping our compliance procedure so that we would qualify for the coverage. Then outside counsel reviewed all the new documentation. I have to watch things much more closely now.”

At LPL Financial, one of the largest independent brokerages with more than 5,100 registered representatives, the E&O crunch is not directly felt, but it is nonetheless omnipresent. David Freniere, senior vice president and assistant general counsel, calls the situation “a challenge for everyone.”

Premiums have risen, and that gets passed on to LPLzzs affiliated brokers, says Freniere. Also being passed along are higher deductibles. A “typical” deductible for an LPL broker might be between $5,000 and $7,500. That figure can be substantially higher if a broker has been called into an arbitration that results in a settlement or a damage award. But the real cost to brokers comes in terms of the extra compliance and bookkeeping required to protect themselves in the event of a claim.

Michael Dorvillier, an LPL broker in LaJolla, Calif., says that while he came to the company precisely because of the compliance and oversight the firm offered, “many brokers find the situation overwhelming.”

Dorvillier, an OSJ for the firm, says that until November of 2003, he had eight registered representatives working for him. He has let them go.

“There was just not enough revenue for many of them because doing what needed to be done to protect ourselves [cost] too much. My signature was on everything, and if any of those reps tripped up, it flowed back to me, then LPL,” he says.

At Raymond James Financial the situation is similar. Jeff Julien, the firmzzs chief financial officer, says E&O insurance premiums have been going up and have been passed onto brokers. He says the firm maintains limited outside coverage because it largely self-insures. To protect itself, the firm has become more particular than ever in its hiring practices, trying to avoid registered reps who are likely to provoke arbitrations.

While the price and availability of E&O coverage is affecting broker-dealers and their reps, the insurance carriers that write the policies face a crisis of their own — one which impacts brokers. First Cityzzs Frawley says that with arbitration filings on the rise, insurer losses are mounting, and now more than ever they want to settle rather than fight. “The carriers want to settle these claims as quickly as possible, especially with the nuisance claims,” he says, “because it costs less than fighting.” Settlement often translates into a permanent mark on a brokerzzs U-4, which has implications for future employment and new business development.

“The problem and frustration I have with E&O insurance,” says LPLzzs Dorvillier, “is the quickness with which they want to settle. They want you to put ego and pridezz aside, but the fact is the issues go much deeper than that for the registered representative.”

According to Cynthia Yousef, a vice president with Quanta Specialty Lines, carriers can be convinced not to rush to settlement. “The message we have for brokers is to keep open lines of communication between the carrier, insurance brokers and yourself, and to be proactive in how an arbitration matter is approached. But without documentation,” she advises brokers, “we cannot develop a successful defense.”

While “document everything” is the mantra in E&O insurance — and now, it seems, in every other aspect of the securities industry — documentation must be deployed systemically. Dorvillier outlines several procedures that brokers can adopt to reduce their risk. First, he strongly recommends the use of “switching letters.”

“These are used when a client moves from one product to another. The client receives in writing their acknowledgement of the back-end fees, if any, they will pay for selling an investment, as well as any front-end fees connected with moving into a new investment.” He says that using a switching letter heads off a common basis of arbitration claims — churning and hidden fees.

Next, Dorvillier uses prospectus receipt forms. Just as switching letters cover fees, prospectus receipt forms cover fees and just about every other disclosure. According to Dorvillier, “Itzzs very difficult for an investor to claim they were misled when the broker has a document that verifies their receipt of a prospectus.”

As an OSJ, Dorvillier reviews trade blotters daily, which LPL requires. “I catch a lot of issues this way before they become problems,” he says.

Finally, Dorvillier says that his firm conducts annual mock audits that have forced him to keep his files and practice organized in a way that will enable him to document any claim an investor might bring. “The LPL auditor will go through the documents in the same way an NASD auditor would, look at random trades, and see if there is required documentation behind each client.”

LPLzzs Freniere says that when itzzs inevitable that a settlement will be made, there are still ways to salvage the reputation of the broker. “In instances where the registered rep is concerned about reputation, we have been able to negotiate a settlement in which the broker is dismissed from the claim.” He says this strategy works best when the investor has a weak claim.

“We simply say, We do not think there is any claim, and he is not going to settle, as long as he is in this case. If you dismiss the broker, we can talk about settlement.zz”

In other instances, Freniere says the firm will seek a stipulated award with the investors. This will result in a settlement, but also with the claim being expunged from the brokerzzs record. The protection of a brokerzzs reputation is, or should be, of paramount concern. But because insurers do not look at claims this way — nor, always, does the broker-dealer — responsibility falls to the individual representative to be his or her own best advocate. The stakes are high, he notes, especially as related to a brokerzzs career progression.

Lou Denton, a founder and principal of independent broker Philadelphia Corporation for Investment Services, simply will not hire brokers with a mark on their U-4s. “In our entire history, we have never had a claim or suit brought against us.”

Part of this, he says, is because the firm does not sell any products it does not understand. For instance, PCIS, which is a unit of Chester Valley Bancorp, will not sell variable annuities, which may be one reason the firm has not carried E&O insurance during its 15-year existence.

“Not having the coverage has created a mindset where we simply say that if something doesnzzt look right, donzzt do it,” says Denton.

That, he suggests, may be the route the entire industry could be forced to follow.

What is E&O Insurance?

Errors and omissions insurance covers wrongful acts in rendering — or failing to render — professional services. Doctors, lawyers, accountants and real estate agents typically purchase E&O coverage, in addition to stockbrokers. While E&O insurance covers many potential problems, it does not cover everything, says Cynthia Yousef of Quanta Specialty Lines Insurance Company in New York, and brokers should be mindful of common exclusions. For instance, E&O insurance does not cover claims arising from fraud or dishonesty. Nor does it cover claims over commission disputes; guarantees you may have made regarding performance, interest rates or market values; or the insolvency of an issuer of securities you may have recommended. Additionally, Yousef says that if discrimination or harassment is a factor in a claim by an investor, E&O insurance generally will not provide coverage.

While model behavior and unimpeachable ethics are the cure-all, understanding the boundaries of E&O coverage helps. Just as investors may make a claim because they believe a faceless insurance company will pick up the tab, brokers can fall victim to the same thinking and take risks because they believe they are insured. That may not be the case.

David Evanson