Don’t churn. Avoid unauthorized trading. Don’t forge documents. Don’t give false or misleading information. Preserve client confidentiality. Above all, don’t steal or “borrow” your clients’ money. These practices are all standard protocols for financial advisers. However, there are less obvious guidelines you need to adhere to so you can avoid getting sued as a financial adviser.
In 2021, the Financial Industry Regulatory Authority (FINRA) received 14,311 investor complaints. In 2020, this number was 5,400. As investors become more educated and processes become more transparent, it's never been a more important time to ensure that your practices are protecting you and your firm from lawsuits. Consider these tips to avoid becoming a cautionary tale about what not to do as a financial adviser.
- Financial advising can be a lucrative and rewarding career, helping clients achieve their financial goals.
- Sometimes, however, recommendations don't turn out according to plan and your client may lose money—ultimately blaming you.
- Maintain transparency with your client, and expect the same level of openness back from them.
- Keep accurate and secured records, understand your clients needs and risk tolerance, and closely supervise employees and staff to protect your firm.
- If a lawsuit is brought, consider mediation to potentially find a mutually agreeable outcome.
Get the Full Picture
As an investment adviser, you have a fiduciary duty to act in your clients’ best interests, to put their interests above your own, and to give advice based on complete and accurate information.
You get complete and accurate information from a client through interviews, questionnaires, records, and documents including tax returns and bank statements. If they give you incomplete or inaccurate information, you may offer them incorrect or inaccurate financial advise.
The Certified Financial Planner Board’s Practice Standards say that advisers who cannot get the information they need shall “either limit the Scope of Engagement to those services the CFP® professional is able to provide or terminate the Engagement.” Even if you aren't a CFP®, this is a valid position to take.
Clients may be embarrassed about their financial position or the circumstances under which they came about their money. It may be easier to encourage clients to disclose this private information if you remind them that financial advisers operate under a strict client confidentiality agreement.
If you are a CFP,® this obligation is even more explicit and must be stated in writing. The best way to provide impeccable service and keep clients happy is to know as much as possible about their finances and about the aspects of their personal and business lives that affect their finances.
Provide Complete and Accurate Professional Disclosures
Just as you expect your clients to disclose certain information to you, they expect you to disclose certain information to them. Not only that, but federal and state regulations require investment advisers to disclose all the information a client needs to make an informed decision about working with a professional and taking their advice.
Clients need to know about any past, present, or potential future conflicts of interest, the risks involved in the methods you use to determine an investment’s suitability, and any unusual risks posed by a particular investment or strategy you might recommend. They also need to know if you’ve been disciplined or sued in the past.
FINRA Fines and Restitution
In 2021, FINRA collected $103 million in fines, up almost $46 million from the year before. In addition, FINRA reported $47 million of restitution, which was $21.8 million higher than 2020.
All of this information and more should be compiled in a detailed document for your client per the brochure rule (or a similar state-level rule if you’re regulated at the state rather than the federal level).
Provide a copy to each client and ask them to sign a form stating that they’ve received it and reviewed it, and keep everything in your records. Besides meeting your legal requirements, by providing this information to clients upfront, you can reduce your risk of being sued and present a stronger defense if you are sued.
Keep Client Information Safe From Cyber Attacks
Keeping your clients' information safe from cyber attacks is critical. Financial advisers are natural targets for hackers because they manage large amounts of money and a variety of people's personal information. As an adviser, it is your duty to be diligent about checking the security of all your third-party vendors.
You should also implement a strategy for how to respond in the event of a hack so that you can minimize the damage to your clients. If you manage any employees, training them to follow best practices for safeguarding client information is crucial to maintain the trust of your clients and the credibility of your practice.
Diligently Train and Supervise Your Employees
In addition to training employees about how to keep your clients' information safe, your employees should be trained in best practices in all areas of client relationships. Diligently supervise all members of your business so that you know how they are handling client information and the kinds of investment recommendations they are making.
One way to prevent any major mistakes that might put you at risk is to have a lead or senior adviser sign off on any plans made or actions taken. Make sure that your employees are setting client expectations appropriately and not making any promises to clients that you can’t reasonably deliver on.
Avoid High-Risk Clients
You don’t have to take on every potential client who approaches you. While you should not discriminate based on factors such as skin color or gender, you should always be selective. In an initial phone conversation or meeting, you might spot red flags in a prospective client.
Perhaps they are not forthcoming about their financial situation, don’t want to review or complete paperwork, or show signs that another family member has too much influence over their finances.
You might not want to get involved with someone who seems reluctant to cooperate, has unreasonably high expectations, or may pressure you into committing unethical acts. Not only may these clients be difficult to work with, but your actions may also have company-wide implications that devastate your relationship with other clients.
Please note that Investopedia refers to investment professionals with a strict fiduciary responsibility who advise clients or manage their financial assets as “advisers.” We refer to investment professionals who follow the suitability standard as “advisors.”
Get the Right Insurance
Financial advisers need errors and omissions insurance to protect themselves against claims that clients might bring concerning negligence, breach of fiduciary duty, or lack of regulatory compliance.
By paying for your legal defense, regardless of your guilt, and by covering certain losses if you are found at fault, proper liability insurance can keep you from going out of business. Make sure your policy covers your employees, too. Cyber liability insurance can provide another layer of protection in the event of a breach of confidential data.
Educate and Listen to Your Clients
Do your clients understand investment risk and the possibility that the money they’re entrusting to you to manage will not grow every year? Yes, you’ll provide a boilerplate disclosure about investment risks that you’ll ask clients to sign before you’ll work with them.
It will explain that investing in securities involves the risk of losing capital, that there is no such thing as a guaranteed investment, and that past performance does not guarantee future results.
Clients might just gloss over this disclosure before signing it, if they read it at all. They might also underestimate their own risk tolerance. That’s why, rather than asking vague questions such as “How much risk tolerance do you have?” it’s more helpful to ask questions such as “How would you react if your retirement portfolio lost 25% of its value in one year? Would you want to sell some of your investments, do nothing, or buy?"
In 2021, 386 individuals were suspended as financial advisers and 269 were barred from the industry. Three firms were expelled and one firm was expended. Each of these figures represented a decline in the number of punishments handed down by FINRA from 2019.
Keep in mind that clients who have never experienced such a scenario might overestimate how well they would handle it. It’s important to learn about their investment history and how past experiences with money have shaped their views.
Just because a client has the financial capacity to absorb a certain level of risk doesn’t mean that they have the psychological ability to do so.
It’s also helpful to provide clients with a basic level of investment education, even if your client wants to be as hands off as possible. This helps them them understand your approach and your recommendations.
If you’re signing up a new client in a bull market, don’t let the next bear market be the first time they get this information. Make sure they’re educated and prepared for every aspect of the behavior of financial markets.
Provide Investment Policy Statements to Your Clients
In addition to providing clients with a basic level of investment education, you need them to understand why you are recommending particular investments and asset allocations. An Investment Policy Statement provided by your firm can help.
A written investment policy statement puts front and center how and why a portfolio will be invested in certain securities. Ask your client to sign off on the plan before you touch their money. Not only will you protect yourself, you'll also be taking an important step toward increasing transparency and trust in your client-adviser relationship.
Don’t Help Clients Invest in Things They Don’t Understand
Maybe you have a great investment product or strategy that you think your client should adopt. You explain it to them, and they still seem confused. Maybe you give them some reading assignments for homework, but they still don’t get it.
While you might be frustrated because you’re making a recommendation that you know is in their best interest, you should never push a client into an investment, strategy or financial product that could later cause a client to feel cheated or misled.
Those are two things that are likely to get you sued or to prompt a client to file a regulatory complaint against you.
That being said, while it may be easy to avoid investing a client’s money in something obviously unsuitable, it’s harder to know what to do when a client wants to retire in 20 years but is afraid to invest in stocks to build the needed nest egg.
This is where education comes in. You may be able to gradually increase their risk tolerance by increasing their financial literacy. However, you can’t push them before they’re ready.
Check In Often
Provide regular, accurate and understandable account statements to your clients, along with a written summary of what has changed since the last statement. Follow up to ask your client if they’ve reviewed the statement and if they have any questions.
Ask them if their portfolio is performing in line with their expectations. By doing these things, you will stay on top of how your clients are feeling about their investments and about your advice. Being proactive in this way can help you get ahead of any problems.
More important, it makes you a good adviser who is genuinely engaged with clients. If you wait for clients to approach you, and if you assume that their silence means everything is fine, you won't know if a problem is brewing.
Checking in regularly also allows you to adjust your client’s portfolio and investment strategy as their life changes. It’s especially important to be aware of family, health, and job changes.
If a client threatens a lawsuit, and if you can’t resolve the problem on your own, propose mediation as a solution. Mediation is an informal, voluntary process, where a neutral third party will help you and your client find a mutually agreeable solution using a method that’s faster and cheaper than arbitration or litigation.
The FINRA mediation process has a great success rate of resolving four out of five cases. Assure your client that if they choose mediation, they don’t have to accept the settlement. They retain their right to arbitrate or litigate if the mediator can’t find a mutually satisfactory outcome.
How Often Do Financial Advisers Get Sued?
In 2021, 14,311 complaints were made by investors. Though not all of these complaints resulted in a lawsuit, this was roughly an 162% increase in complaints from the year prior.
How Can Financial Advisers Avoid Lawsuits?
There are many practical steps advisers can take to avoid lawsuits. Being transparent, asking for transparency back from your client, safeguarding client assets and information, and ensuring proper insurance coverage are all great measures to protect you and your firm.
When Can Financial Advisers Get Sued?
Financial advisers are fiduciarily responsible for safeguarding their clients assets and acting in their best interests. If the adviser can demonstrate that their actions were well-intended regardless of the outcome, the financial adviser is often not guilty of any crime. However, if an adviser's actions are ill-mannered or not in the best interest of their client, the client may have basis for a lawsuit.
The Bottom Line
Even the most conscientious adviser who gives careful attention to each and every client can get sued. The behavior of financial markets is beyond any adviser’s control, and when even the most soundly constructed portfolio loses money, a distressed customer may look for a scapegoat and a way to recoup their losses by calling a lawyer and looking for wrongdoing.
Following the practices described above will minimize the chances that a client ever files a lawsuit against you.
Author's note: Two Certified Financial Planners, Simon Brady and Paul Ruedi, Jr., contributed to this article.