How Financial Advisors Can Protect Themselves Against Lawsuits

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.

This is protocol for financial advisors. But there are less obvious guidelines you need to adhere to ro avoid getting sued as a financial advisor – to avoid the major disruptions to your personal and business life that a lawsuit would bring. FINRA received 3,000 investor complaints in 2017, filed 1,369 new disciplinary actions, imposed $64.9 million in fines, barred almost 500 individuals and suspended 733. Consider these tips to avoid becoming a a cautionary tale about what not to do as a financial advisor.

As an investment advisor, 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. You tell your client about the importance of providing complete and accurate information and let them know that your recommendations will be affected if they give you incomplete or inaccurate information. The Certified Financial Planner Board’s Practice Standards say that advisors who cannot get the information they need shall either “restrict the scope of the engagement to those matters for which sufficient and relevant information is available; or terminate the engagement.” This is a solid standard to follow even if you aren’t a CFP®.

If you’re bold enough, you might go a step further and ask clients point blank: “Is there anything you haven’t told me because you think it’s embarrassing? Because I’ve probably seen it before.” Explain that you can’t do your job if they don’t tell you about their gambling problem, their mistress, their failing business, their shopping addiction, their parent’s constant guilt trips for financial help, their hidden account, the tax returns they haven’t filed, or whatever the secret might be. It may be easier to encourage clients to to disclose this private information if you remind them that financial advisors 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. (See: Tips on How Financial Advisors Can Talk to Clients.)

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 advisors to disclose all the information a client needs to make an informed decision about working with a professional and taking his or her advice. Clients need to know about any past, present or 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.

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 up front, you can reduce your risk of being sued and present a stronger defense if you are sued. (See: Asset Manager Ethics: Disclosures.)

Keeping your clients' information safe from cyber attacks is key. Financial advisors are natural targets for hackers because they manage large amounts of money. As an advisor, 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 keeping client information safe is crucial for maintaining the trust of your clients and the credibility of your practice.

In addition to training about how to keep your clients' information safe, if you have employees, they should be trained in best practices in all areas of client relationships. Diligently supervise all members of your business so you are in the loop about how they are handling client information and what 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 advisor 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.

You don’t have to take on every potential client who approaches you—and while you should not discriminate based on factors such as skin color or gender, you should always be selective, even when business is slow. In an initial phone conversation or meeting, you might spot red flags in a prospective client. Perhaps they are not being 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 or who might have family drama; these circumstances could put you in stressful and even litigious situations. (You should, however, report and seek help for victims of suspected financial abuse.) Clients who have unreasonable expectations about what you can do for them or who seem uncomfortable with giving you the necessary authorizations to manage their money may also be too risky. (See: Advisors: Here’s How to Handle Difficult Clients.)

Financial advisors need errors and omissions insurance to protect themselves against claims of negligence, breach of fiduciary duty or lack of regulatory compliance that clients might bring. 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 if you’re ever hit with a lawsuit. Make sure the policy covers your employees, too. Cyber liability insurance can provide another layer of protection in the event of a hack. (Learn more: What Advisors Must Know about Professional Liability Insurance.)

Do your clients understand investment risk and the possibility that the money they’re entrusting 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 a risk of loss that they should be prepared to bear; that there is no such thing as a guaranteed investment; that past performance does not guarantee future results; and so on.

But clients might just gloss over this disclosure before signing it, if they read it at all. And they might underestimate their own risk tolerance. That’s why rather than asking vague questions like “How much risk tolerance do you have?” it’s more helpful to ask questions like “How would you react if your retirement portfolio lost 25% of its value in one year? How would you feel, and would you want to sell some of your investments, do nothing, or buy?" 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 they have the psychological ability to. (See: Risk Tolerance: Why Advisors, Investors Mess It Up and The Importance of a Client’s Risk Assessment.)

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, to help them understand your approach and your recommendations. And 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 from the get-go.

In addition to providing a basic level of investment education, which may take a significant effort for a client with little to no investment background, you want your client to understand why you are recommending that they put their money in particular investments. In addition, if you're recommending a specific asset allocation to help your client achieve their goals, they should understand the reasoning behind that recommendation.

In addition to explaining to client how their portfolio will be invested and why, you should provide a written investment policy statement reiterating that information. Require 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 to increase transparency and trust in your client-advisor relationship.

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 get 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, such as small-cap international stocks for an 80-year-old retiree with a low risk tolerance, it’s harder to know what to do when a client tells you they want to retire in 20 years but you know they won’t have a large enough nest egg to do that without investing in stocks—which they’re afraid to invest in. This is where education comes in: you may be able to gradually increase their risk tolerance by increasing their financial literacy. But you can’t push them before they’re ready. (See: Investment Suitability 101.)

Similarly, let’s say a client approaches you about investing in bitcoin or another cryptocurrency, but they don’t understand how it works. Saying, “No problem, I’ll handle everything for you!” is a recipe for disaster if the investment doesn’t perform as the client hopes. (See: Do Advisors Have a Fiduciary Responsibility to Offer Bitcoin?)

Provide regular, accurate and understandable account statements to your clients along with a written summary of what has changed since the last statement. Then 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 advisor who is genuinely engaged with clients. If you wait for clients to approach you, and if you assume their silence means everything is fine, you might have a problem brewing.

Checking in regularly also allows you to stay on top of adjusting 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. 

Even the most conscientious advisor who gives careful attention to each and every client can get sued. The behavior of financial markets is beyond any advisor’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. But 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.