Money - lots of it - is on the line, and that means "lawsuits are inevitable for financial planners," says Sheila Chesney, principal at Chesney & Co., a wealth management firm in Sheldon, S.C. Chesney knows that all too well. In recent years, a client couple with whom she thought she had "parted on good terms" have brought two actions against her.
"After our engagement was terminated, I received a nasty letter," Chesney relates. That led to a round of mediation, which was deemed unsuccessful. A bit later, Chesney was served in a civil lawsuit, which she has moved to dismiss. "It's cheap to file a suit," she says. "Lawyers may be hoping that the scare factor will get results."
Fortunately, Chesney says, she has thorough documentation that provides "hard evidence" to justify her actions. Hundreds of emails as well as recordings show that those clients were kept informed. Indeed, good record-keeping and client communications are keys to defensive financial planning in these litigious times.
"As professionals, financial planners need to protect themselves by carefully fulfilling their legal responsibilities," says Rick Kahler of Kahler Financial Group in Rapid City, S.D. "During my career in real estate and appraising, I appeared in court many times - usually as an expert witness. I've learned that a lawsuit is the last way to settle a professional dispute. The best way to stay out of court is to be comprehensive and complete in actions, words and documentation."
Mike Foltz, a principal at Balasa Dinverno Foltz, a wealth management firm in Itasca, Ill., agrees that words and documentation should complement savvy planning. "After practicing law for over 20 years," he says, "I believe that most lawsuits are the result of poor, infrequent communication. I do not believe an advisor can communicate too much with clients."
Client communications should be documented, and that documentation can begin with a well-designed investment policy statement. "An IPS is a critical tool that defines the responsibilities of the client and the advisor," Foltz says. "If drafted properly, it defines the parameters of the client's portfolio and how it is to be invested. The advisor must have systems to monitor his or her compliance with the IPS provisions." At a minimum, the statement should spell out a stocks-to-bonds allocation, which the planner should follow.
"A good IPS will spell out both parties' responsibilities," Foltz says. "While we monitor asset allocation, clients must tell us about changes in their personal situations that could affect their plans." Foltz suggests having a model statement reviewed by a lawyer, who can indicate whether it will support a planner's actions.
FOCUSING ON SUITABILITY
Beyond the investment policy statement, self-preservation is an ongoing effort. "All of our client contacts are thoroughly documented by writing notes or a summary after the contact," says Ernest Hathaway, the registered principal at Financial Strategies Institute in Midvale, Utah. "We strive to have every subject that we discussed mentioned in the notes, with particular attention to suitability and recommendations. Protecting ourselves from potential client lawsuits is a major concern at our firm."
Hathaway says that suitability (risk tolerance, objectives, circumstances) is updated at every client meeting and is documented in the notes. "For every unpleasant situation," he adds, "we follow up the client meeting with a letter that clearly states our warnings and recommendations. I recently sent a letter to a client telling him that he must spend a lot less or he's going to run out of money."
All notes, emails and correspondence are recorded at Financial Strategies Institute. "We use Redtail and Zimbra," he says, referring to client management and email programs. "Once entered, the documents cannot be edited or deleted by us. In addition, we regularly discuss suitability and risk issues at internal meetings so that our staff and advisors know that we are serious about being compliant. We also are implementing increased client contact between reviews, which we hope will help reduce misunderstandings and put us in a better position to quickly make needed adjustments."
Prudent advice construction is another vital part of defensive financial planning, according to Foltz. "For example," he says, "I like to shape investment recommendations by asking the client what will cause more anguish: missing out on some run-up in the market by being invested too conservatively or watching a portfolio drop in value because the stock-to-bond allocation is too aggressive. Usually, the response will help me tailor advice in line with the client's expectations."
IMPORTANCE OF INSURANCE
Even planners who give good advice and document it carefully can run into disputes. "Insurance should be the first line of defense for an advisor," Foltz says. "Every advisor needs a good professional liability policy."
Hathaway says his firm recently doubled the amount of errors and omissions insurance it carries. "Some arbitration hearings seem to be slated against the rep," he says. "Some of the judgments are huge. Without insurance, a serious amount could come out of an advisor's pocket."
According to Foltz, an advisor's liability policy can provide valuable hints. "Good insurance policies will limit the type of work the advisor may engage in," he says. "This may help an advisor determine problem areas that should be avoided." Options, derivatives, hedge funds and limited partnerships are among the investments that a policy might not cover; this means insurance companies are telling planners that these are high-risk areas.
Further tips for self-preservation may be found close to home. "Advisors should consider some of their own medicine," Foltz says. "Many states now have laws that shield trust assets from claims of creditors. Currently, Alaska, Delaware, Nevada and South Dakota provide the best protection against creditors while permitting the grantor access to trust assets. Advisors might build a nest egg in a trust formed under the laws of one of the mentioned states."
Similarly, Kahler recommends planners follow the same advice they give to clients in terms of asset protection. "That means the strategic use of trusts, domestic asset protection trusts, LLCs and corporations," he says. "Planners should use those entities to hold both their practices and personal assets. Of course, they should not be in the same entity."
Kahler believes most businesses should be owned by an LLC or a corporation. "The business should be held separately from personal assets such as real estate and liquid investments," he adds, "which could be held in various LLCs" and then owned by a domestic asset protection trust.
Chesney notes that an LLC is not impervious to charges of negligence or fraud. "You can be sued personally," she says. "Still, an LLC is worthwhile because it provides some protection. The most important thing, though, is to document everything, even things that appear silly at the time."
This practice has helped Chesney get through her current dispute. "First we went to mediation, which turned out to be a waste of time and money," Chesney says. "Mediation is designed to meet in the middle, but I felt I had done nothing wrong, so I didn't agree to anything."
Now that a lawsuit has been brought, she hopes for a favorable outcome because of the paper trail she created during the planning engagement. "All of our emails are journaled outside the company," she says. "It's critical to show the history of how you worked with clients."
Donald Jay Korn, a Financial Planning contributing writer, also writes regularly for On Wall Street.