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BD/IA Risk Review – August 2020

Financial, Executive and Professional Risks (FINEX)|Investments

By Brian Cavanaugh , Jack Jennings and Jeremy Sokop | July 31, 2020

Risk and insurance considerations and approaches.

Department of Labor proposes new “fiduciary” standard

On June 30, the Department of Labor (DOL) proposed a regulation titled “Improving Investment Advice for Workers & Retirees.” Many view this new rule as a replacement of the vacated Fiduciary Rule, which was struck down by the Fifth Circuit Court of Appeals in 2018. The new proposed rule would allow exemptions for currently prohibited transactions relating to the management of retirement investments.

Under the exemptions, financial institutions and investment professionals providing advice to retirement investors may be permitted to receive a wide variety of currently prohibited compensation, including “commissions, 12b-1 fees, trailing commissions, sales loads, mark-ups and mark-downs, and revenue sharing payments from investment providers or third parties.” This new exemption would apply to “registered investment advisers, broker-dealers, banks, and insurance companies (financial institutions) and their individual employees, agents, and representatives (investment professionals)” that provide fiduciary investment advice to retirement investors. Per the DOL, “The exemption also would allow Financial Institutions to engage in principal transactions with Plans and IRAs in which the Financial Institution purchases or sells certain investments from its own account.”

Crucially, per the DOL, qualification for these exemptions are conditioned upon satisfaction of the Impartial Conduct Standards, which include “a best interest standard; a reasonable compensation standard; and a requirement to make no materially misleading statements about recommended investment transactions and other relevant matters.” The original five-part fiduciary test in effect since 1975 under the Internal Revenue Code and ERISA is unchanged by this new rule. Noted, the DOL was careful to draft the new regulation in concert with the SEC’s Regulation Best Interest (Reg. BI) which went into effect June 30, 2020; the intent being that registered reps in compliance with Reg. BI would also be deemed in compliance with the requirements of this new rule.

What does this all mean for E&O and D&O purchasers? It’s possible this new rule will result in a net benefit for the wealth management industry from a “cost of insurance” perspective. Assuming wealth managers take advantage of the exemption, we might view this safe harbor for E&O/D&O purchasers as decreasing the overall volume of claims from a regulatory enforcement perspective (considering both FINRA/S.E.C.). It’s certainly worth noting that policyholders and their brokers should review their regulatory investigations coverage to ensure it provides the same or similar level of coverage for DOL investigations as is provided for SEC and/or FINRA investigations. It remains to be seen which agency(ies) will enforce any violations of this safe harbor and whether violations will be costly.

As we’ve discussed in many prior articles, some limited investigation coverage is available for BD/IA E&O purchasers, and clients should be demanding it. This coverage may only be available on a sub-limited basis; however, it’s often available with a substantially lower deductible — in many cases $0 for both the firm and the registered reps/advisors. We have successfully designed and implemented higher regulatory coverage beyond the primary insurer’s willingness to provide. This coverage is becoming a critical asset for an increasing number of clients, and we highly recommend it.

The industry strikes back

Over the past several years, retail BDs have been beset by regulatory headaches relating to 12b-1 mutual fund fees and related disclosures. These headaches have taken the form of SEC industry exams, the defense of which has left some firms out of pocket tens or hundreds of thousands of dollars — in some cases defense bills have run in the millions.

However, since April, industry groups have been pushing back in response to the SEC’s “regulation by enforcement” approach — and with good reason. The SEC also announced in April that they would take a “regulation by enforcement” approach to the newly implemented Regulation Best Interest. While the full cost of Reg. BI compliance remains to be seen from an enforcement perspective, if it resembles anything like 12b-1 fee and disclosure examination and enforcement, regulatory defense expenditures could be in for a major upswing in 2020/2021.

Where does E&O coverage fall into the equation? Or does it at all? It’s commonly understood, BD/IA E&O policies are not a “litigation fund” that clients can call upon for every action as a plaintiff, or even in every action as a defendant; however, the policies are intended as a principal indemnification tool for lawsuits grounded in malpractice. The fundamental question regarding coverage is: “Can the practice of charging fees be deemed ‘malpractice?’” We think in the limited case of 12b-1 fees — and exams relating to those fees — that it depends on the facts and policy language but, based upon some of the language we’ve seen, yes, it’s possible. Coverage for these types of claims will hinge on the breadth of regulatory coverage in your policies (both D&O and E&O).

As we discussed above, regulatory coverage within BD E&O policies is fairly limited, including sub-limits which are often a small percentage of the policy limit. Additionally, the industry’s characterization of 12b-1 exams as “sweeps,” a term often carved out of regulatory investigation coverage, presents further coverage challenges. We previously discussed how D&O policies afford broader regulatory coverage; however, the broad E&O exclusions may be a challenge. In the event of a formal action in enforcement by the SEC, coverage issues like wrongful act triggers and satisfying the definition of claim become easier and more definite; however, coverage is still not without challenges. Depending on the length of time from the initial investigation to civil action, various reporting and notice issues can arise. This brings us back to the issue of the initial claim and adequacy of notice, how it was made and how would the policy respond.

The key takeaway is to ask your broker to secure as much regulatory coverage as possible in your D&O and E&O policies. Ensure that coverage is sufficiently broad so that all matters related to managerial malpractice are handled by your D&O policy; conversely, all matters related to investor malpractice and supervision should be handled by your E&O policy. Policy language should be adaptable with the changing regulatory environment and firm exposures.

Selling away – Insuring the unexpected

In our December and January Newsletters we discussed the importance of securing selling-away coverage in your E&O policy. A recent SEC Press Release detailing a $60M Ponzi-like scheme underscores that point.

Many broker-dealers and registered investment advisors feel they have a firm grasp on supervisory procedures, their product mixes and compliance protocols, among other considerations. However, selling-away coverage is still beneficial, even for the most diligent risk manager, due to the coverage’s core function: protecting against the unknown. Unfortunately, adding selling-away coverage may come at a significant cost — current market conditions include rapidly increasing rates. In addition to the cost burden, selling away may come with a higher retention structure than the master policy retention; however, we think the cost and risk retention are worth the spend this year, especially as greater swings in volatility may cause more cases like the one mentioned above to come to the surface.

Firms will want to carefully balance their claims histories, portfolio mixes, registered representative complaints and, of course, cost when considering additional investment in their insurance programs. There is no better tool to insure against the unexpected investor malpractice claim than selling away and no better year to do it.

Changing consumer behavior – Full-suite firms and their insurance programs

In past articles, we discussed a shift in the wealth management industry from commission business to advisory business. In speaking with several large retail investors, we have come to believe there may be growing demand in advisory business generally, but also for products and services offered by those advisors. It seems these investors are not alone. Per a March 2020 report by Research and Markets, “Trends to Watch in Wealth Management: 2020,” there will be a greater emphasis on “ensuring affluent and HNW clients’ credit needs are met. The use of technology will make specialist lending more accessible and economic for clients outside of the UHNW space.”

As investors close in on retirement aggregating services such as personal credit management, insurance and even travel services with one provider make a lot of sense. The question becomes: “As an advisor, am I insured for these services and to what extent? Secondly, to the extent these services may be offered on a one-off basis or as an ‘outside business activity,’ is my insurer willing to afford coverage for these types of services, or will I have to look elsewhere?”

Insurance carrier appetites for ancillary services vary greatly from carrier to carrier, but generally we find that the professional liability industry is a solutions-oriented one. Where one insurer is unwilling to offer coverage for a particular service or product, another market with greater flexibility will step in — perhaps with different terms and covenants accordingly.

The key takeaway is to take a full inventory of all services provided during the renewal process and discuss with your insurance carrier about services and products you want covered and those you don’t. If a carrier proposes a sub-limit or limitation on coverage with respect to one or more services, discuss with your excess carrier or perhaps a non-incumbent that might offer difference-in-conditions coverage to drop down as primary for specified services.

Cyber protection

On Wednesday, July 15,Twitter was hit by a massive hack including the accounts of Bill Gates, Kanye West, Joe Biden and Barak Obama, encouraging Twitter users to send bitcoin to cryptocurrency accounts. On Friday, July 17, it was announced that the FBI is investigating the attacks. Although firms are being even more cautious than ever, including investing tens or hundreds of thousands in IT infrastructure, the risks still include many unknowns carrying implications for coverages well beyond cyber, such as D&O, FI bond and even E&O.

Many firms are being faced with mandates from investors, service providers and outside directors to carry higher limits for cyber liability. While these mandates may be compulsory for firms, we view these mandates as opportunities to take a second look at the coverages in their existing cyber and FI bond programs. Centrally, firms should not only focus on the amount of coverage offered, but also the quality of coverages, including a focus on social engineering and fraudulent transfer theft scenarios. Some interesting data on point — the FBI Internet Crime Complaint Center reported an increase from 1,000 to 3,000 – 4,000 phishing cases daily. What does that mean for your insurance? It means a greater probability of a compromise to your network and thereby a greater likelihood of impersonation and fraudulent transfer requests — occurrences for which you absolutely want to be covered in the event of a loss.

The key takeaway here is that firms should look to increase their crime coverage 1:1 with their cyber to preserve the intent of the contractual mandates in ensuring adequacy of coverage. In addition to increasing the pure size of the policies, you may also want to enhance the quality of those programs by increasing social engineering sub-limits. In a growing number of claims we are finding that the standard coverage extensions of $100K – $250K may be enough to cover even the most favorable fact patterns. Working with a qualified insurance expert will help you to weigh the costs and benefits of each approach, but the point is to adapt to the changing universe of risk and consider revisiting these coverages as often as necessary to protect the assets of your firm.

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