One-Man Think Tank: Six steps to avoid getting sued and having your reputation destroyed in the bargain

Elizabeth’s note: Ron Rhoades, RIABiz’s One-Man Think Tank columnist, plans a series of columns on the risks faced by RIAs to their greatest asset: their reputations. This column is about the risk of litigation. As an RIA and a lawyer, he writes with authority on the subject.

Faith Baldwin once wrote, “Character builds slowly, but it can be torn down within incredible swiftness.” The parallel to the reputation of a registered investment advisory firm is strong; with only one stumble, and even without either adverse intent nor neglect, the reputation of a firm, and with it the firm’s future, can instantly become unraveled.

The “risk assessment” part of the Annual Compliance Review required of each SEC-registered RIA firm (which is also required of many state-registered firms), grades possible risks to the firm. Each time I’ve undertaken the review, I’ve noticed that the risks perceived to be greatest to our firm are identified as those circumstances which, if they were to occur, would result in damage to the firm’s public reputation.

Loyalties tested

Why? The answer is that even with sound explanations of a publicly disclosed adverse event, potential new clients would likely avoid the firm altogether. Potential clients rightfully adhere to the old adage, “Where there’s smoke, there’s fire.” Even the loyalties of long-time clients would be tested by any adverse publicity involving either the firm or any of its employees.

Just one of the major risks facing an RIA firm today is that resulting from a dispute with a client making its way to a public forum. Should a former client sue an RIA firm, the resulting reputitional damage to the firm could be catastrophic – regardless of the merit of the client’s complaint. There are many ways to mitigate this risk, however, through sound practice management policies and procedures.

First, be careful in accepting new engagements. Does the potential client possess any history of litigation? Does she or he speak ill of prior advisors? Does the prospect’s personality profile fit with the firm – and the specific advisor assigned? Is the prospective client requesting services the firm does not normally provide?

Second, define the client’s, and firm’s, expectations in advance, and in writing. Don’t over-promise as to what the firm can deliver. Adopt monitoring procedures to ensure that services that are promised are delivered within the established time parameters. Never guarantee investment performance. As part of this exercise, have each advisor proactively explore with the client the historical volatility of the client’s investment portfolio. Ensure the client understands that the RIA firm and its advisors do not possess a “crystal ball.” [If you do profess to be able to time the market, or engage in tactical asset allocation, or pick fund managers or stocks, share with clients that there are limits on anyone’s ability to forecast future events, and, regardless of any past record of success, there can be no assurance that your wisdom or insight will prevail to secure superior returns in the future.] And don’t forget to document the client’s investment strategy in a well-worded Investment Policy Statement, signed by the client.

Third, temper your clients’ fears of market value declines and/or economic uncertainty. Many clients harbor such fears; tempering them remains a large part of the RIA’s value proposition. In our firm we actively inform clients, during good markets, that “the market does not always go up … there will be times, often unpredictable, when the market goes down sharply and stays down for prolonged times.”

As part of counseling the client during market downturns, seek to understand the “emotional brain” we all possess. The rational brain possesses limits in its ability to counter strong emotions (such as fear). Learn how to better counsel clients to counter ad hoc, emotional, and usually wrong, reactions to short-term market events.

Firing a client

Fourth, don’t hesitate to fire a client who fails to adhere to the investment strategy previously agreed to. Explain to the client that you do not feel like you can add value for him or her, when the client fails to adhere to the advice given.

Fifth: Unless clearly barred by your state’s laws, every client services agreement should possess an arbitration clause. But note this – unless you are dually registered, do not select FINRA to provide the arbitration. Rarely do FINRA’s arbitrators understand your business as an RIA, Moreover, clients perceive industry-controlled arbitration to be inherently unfair. While much controversy exists regarding whether mandatory arbitration – even in a neutral forum – is a fair requirement to request of the client of a fiduciary advisor, the fact of the matter is that arbitration often results in less costly resolution of disputes, and it can keep claims without merit out of the public eye.

Sixth, and finally: if an adverse event does occur, make every attempt to make the client whole. Where larger sums are involved, seek proper legal counsel to advise during any negotiations with a client who may have suffered harm, to prepare appropriate settlement documentation (including confidentiality covenants), and to advise on the timing and manner of any required notifications to regulatory bodies and industry associations.

There are many other risks which could endanger an RIA firm’s reputation, including employee embezzlement or misappropriation of a client’s assets, failure in due diligence processes, failure to avoid or disclose (and, even with disclosure, properly manage) conflicts of interest, material violations discerned in regulators’ examinations. I’ll return to these in future columns.