Smart Steps Advisors Need To Take To Steer Clear Of Legal Trouble

Posted on March 2nd, 2020 at 1:27 PM
Smart Steps Advisors Need To Take To Steer Clear Of Legal Trouble
If you're lucky, you'll go your entire career without facing litigation. But even the most diligent advisors can get ensnared in legal trouble.
Advisors fall into legal hot water for many reasons, including poor documentation or bad judgment in managing client relationships. While blatantly unethical or illegal acts do occur on occasion, it's more common for advisors to trip up when they're not properly protecting themselves from potential liability.
Most advisors appreciate the importance of documenting client communication. But that doesn't mean they always follow through.
Consider this scenario: A client's portfolio plummets in a downturn. The disgruntled investor quits your practice and subsequently claims that you didn't explain investment risks clearly. Absent specific documentation, your legal exposure increases.
Proving that you made a client sign a disclosure form riddled with legalese may not absolve you. Educating clients in plain English about the risks provides an extra layer of legal protection.
"Stay away from esoteric, trickier, hard-to-explain investments," said Gregory Simon, a Chicago-based attorney. Even if you avoid alternative investments and stick with relatively straightforward funds, you still need to convey in clear language what the client is buying and what limitations and risks come with it.
"The more you spell things out for the client in layman's terms, the better," Simon said. If you describe an investment as "illiquid," for example, go a step further and stipulate in writing that the client "will not be able to sell this investment for five years."
Or if a client expresses a willingness to take "moderate risk" in investing, drill down to determine what that means. Quantify what outcomes the client would find tolerable.
"Terms like 'moderate' are kind of ambiguous," Simon said. It's better to get in writing that a client would feel comfortable if their portfolio dropped by, say, 10% or 20%.

Conflicts Of Interest

Aside from vague communication with clients, another challenge for advisors involves steering clear of conflicts of interest. Many financial planners say that they treat their clients as family, but such closeness can work against you.
While there's nothing wrong with socializing with clients, friendships might lead you to cross a legal line. You may not realize the impropriety of getting too involved in a client's business or personal life.
Avoid situations that introduce the possibility of conflict of interest, says Max Schatzow, an attorney at Stark & Stark, a law firm in Lawrenceville, N.J. For starters, don't engage in a side business deal with a client.
"It can be something like 'Here's an investment opportunity. Let's go into this together' or 'My brother is starting a business. Let's invest together,' " he said.
Never lend money to a client, borrow their property or accept extravagant gifts from them. And while it's not illegal to have a romantic relationship with a client, Schatzow sees it as potentially problematic.
"A lot of advisors are close friends with a client, so the line gets blurred between their personal relationship and professional relationship," he said.

Reporting Requirements

If an issue arises in a client relationship that concerns you, Schatzow suggests consulting your compliance team.
"If you're worried they'll say no, then what you're doing is probably not a good idea," he said. "Almost all conflicts of interest can be overcome with full, informed consent. But that shouldn't be left to the advisor," as compliance officers can provide proper guidance on how or whether to proceed.
Another legal pitfall lurks when planners dish out what Schatzow calls "self-serving advice that would generate some monetary or non-monetary benefit to the advisor." An obvious example involves selling commission-driven products without appropriate disclosure, but more subtle perils include urging clients to donate to a charity in which you serve on the board of directors or investing client assets in a mutual fund company that employs your spouse.
"There are all types of self-dealing out there even if you're not trying to do something wrong," Schatzow said.
Advisors who join a firm face a different type of legal issue at the outset: negotiating an employment agreement.
"Whether you're a broker or an RIA (registered investment advisor), never sign the first employment agreement or independent contractor agreement that the firm puts in front of you," said Stephany McLaughlin, a partner at Eccleston Law in Chicago. "The firm might say, 'This is a standard deal.' But you need a lawyer to negotiate on your behalf," especially to address "termination for cause" provisions and control and ownership over your client accounts.
With regard to regulatory reporting, advisors need to document their communications with their managers and compliance. Don't assume that the firm will handle your regulatory reporting in case of a compromise with creditors or bankruptcy.

Related Attorneys: James J. Eccleston, Stephany D. McLaughlin

Tags: eccleston, eccleston law, james eccleston, legal trouble, litigation, financial advisors

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Jim, Stephany and the whole team were a God send.  We felt like we were put into a situation where we had no advocate. Jim’s team came in with a strong, well laid out strategy on how to get our story heard. Where our outside compliance company had no ability to help, our Broker Dealer was impenitent, and the regulators were aggressive pursuing vague rules, Jim came like a barricade against an assault we did not understand. Though you pay member dues to be affiliated with FINRA and a B/D, you have no voice. The only thing that is truly heard in this un-level playing field is a bulldog’s bark like Jim’s. I would encourage anyone to call Jim and his team to find a real ally in the tough and complicated world of securities regulation. They are truly the best.

Greg P.


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