By Suzanne Barlyn
April 8(Reuters) - Choosing professional liability insurance is often a daunting process for financial advisory firms, leading many to gloss over the fine print or skimp on coverage. That can prove to be a costly misstep.
Coverage limits and exceptions may be tricky to decipher. What's more, steep premiums may tempt some firms to buy cheaper, less comprehensive coverage.
But making a mistake can ultimately leave brokerages and other investment advisory firms holding the bag for hefty legal expenses if problems with regulators crop up or clients sue.
A federal court ruling that recently went against David Lerner Associates, a New York-based brokerage, illustrates what could go wrong if a firm fails to line up proper coverage.
Judge Joseph Bianco of the U.S. District Court for the Eastern District of New York found that the firm's policy from the Philadelphia Indemnity Insurance Co did not cover claims stemming from performance of 'professional services,' according to a March 29 opinion. The company is a unit of the Philadelphia Insurance Cos, which is owned by Tokio Marine Holdings Inc .
As a consequence, the court said the insurer had no obligation to pay for the firm's legal defense in a class action lawsuit and separate regulatory action that led to a $12 million settlement to customers who bought into a $2 billion real estate investment trust.
In essence, the court said the Lerner firm's responsibility to conduct due diligence on the REITs it sold - which regulators and plaintiffs said was not adequate - was a type of 'professional service' excluded by the coverage. The insurance covered only misdeeds by company officials.
Philadelphia Indemnity declined to comment. A Lerner spokesman said the firm is considering whether to appeal.
It is uncertain whether Lerner misunderstood its policy or it was simply trying to save money. What's clear is that many small brokerages face challenges when selecting coverage.
Securities industry rules require brokerages to buy a fidelity bond, insurance that protects customer assets in limited circumstances, such as employee theft.
But it will not cover legal expenses for regulatory actions or rulings to pay customers in arbitration and court cases, said Joel Beck, a Lawrenceville, Georgia, lawyer who advises brokerages on regulatory issues.
That is when a type of policy known as errors and omissions coverage, or professional liability insurance, can help. While no policy is air-tight, some cover more than others.
Make no mistake, brokerages that commit fraud or illegal acts should not expect any slack. 'No one is going to insure you for your own deliberate conduct,' said Matthew Farley, a lawyer for Drinker Biddle & Reath LLP who advises brokerages on regulatory issues.
But other areas are less clear-cut, and sparring with an insurer in court after a firm rings up big legal fees is no way to determine what is covered. Legal defense bills for a regulatory enforcement action can set a firm back $500,000 or more, say lawyers. And fighting a class-action can run into the millions - that does not even account for any damage awards.
Certain policies make a poor fit for some firms. They may exclude, for example, coverage for selling privately traded securities, said Jessica Thayer, senior vice president at Theodore Liftman Insurance Inc, a Boston-based insurance broker.
Brokerages may also need to ask insurers to change certain boilerplate language, Thayer said. The standard policy, for example, may not spell out that the insurance pays for defense costs through the final outcome of a legal proceeding. In many cases, insurers will agree, she said.
CHEAP IS DEAR
Some firms find insurance contracts so puzzling they decide to skip professional liability coverage altogether.
For other small brokerages - typically those with 100 brokers or less - high premiums and limits on coverage can deter them from buying insurance, said Frank Vento, head of the investment management practice for Marsh Inc, a global insurance broker and unit of Marsh & McLennan Cos.
Premiums for $1 million of coverage - the minimum a firm should consider - vary depending on many factors but can run as high as $50,000 per year, said Vento. Even then, firms usually have to pick up the first $100,000 of legal defense costs. Some small brokerages are not able to get coverage, depending on factors such as previous insurance claims, Vento said.
Premiums generally cost less for registered investment advisers (RIAs), which typically charge a flat fee for services based on a client's assets under management.
RIAs that manage $1 billion or less can pay under $20,000 a year for coverage because their work is typically less risky than selling individual securities, Vento said.
That's because RIAs must recommend what is in their clients' best interests, whereas brokers can recommend what is 'suitable' based on factors such as risk tolerance and age. But what is 'suitable' may not turn out to be best for clients, leading to more frequent claims against brokers, say lawyers.
Some smaller firms often cut corners by buying only a policy that covers misdeeds by the management, known as directors and officers liability insurance, instead of professional liability coverage for the firm's actions, said Vento. But the potential savings of tens of thousands of dollars will not matter if coverage does not kick in when a problem crops up.
Last week's court ruling against David Lerner Associates spotlights those limits. The firm had directors and officers insurance but not professional liability coverage for the matters at issue in its legal woes, its spokesman said.
(Reporting by Suzanne Barlyn; Editing by Lauren Young, Frank McGurty and Richard Chang) Keywords: INSURANCE COVERAGE/BROKERS
(Suzanne.Barlyn@thomsonreuters.com)(646-223-8550)(Reuters Messaging: email@example.com)
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