E&O Insurance: Insights to the Broker-Dealer and Carrier Relationship

Barbara A. HalperPrincipal/CEOFR Consulting Services, Inc.

Conrad M. Deneault, Jr.Senior Vice PresidentThe David and Henry Co.

Brandon S. ReifManaging Partner, Los Angeles Winget Spadafora & Schwartzberg LLP

Presentation Outline

1. BROKER/DEALER E&O TRENDS

2. COMMON E&O COVERAGE GAPS

3. OBTAINING/RETAINING ALTERNATIVE PRODUCT COVERAGE

4. LOSS OF COVERAGE/COVERAGE RESTRICTIONS

5. CARRIER RESPONSE TO CLAIM SUBMISSION

6. MULTIPLE CLAIMS VS. SINGLE CLAIM

7. FINRA STATISTICS

8. RISK MANAGEMENT STEPS TO IMPROVE THE ODDS

E&O Insurance: Insights to the Broker-Dealer and Carrier Relationship

BROKER/DEALER E&O TRENDS

a. E&O experience typically lags FINRA statistics by 12-18 monthsi. Carriers are paying on the claims filed in 2010-2011 ii. Alternative products involved in a significant percentage

1. 2009-2011 focused on Regulation D offering (Private Placements)

2. 2012-2013 focusing on TICs and Registered Non-Traded REITs and BDCsa. Revaluationsb. Reduced or eliminated distributions

3. 2012-2013 focusing on inadequate due diligence and point of sale (concentration and illiquidity)

b. Coverage restrictions, higher retention levels, price increasesi. Product class exclusionsii. Product class sub-limits of liability (Reg. D/Non-Traded)iii. Increased retention levels and/or coinsurance

c. Much more in depth underwriting-longer cyclei. Product-Specific (not sponsor) underwriting information

requiredii. Blanket Alternative Product coverage much more difficultiii. Annual renewal process is more rigorousiv. Carriers may decline to renew policies that did not even cause

losses

BROKER/DEALER E&O TRENDS

COMMON E&O COVERAGE GAPSa. Incorrect policy terminology can lead to coverage issues. Most

underwriters do not fully understand the nuances of alternative products i. Example Endorsement

COMMON E&O COVERAGE GAPSa. Incorrect policy terminology can lead to coverage issues. Most

underwriters do not fully understand the nuances of alternative products i. Example Endorsement

a. Incorrect policy terminology can lead to coverage issues. Most underwriters do not fully understand the nuances of alternative products ii. Actual endorsements used by E&O carriers todayiii. Coverage pre-requisites based upon incorrect terminology

and/or underwriter’s lack of product understanding creates coverage issues1. Accredited Investor requirement for Registered, Non-

Traded securities2. Lack of product understanding

COMMON E&O COVERAGE GAPS

b. Policy Exclusionsi. Alternative product coverage remains subject to product-

specific exclusions1. Hedge Funds/Fund of Funds2. Promissory Notes (Debentures?)3. Futures/Commodities4. Options/Derivatives (Structured Products?)5. Unregistered Securities (Municipals and Government?)

ii. Trade Error/Cost of Correctionsiii. Severability of Prior Knowledge condition

COMMON E&O COVERAGE GAPS

b. Policy Exclusionsiv. Distressed Product/Entity Endorsements

COMMON E&O COVERAGE GAPS

c. Inadequate policy limits vs. exposure

COMMON E&O COVERAGE GAPS

OBTAINING/RETAINING ALTERNATIVE PRODUCT COVERAGE

a. Demonstrate broker-dealer policies/procedures in 2 key areas: due process and supervision

b. Product Approval Due Diligencei. Thorough checklists (sponsor and offering)ii. Independent third party reports with background check on

principalsiii. Experienced firm personnel performing due diligenceiv. Specific due diligence on a per-offering basis (not sponsor level)v. On-going monitoring of the sponsor and offering after the sale vi. Training of the representatives (the offering and suitability)

1. Representatives need to understand the product 2. Representatives must understand the suitability

characteristics of the productvii. Involve your sponsors!

1. Participation in the due diligence process2. Participation in the training of representatives3. Access to wholesalers, principals and headquarters4. Proof of sponsor level E&O/D&O

c. Point of Sale Supervisioni. Customized disclosure formsii. Customer attestations of material risksiii. Net worth and income verification beyond checking boxes

1. Net worth statements (assets vs. liabilities)2. Tax returns3. Banking statements

iv. Investor’s prior experience verification1. Prior broker-dealer account statements 2. Prior alternative investment transactions

v. Concentration limits as % of liquid net worth and total portfolio liquidity1. Per alternative investment2. Per alternative product sector3. All alternative investments4. Verification of other account holdings

OBTAINING/RETAINING ALTERNATIVE PRODUCT COVERAGE

LOSS OF COVERAGE/COVERAGE RESTRICTIONS

a. E&O policies are Claims-Made policiesi. Upon expiration, the policy coverage terms are gone foreverii. Coverage terms can change dramatically from one year to

next1. Underwriters can restrict or eliminate coverage for

problem exposures at each renewal cyclea. Problem product classes (TICs/Viaticals/Life

Settlements)b. Problem sponsors (Medical Capital/DBSI)

2. What coverage is in place today is unimportant. It is the coverage in place at time of claim that counts.

b. Loss of Coverage Strategiesi. Product Class (Reg. D and Hedge Funds)

1. Provide granular information on the individual products offered within the class to salvage offering-specific coverage a. Due diligence by offeringb. Suitability proceduresc. Product performance data

2. Be prepared to accept increased retentions and/or sub-limits of liability on certain product classes

3. Last resort: purchase the extended reporting period (ERP) under the expiring policy to maintain coveragea. Example: Heavy TIC exposure. Loss of TIC coverage

at renewal. Purchase ERP on expiring policy, and accept new policy.

LOSS OF COVERAGE/COVERAGE RESTRICTIONS

b. Loss of Coverage Strategiesii. Specific Product. Past examples include DBSI, Medical

Capital, Provident Royalties, Striker Petroleum, Desert Capital, and others. Underwriter will exclude upon renewal cycle.1. Utilize Notice of Facts/Circumstances Policy provision to

preserve coverage2. Provide details, including product name, number of

investors, amount invested, and facts which cause expectation for possible future claim

LOSS OF COVERAGE/COVERAGE RESTRICTIONS

CARRIER RESPONSE TO CLAIM SUBMISSION

a. How does carrier respond to the tender of a claim under the E&O policyi. Acceptii. Denialiii. Reservation of Right

CARRIER RESPONSE TO CLAIM SUBMISSION

b. Denial or Reservation of Right i. Coverage issues raised by the pleading

1. Allegation of intentional actsa. Fraud, deceit, and other illegal or wrongful actsb. Knowing breaches of fiduciary duty

2. Open-ended demands 3. Products not approved by the broker-dealer

ii. Exclusions in the insurance policy1. Certain types of products2. Certain types of relief

a. Punitiveb. Civil or criminal fines, penalties or sanctionsc. Rescissiond. Injunctive or declaratory relief

3. Prior Actsa. Claims arising from acts or omissions prior to the

date of the insurance policyb. Retroactive dates

CARRIER RESPONSE TO CLAIM SUBMISSION

c. Policy limits applyi. If plaintiff/claimant receives a judgment in excess of liability

limit, insurance carrier will not indemnify insured for the portion of the judgment that exceeds the liability limit

ii. The “burning” limits

d. Grounds for rescission of insurance

CARRIER RESPONSE TO CLAIM SUBMISSION

e. Practical advice for the insuredi. Full disclosure in the insurance policy applications

1. Accurate disclosures may mean no coverage, sub-limits and/or larger premiums

2. But, inaccurate disclosures will haunt you later and may result in rescission

ii. Review the E&O policy as part of the new product due diligence evaluation

iii. Contact your insurance broker before approving a new product

iv. Contact your insurance broker to tender claims and to interface with carrier

v. Minimize moves to new carriersvi. Do not under-insure

1. WFP Securities Corp. publicly disclosed $30-plus million in claims, $1 million insurance

2. AFA Financial Advisors, LLC publicly disclosed $23-plus million in claims, $5 million insurance

MULTIPLE CLAIMS VS. SINGLE CLAIM

a. Different claimants involving the same investment product: is it a single claim or multiple claims?i. If treated as a single claim, the carrier will only cover up to

the maximum per limit policy amount. The insured is then responsible for additional claims stemming from the disputes

ii. If treated as multiple claims, the insured is entitled to payment up to the policy limit for each individual claim

b. The Ninth Circuit Court of Appeal treats claims from individual claimants against the same representative stemming from the same investment product as multiple claimsi. Fin. Mgmt. Advisors, LLC v. Am. Int'l Specialty Lines Ins. Co.,

506 F.3d 922 (9th Cir. Cal. 2007)1. Two separate claims are not logically related simply

because two claimants blame the same representative2. Investors are unrelated where they have unique

investment objectives or unique financial situations

MULTIPLE CLAIMS VS. SINGLE CLAIMc. Practical significance for the insured

i. Multiple claims are a double-edged sword1. The insured may have more money for policy limits toward

defending multiple claims2. But, the insured will have to pay deductibles for coverage of

each claima. When the insured is facing dozens of claims from the

same investment product(s), the deductible costs pose a financial concern (net capital issues)

d. Bottom line i. Whether the insured wants the carrier to treat claims involving a

single investment product as a single claim or multiple claims is determined on a case-by-case basis

ii. It is very common that the insured and the carrier will reach competing opinions

iii. Leaves room for settlement negotiations between carriers and the insured

iv. Consider negotiating informal resolutions with carriers – they are better funded to litigate and in no need of prompt resolution

FINRA STATISTICS

a. 69% of all cases result in some form of payment to the claimants (direct settlement, mediation, and panel award) i. Only 19% resolved at hearing

1. Of these, only 45% result in claimant award!

b. We want more cases to go to full hearing i. Well positioned, defensible casesii. Effective risk management leads to well positioned cases and

increased odds

RISK MANAGEMENT STEPS TO IMPROVE THE ODDS

a. Documentation-foundation to a successful claim defense i. Make a claim go away early

1. Claimant attorneys work on contingency2. Make the case less attractive and they are apt to move

onii. Inadequate documentation = “He said, she said” argument

1. FINRA stacks the deck in favor of the investor. “He said, she said” argument are losers

2. We are concerned with what we can prove

RISK MANAGEMENT STEPS TO IMPROVE THE ODDS

b. Memorialize all substantive phone calls/meetingsi. Phone call notesii. Meeting Notesiii. Follow-up lettersiv. Firm level documentation/risk management

1. Active account letters2. “Happiness” letters3. Negative and/or affirmative consent letters4. Concentration limits (any one product/product class)5. Firm-Specific specialty disclosure requirements

a. Alternative product investor suitability affirmationb. Portfolio concentration customer acknowledgementsc. “Exception” reports