Custodian of Funds / Lost Accounts

Part 8:  The Investment Advisors Guide to Errors & Omissions Insurance

  By Gary Sutherland, CIC, MLIS

Since the Madoff affair there is heightened scrutiny for advisors who provide investment advice and hold client funds. As a result, such scenarios are rarely seen in the RIA retail community where errors & omissions premiums fall into expected ranges. The hedge fund space is where this might be seen more often, but even there, prime brokers are involved and asset managers are separate entities from the partnership or LLC.

Changes to the applications themselves are usually driven by sudden changes within the risk exposures, and they usually follow a wave of claims that underwriters believe they can avoid with better applicant screening.

The Madoff case was a good example of a single event changing the Application. With all the press coverage surrounding the case, insurance carriers identified a critical weakness or exposure, and they made changes to the application to better protect themselves from large claims involving theft of client’s funds, Ponzi schemes, and other forms of fraud. Keep in mind that errors & omissions insurance will not cover criminal activity, but the carriers inevitably incur legal fees and ancillary cost when their insureds are caught in the middle of a Ponzi scheme.

One major carrier’s application now includes the custodian question below:

Are you associated with, or consult with any broker-dealer, investment advisor or investment manager who does not use an independent third party as a custodian for client funds?

This carrier not only wants to know if you advise clients and hold the clients funds, but it also inquires about anyone who is affiliated with your firm.

Generally insurance policies are designed to cover one specific exposure. An errors & omissions policy is designed to cover mistakes made in rendering professional services (as defined in the policy), as opposed to theft related claims. Because of the potential of being involved in an unrelated claim, underwriters want to proof that the applicant firm also carries a fidelity bond, ERISA bond, or other forms of employee dishonesty insurance.

We are often asked this common follow-up question: does this mean I can never accept checks from clients or essentially handle or take possession of client assets? Our response is no; however whenever possible avoid it, and have client funds sent directly to outside custodians.

Lost Accounts

Underwriters often ask about lost accounts to assess any potential problems or red flags with the investment professional’s handling of their business. In the normal course of business accounts do come and go. However atypical volume of client turnover will raise underwriter concern. Atypical volume includes:

– A high number of accounts leaving as a percentage of the advisor’s business, or
– Large dollar assets leaving the firm as a percentage of the firm’s AUM.

Your application may include questions such as:

1. Number of accounts lost in the last twelve (12) months?
2. Total assets for accounts lost in the last twelve (12) months?
3. Reasons for loss of accounts: ________________________________________________

Often the answer is simple and easily understood, and addresses any concern. As we have stated before, the key is to provide a clear, definitive explanation, and to avoid any lingering underwriter doubts.

Conclusion

Understand that inadequate answers regarding lost accounts may give rise to either higher premiums or outright rejection of your application. Consistently detailed explanations are recommended, rather than appearing to avoid the legitimate cause for concern.

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Contact us for additional information:

Gary Sutherland, MLIS, CIC    Garys@mcgowanprofessional.com    508-656-1350