Errors and omissions coverage for securities brokers.

• Author: Pratt, Scott T.

ON "Black Monday," October 19, 1987, the Dow Jones industrial average plummeted 508 points--more than 20 percent--to 1738.74, becoming the largest single-day drop in that average in the history of the stock market, even exceeding the crash of October 29, 1929. One of the effects of Black Monday has been increased litigation between disgruntled investors and their securities brokers. That effect has not been felt uniformly but has resulted in much more litigation against the national wire houses than against broker-dealers in the financial planning arena.

Just when the statutes of limitations began to run on claims arising from Black Monday, investments in high-yield bonds and, more recently, limited partnerships have provided fertile ground for investor claims. The expanding array of investments available to the public has led to increased litigation between customers and brokers.(1) Data compiled by Securities Arbitration Commentator reflect a 559 percent increase in cases filed with self-regulatory organizations (SROs) between 1980 and 1992.(2) The most dramatic increase occurred between 1987 and 1988, when claims filed in arbitration grew from 4,358 to 6,101, a 40 percent increase.

It should be noted that the increase in claims filed in arbitration may reflect movement away from courts to the SROs as the forum for resolving disputes. This may be attributed to the U.S. Supreme Court's decision in Shearson/American Express Inc. v. McMahon,(3) in which the enforceability of an arbitration clause contained in a customer agreement between an investor and a brokerage house was upheld. Most brokerage houses now include arbitration clauses in their customer agreements.

Not only the number but also the size of claims is increasing. According to Richard Ryder, publisher of Securities Arbitration Commentator, about 40 percent of the claims currently filed exceed $100,000, while one third exceed $250,000.

It is not only the potential of a large judgment that makes investor claims so daunting, the cost of defending against such a claim can be high. An analysis of four years of claims experienced by the Financial Services Mutual Insurance Co., an insurer that offers coverage for financial planners and securities brokers, indicates that the largest exposure against which a securities broker purchases insurance is the cost of defending a claim. The company's figures reveal that only 27 percent of the total cost of a claim was incurred in connection with settlement or judgment, while 73 percent was spent on defense costs.

This leads to the conclusion that a very compelling reason for buying professional liability insurance is to protect against the expense of defending a claim, even when the claim, on its merits, should never have been brought.

THE UNINSURED

Despite the increasing number of claims, the large damages sought and the high defense costs associated with defending even the most non-meritorious claim, it is estimated that only 10 percent of registered representatives are covered by an errors and omissions insurance policy.(4)

To the authors' knowledge, none of the national wire houses has purchased E&O insurance, even on an excess-loss basis. Some New York Stock Exchange regional firms have coverage, but most do not. In contrast, most of the broker-dealers who service the financial planning industry have E&O policies in place. A shared characteristic of broker-dealers who have obtained coverage is that their representatives are independent contractors rather than employees of the broker-dealer.

Today, only a handful of insurance companies write coverage for the securities industry. Reliance Insurance Co., once the largest carrier offering that coverage, decided to stop writing policies because of the frequency and size of losses it was experiencing. Among the companies still offering coverage are American International Surplus Lines Insurance Co., Home Insurance Co. and Financial Services Mutual Insurance Co. The FSM policy, however, is now undergoing substantial revisions.

Insurers that have written coverage have been most interested in broker-dealers who emphasize long-term investment strategies using few, if any, proprietary products. Insurers have been particularly hesitant to cover risks involving investment banking, market-making, options, commodities, or the underwriting of new offerings.

THE INSURED

What are the basic protections afforded by this insurance? What are some of the critical coverage issues with which attorneys for both the insurer and the insured should be familiar in assessing available coverage?

To answer those questions, it is necessary to have a rudimentary understanding of the typical allegations contained in claims brought by investors against securities brokers.

TYPICAL CLAIMS

1. Unsuitability

   By an overwhelming margin, the most commonly asserted claim is that of unsuitability. Simply put, unsuitability...