León Cosgrove

Client Alert: How Financial Advisers Can Avoid or Deal With Litigation in the Wake of COVID-19

By: Coren H. Stern

People do not like to lose money. Behavioral economists claim that humans are wired for loss aversion. In fact, some psychological studies suggest that the pain of losing is psychologically about twice as powerful as the joy we experience when winning. Therefore, investors forget that even well-diversified portfolios tend to lose value when markets decline, and often want to point fingers at someone. This phenomenon becomes evident when one examines FINRA’s Dispute Resolution’s case filing statistics in conjunction with overall market performance. Twenty years of data clearly reveals increases in customer case filings in years following poor market performance.

For example, from October 2007 to the end of that year, the S&P 500 declined by3.8%. The year following that lackluster performance, FINRA Dispute Resolution filings were up 53.86% percent from the prior year. In 2008, the S&P 500 declined by 38.49%. In 2009, following this dreadful performance, FINRA Dispute Resolution received 7,137 new case filings, a 43.26% increase over the prior year (which was already elevated). This is a similar trend to the one observed following the Tech Wreck, from 2000 to 2003. Following the year 2000, where the S&P 500 declined by 10.14%, case filings increased by 23.81% over the prior year. This trend continued as the S&P 500 dropped by 13.04% in 2001 and 23.37% in 2002, with cases increasing in 2002 and 2003 by 8.69% and 16.11%, respectively.

The converse also proves this theory to be true. From March 2009 through the end of 2019, the S&P 500 increased by 339.51%, the Dow Jones Industrial Average increased by 300.06%, and the NASDAQ increased by a whopping 564.15%. During this time, markets did amazingly well, investors made money, and the FINRA Dispute Resolution statistics generally showed year over year decreases in typical customer case filings.

Recently, the COVID-19 Pandemic resulted in dramatic market declines. The psychological effect of these declines was amplified by the fact that, as recently as mid-February 2020, the major market indices reached all-time highs on what seemed to be a daily basis. Accordingly, leading up to this downturn, investors had been reviewing their portfolios with satisfaction and a sense of financial wellbeing, before the bottom seemingly dropped out from under them. Based on the above-referenced statistics, and upon basic psychological principles, it is likely
that FINRA claims are set to jump dramatically in the coming year.

In other words, financial advisors are going to get sued. So what should one do in the meantime? How does a registered representative get ready for the clients who will come pointing their fingers, arguing that they should not have lost money, even if the declines in their portfolios are market driven?

1) Communicate With Your Clients

Clients want an advisor and a partner. It is very difficult for an investor to deal with market declines or losses. It’s often even harder to take a loss and believe that it is no one’s fault or market driven. Many investors, as evidenced by the abovereferenced statistics, will blame their financial advisor. This becomes very difficult, however, when the financial advisor is in constant contact with the investor – when the advisor is right there, communicating with the investor and talking about what happened, and what the plan is to weather the storm or even recover the losses. While this advice is anecdotal in nature, people are less likely to sue someone who they view as their friend and partner, while conversely, it’s easy to sue someone who ran for the hills when the going got tough. So call your clients. Talk to them. Give them regular updates. Remind them that you are their partner and their ally, and that markets are fickle, but generally recover. Talk about their goals, and adjust them if they have changed. But it cannot be stressed enough – do not go silent. People who are ignored are much more likely to sue than those who feel like they are being heard.

2) Be Proactive

Don’t wait for your clients to reach out to you. A very seasoned attorney I used to work with once told me that the most important time to visit a client was not after a huge victory, but after a crushing loss. Why? Because everyone takes a victory lap – very few people show their face when times get tough. So while perhaps it was said above in a different way, one has to understand that for investors who are at or near retirement, they need to hear from their advisor and they need to know that someone is on their side and looking out for them. That way, even if they do feel like something went wrong, they will be less likely to sue you and morelikely to want to work with you.

3) Document Your Contacts With Clients

This is good advice even in good times. Registered representatives should be constantly taking notes of their conversations with clients and documenting their goals and conversations, but now it is even more important. A client who indicates that they are happy with the service they are receiving and the allocation of their portfolio while the market is going up shouldn’t automatically change their view when the market declines, and such documentation is vital if that client decides to drag you into an arbitration. And now, with markets already down, it might be a good time for financial advisors and their managers to speak to clients, make them feel heard and give them a voice, while documenting exactly what the clients say. If those clients indicate that they are satisfied with the firm and their advisors’ performance, and then file a lawsuit later, such conversations will be exactly what your lawyer needs to defend the suit.

4) Don’t Downplay Portfolio Declines or Market Losses

Nothing vexes an investor who spent their entire lives saving for retirement more than an advisor who brushes it off as inconsequential or a “fact of life.” No matter how big or small an investors’ portfolio is, it is likely a big deal to that client, no matter how small a percentage that client may be of your assets under management. With lawsuits, there is a point of diminishing returns for you. In other words, a lawsuit against you for $100,000 is likely going to be almost as disruptive as a lawsuit for $1,000,000, in terms of disclosures on your record, time spent dealing with lawyers and defending the claim, and deterrence with respect to future clients possibly choosing not to work with you. Thus, treat every client as if their loss is your loss and as if every loss is life changing (even if for you, it isn’t).

5) Do Not Make Promises That You Can’t Keep

Clients want to hear positive prognostications and predictions that their portfolios will recover, but no one can predict the future with any degree of certainty. So when your client tells you that they are unhappy with the decline in their portfolio, or asks when you expect it will recover to pre-pandemic levels, don’t give them an overly rosy outlook. They will view that as a guarantee, and if it doesn’t happen, they will next tell it to a panel of arbitrators. While people want to hear good news, what they want more is honesty. Talk to them about what has happened in the past, give them your best guess for the future, and explain what your plan is and why you think it is best for their investment objectives, risk tolerance, and personal financial profile. But no matter how insistent a client may be, do not make a guarantee. It will assuredly blow up in your face.

At the end of the day, financial advisors are not in control of the market and often cannot prevent all lawsuits. But data indicates that market declines almost always precede litigation and it is not too late for registered representatives to take steps to try and head lawsuits off.

Coren Stern is a partner at León Cosgrove LLP and chairs the firm’s securities litigation and regulatory practice. For more information, please call 305.740.1975305.740.1975 or email him at cstern@leoncosgrove.com.