E&O Insurance
Chapter 2
General Liability
Industry Variety
The financial planning industry has one characteristic that is unique to this industry: its members come from a variety of other industries. Financial planners can be accountants, stock brokers, or insurance agents. It may be possible to predict the future treatment in the professional liability field by looking at the treatment of these various professions. We have also seen the banking industry go into the financial planning field, as well as other industries not otherwise considered a financial planning field.
This chapter will primarily focus of the three professions from which the majority of financial planners come. This would include insurance agents, accountants, and stockbrokers. The financial planner’s duties often include many of the duties of these professionals. Looking at how the courts have treated these professionals can help us determine how the financial planning field will be treated by the courts. It is particularly relevant since the duties of an insurance agent, for instance, parallels those of a financial planner - preparing and analyzing financial statements, determining risk exposures, determining adequate insurance amounts, investing the client’s money, and planning the client’s retirement and estate planning needs.
In recent years we have also seen cases establishing a standard of care for investment advisors. Certainly, financial planners would fall into the category of investment advisors, as do some insurance agents. Looking at these cases also offers a means of predicting how a financial planner will be treated in court.
Insurance Agents
Insurance agents are in the ranks of
other professionals in the quest for risk avoidance, which means that liability
insurance is a must. Physicians have had to pay plenty over the last years for
professional liability insurance. Attorneys joined physicians as liability
risks, followed by accountants, then insurance agents and financial planners.
Insurance agents are further faced with limited liability insurance coverage
and increasing premiums. Add to this the national awareness about potential
liability risks, making clients more apt to litigate in the event of a mistake
on the part of the insurance agent. It is safe to say that liability insurance
is a necessary part of doing business for insurance agents, just as it is for
physicians and attorneys.
As we stated, there could be a conflict of interest for an insurance agent who is also a financial planner. The two roles need to be separately maintained to some degree. Of course, all industries who deal with finances must consider how the various roles interact. The insurance agent who is also a financial planner will want to market their services, but each type of service must be correctly handled. The ethical standard in these circumstances must always consider the client first and commissions second.
We could use the example of a young family, both parents are age 26, with one child, age three, who comes to an insurance agent/financial planner wanting life insurance. It is determined that the family needs at least $250,000 life insurance coverage. However, the family cannot afford the cost of a whole life policy. Should the insurance agent sell them less insurance coverage and receive higher commissions? Or should the agent sell the family a less expensive term policy covering the family the way the financial planner saw fit? Naturally this potential conflict of interest exists for the insurance agent who is not a financial planner, but the problem seems to increase in severity for the agent who is also a financial planner since their primary function is not to sell a product but to provide financial advice. Some industry people feel consumers should seek out a financial planner that does not sell products of any kind; they merely advise consumers.
Insurance Agents’ Professional Negligence
Conflict of interest is one of many professional liability problems facing insurance agents or brokers. They, like other professionals, can be found liable for negligence, violation of a statute, and breach of contract.
Negligence is the broadest field of exposure for an insurance agent.
Negligence is a tort - a civil wrong not based on a contract. Negligence is
often the result of carelessness, thoughtlessness, forgetfulness, ignorance, or
just plain stupidity. It involves errors and omissions made by the insurance
agent. The majority of the liability imposed by laws stem from accidents
derived from negligence. If negligence can be shown to be the proximate cause
of an injury to another, the negligent party is libel for the injuries or
damages sustained. We tend to think of negligence and damage to others to be
physical, but financial damage is also possible. Negligence could be defined
as the failure to exercise the proper standard of care required by the
circumstances. Negligence never involves intent. A negligent act may include not
doing what was required under the circumstances or doing something that fails
to measure up to what would be expected of a prudent person in like
circumstances. Faulty judgment may result in liability negligence, even though
the motive behind the act was purely innocent. This point is very important
when it comes to anything financial. A financial loss does not necessarily mean
faulty judgment; no one has a crystal ball when it comes to investing.
However, if the advice given is indeed found to be faulty, then a malpractice
lawsuit is possible.
There are laws that require all persons to use prudence in their actions so that others will not suffer bodily injury or property damage. Failure to heed such prudence gives the injured party a right to action against the negligent party for damages. “Prudent behavior” is based upon what society expects of the individual. The conduct must be reasonable in light of the risk involved.
Insurance Agent’s Presumed Negligence
Ordinarily the burden of proof lies on the plaintiff (claimant) in a negligence case. The plaintiff must prove that the defendant failed to exercise the reasonable standard of care for a prudent person. However, this may not always be the case. If the facts presented justify a reasonable form of judgment of negligence, the courts may lift the burden of proof requirement by applying the common law doctrine of res ipsa loquitor (meaning the thing speaks for itself). Negligence is presumed without the plaintiff having to prove it. The burden of proof is then shifted to the defendant. Under this law a legally sufficient case of negligence can be established and referred to the jury if the:
· plaintiff’s injury was caused by a defective object,
· injury could not have occurred without the defendant’s negligence, and
· object causing the injury was controlled by the defendant.
These conditions establish presumed negligence.
The law of presumed negligence applies when an accident causes an injury preventable by the use of prudent care and/or safety inspections. Presumed negligence has been applied to a number of accidents which occurred without witnesses: railroad or aviation injuries, medical malpractice claims, and/or damages from defective products for example. The last example of product liability has some difficulty applying res ipsa loquitor in the courts. That is because the claimant, not the defendant, controls the product. The control of the product lies in how it was used: properly or improperly. However, the courts have held defendants in control of the product if it has not been changed since leaving the manufacturer. The courts are not consistent with these decisions, though.
Insurance Agent’s Contributory Negligence
When negligence is presumed, the plaintiff must not be guilty of contributory negligence. The circumstances of the accident must be unquestionable as to the negligence. If the accident could be caused by any other means the res ipsa loquitor law is not applicable. Presumed negligence does not exist if the accident results from circumstances beyond the control of the defendant. The accident must be such that the injury could not have occurred ordinarily without the negligence of the defendant. An accident resulting from a third person’s involvement or from any physical or mechanical action is also not applicable.
Insurance Agent’s Imputed Negligence
Imputed negligence makes an individual responsible for negligent acts of others. Employers may be liable for the action or negligence of their employees, as well as the employees themselves. If an employer uses independent contractors whose employee negligently causes an injury, that employer could be held liable if it provides faulty instructions or tools. Imputed negligence can occur even to unaware individuals. Landlords whose tenants cause an injury from a negligent act could be held liable. Parents could be held liable for the actions of their children.
Vicarious liability laws impute liability to automobile owners even though they are not driving or even riding in their cars. Even if the car was borrowed by a friend, the owners of the vehicle could still be liable for the actions of the driver. Under the family purpose doctrine liability applies particularly to the automobile owner whose family members negligently use the car.
Although presumed negligence may not apply if a third person is involved in the negligent act, imputed negligence does apply to third persons who may not be directly involved.
Insurance Agent’s Negligence in Tort Liability
Where allegations of negligence are made, lawsuits present major issues in tort liability.
There are typically specific things which must apply:
1. Before a court will award damages for negligent liability to a plaintiff, four requirements must exist. They are:
a) a legal duty to protect the injured party,
b) a breach of that duty or wrong,
c) an injury or damage to the plaintiff’s person, property, legal rights or reputation, and
d) a reasonably close proximate relationship between the breach of duty and the plaintiff’s injury.
2. Defenses in a negligent action.
Since there are never absolutes, a plaintiff may prove all four elements (legal duty, breach of duty, the injury and proximate relationship) of a negligent act and still not be awarded damages. The defendant has several successful defenses available. Two principal ones are:
a. Contributory negligence, and
b. Assumption of risk.
Contributory negligence means that the plaintiff is also negligent, and that negligent action contributed to the loss incurred. If the plaintiff is guilty of contributory negligence, they may be denied damages. Contributory does not relieve the defendant of duty to the plaintiff. Instead, it denies the award of damages to the plaintiff if both parties are at fault.
In a strict sense, the doctrine of contributory negligence does not always produce equitable results. A slight degree of responsibility, (negligence) on the part of the plaintiff could result in no award of damages.
There are two substantial variations of contributory negligence rules:
a) comparative negligence, and
b) last clear chance.
Under comparative negligence, the court, often the jury, attempts to scale or diminish in proportions the awards according to the comparative degrees of negligence of the parties involved. Not all states have comparative laws. Partial comparative negligence statutes are more common.
Under the last clear chance doctrine, the defendant is able to prove that the plaintiff had the last clear chance to avoid the accident. The last clear chance doctrine states that the defendant with the last clear chance to avoid the accident is guilty of contributory negligence by failing to avoid the accident. If both the plaintiff and defendant were inattentive, this doctrine does not apply.
3. Statutory modifications of the common law on negligence.
The most common type of negligence for insurance agents is failure to place necessary insurance, failure to obtain proper coverage, failure to properly advise of the company’s rejection or lack or coverage, failure to cancel a policy at the insurer’s request, and failure to fully disclose the nature of the risk. In addition to this, the agent may be liable for giving unauthorized instruction to insureds or unauthorized interpretations of coverage, delaying the underwriting or claim information, or binding an unacceptable risk.
We can look at some examples of an agent protecting themselves from a liability claim by informing the client of their options completely. Many property and casualty agents are expected to mention the availability of umbrella liability insurance when they are selling an auto or homeowners policy. This is not done for the purpose of receiving higher commissions. Umbrella liability policies do not offer the agent particularly large commissions. The agent who does this is doing it to protect themselves in the event that the insured suffers a loss greater than the amount of liability protection provided under the auto or homeowners policy. By informing their clients of the option of buying more liability coverage, the agent is preventing the insured from filing a suit against them for failing to provide adequate coverage. Of course, this insurance offer should be documented, perhaps even obtaining a reject signature from the consumer.
Another example of an agent protecting themselves from lawsuit is the practice of giving complete information. For example, the insurance agent who informs the policyholder of the minimum insurance coverage required by the state, but given the client’s assets, suggests a larger amount of coverage as appropriate. The client then has the option of declining the additional coverage, thereby, releasing the agent of a negligent act. The agent should then document that the coverage had been discussed and refused by the client. The agent may go as far as having the client sign a form acknowledging this denial of additional coverage. In this way, the client will not be able to claim that the agent failed to offer the adequate coverage needed.
Insurance agents and brokers can be held liable for a vast array of actions. It should be noted that they can be liable to both the client and to the insurer for which they work. We should also make a distinction between agents and brokers. Agents are considered representatives of the insurer. Brokers are considered representatives of the insured. The broker’s primary allegiance is to the client. Knowledge of the broker is not considered to be knowledge of the insurer. The agent and the insurer are deemed to have the same knowledge.
Express Authority & Ostensible Authority
Identifying the distinction of knowledge could be critical if an insured chose to sue both the agent or broker and the insurance company. Normally, if the broker is involved the insurance company can escape liability. As with anything, there are always exceptions. Sometimes when dealing with the agent, the insurer can still be held liable even if the agent oversteps their express authority. Express authority refers to the powers given to the agent in the agency agreement or contract. In addition, the agent also has certain implied powers. The courts have used the doctrine of ostensible authority to give agents those powers the public reasonably expects them to have. An example of liability would be that of a life insurance agent who accepted the premium for a life insurance contract with a company for which he was not contracted. The insurer had not given the insurance agent the authority to accept the premium. The insurer could be bound since it is reasonable for the public to believe that an agent has the authority to accept premiums.
Another example where ostensible authority can be invoked is when an agent is told by the insurer that the company will not write homeowners coverage on homes over 50 years old. Assuming the agent writes a policy on a home over 50 years old, the insurer could still be liable to the insured if any claims arose since there would be no reason for the insured to know the issuance of such policies was forbidden. Of course, in these situations, the insurer may have recourse against the agent for the actions they took.
In many situations, the agent/broker distinction can become less critical. Instead, the actual facts of the situation will be looked at to determine whom the agent or broker was representing:
1. the insured, or
2. the insurer.
In any case, the agent or broker must and is expected to act with reasonable care and diligence when representing the insured or insurer. Another aspect to look at is how the courts view the insurance agent. Assuming the court views the insurance agent as a professional, the applicable standard of care would be that of the skill and expertise of the average professional in that industry. We all know, of course, that some agents are more expert than others. Those who overstep the bounds of common sense cause the entire industry to experience change, as states legislate to protect the consumers.
We can look at court cases that discuss the implied law duty of good faith and fair dealing that is imposed on agents and insurance companies. In the case of Fletcher v. Western National Life Insurance Company, the court stated:
We think that, similarly, the implied-in-law duty of good faith and fair dealing imposes upon an insurer a duty not to threaten to withhold or actually withhold payments maliciously and without probable cause, for the purpose of injuring its insured by depriving him of the benefits of the policy.
In a similar court case, United States Fidelity and Guaranty Company v. Peterson, it also mentions this same standard of care:
Where an insurer fails to deal fairly and in good faith with its insured by refusing without proper cause to compensate its insured for a loss covered by the policy such conduct may give rise to a cause in action in tort for breach of an implied covenant of good faith and fair dealing. The duty violated arises not from the terms of the insurance contract but is a duty imposed by laws, the violation of which is a tort.
The courts here are referring to insurers in speaking of the duty of good faith and fair dealing, but it is also applicable to the insurance agent. Typically, if the insurance company is sued for bad faith, the agent will also be named as a defendant.
Torts & the Basis for Liability Claims
Question: What is the legal basis for a liability claim?
Answer: A claim that is based on a liability imposed by law which develops as the result of the invasion of the rights of others. This legal right is more than a moral obligation of one person to another. This legal right has the backing of the law. Legal rights impose many specific responsibilities and obligations. The invasion of such legal rights is deemed a legal wrong. The legal wrong may be:
1. criminal (public), or
2. civil (private).
A criminal wrong is an injury involving the public at large and is punishable by the government. The action on the part of the government to effect a conviction and impose fines or imprisonment is termed a criminal action.
A civil wrong is based upon two things:
1. torts, and
2. contracts.
Torts & Contracts
Torts are wrongs independent of contract wrongs. In other words, they involve actions of the agent or others but not the contract. This includes false imprisonment, malicious prosecution, trespass, conversion, battery, assaults, defamation (libel and/or slander), fraud, and negligence.
Contracts may involve legal wrongs when implied warranties are violated, or contract obligations are breached.
Liability Under Torts
As stated before, torts include all civil wrongs not based on contracts. As a result, they are a broad residual classification of many private wrongs against another person or organization. Torts occur independently of contractual obligations and may result from:
· intentional acts or omissions,
· strict (or absolute) liability imposed by statute law, or
· negligence. Most torts are based on negligence.
Insurance Agents’ Civil & Criminal Violations
Insurance agents can also be found liable for statutory violations, both criminal and civil. For insurance agents whose livelihood is dependent upon their employment, this is an especially serious form of liability since criminal violations can require a conviction and impose fines or imprisonment or both, depending on the severity of the crime. Sometimes the insurance agent is given the option of having a hearing before the state insurance commissioner rather than appearing in court. In other instances, if the agent surrenders their license voluntarily, no further action is taken.
Fraud is perhaps the most common crime committed by insurance agents. The following are some examples in the “Professional Liability Pitfalls for Financial Planners” by Cheryl Toman-Cubbage of real-life cases of crimes committed by insurance agents.
In Colorado, a man was involved in a car accident that resulted in almost $7,500 damage to his car and another vehicle. When he contacted his insurance agent, he was assured that the damages would be paid. But, as it turned out, the agent was not licensed to sell insurance in Colorado and had never sent in premium to the insurance company. As a result, the man found out he was uninsured. He had no recourse against the insurance company for the agent’s action since, in Colorado; it is unresolved whether an insurance company is responsible for the actions of its salespeople. He sued the agent and was awarded $5,000, but the agent filed bankruptcy, so the plaintiff was unable to collect the judgment. The agent did surrender his license.
Another case involved an elderly couple who took the advice of an insurance agent to discard all their old policies and buy the health insurance he sold. They gave the agent a check, but never received a policy. After contacting the company the agent said he worked for, the couple found out he was no longer employed by this company and had no authority to sell its policies. A result of this incident and other circumstances similar to this, the agent’s license was revoked, and he was convicted of theft and sentenced to five years’ imprisonment.
We have probably all heard of stories of unscrupulous agents taking advantage of their clients. States pass legislation in the hope of reducing fraud, but it is unlikely that laws will ever be entirely successful. What the examples above show is that an agent can receive criminal punishment for acts of fraud they commit. Unfortunately, for many agents who commit fraud, no physical punishment is ever experienced, although they do commonly lose their license to sell insurance. Some agents, however, will simply move to another state and hope that their past does not catch up with them.
It has been said that an ethical code of conduct cannot be mandated. An agent is either ethical or not, and laws merely point out those who are not. While this may be true, laws (and resulting punishment) do at least prevent those who lack any ethics from continuing in the profession. Unfortunately, consumers will remember the unethical far longer than the hardworking ethical agent and financial planner.
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It has been said that an ethical code of conduct cannot be mandated. An agent is either ethical or not, and laws merely point out those who are not. |
Insurance Agent’s Breach of Contract
Contracts may involve legal wrongs when implied warranties are violated, or contract obligations are breached. An insurance agent would likely not be sued individually for breach of contract. The insurance companies and agencies themselves are more likely to be sued for such a lawsuit since they would be viewed as responsible for denial of a claim or violation of a condition.
However unlikely it is that an agent or broker would be sued for breach of contract, it is possible. We can look at the language of the case of Milwaukee Bedding Company v. Graebner:
It is a general rule that, where an application for insurance is made to an agent who represents several companies, no contract of insurance is engendered between the insured, and any particular company until such company is designated by the agent. But, where the company is selected by the agent, and in some manner designated as the company in which the insurance is to be written, a binding contract results. In such case the agent becomes the agent of the insured for the purpose of selecting the company.
The agent of the above case was found not guilty, but the language describes the traditional relationship between a broker and the insured. It could also be assumed from the opinion that an agent can be liable for a breach of contract to procure insurance. For instance, in the case of Marano v. Sabbio, an insurance broker promised to procure burglary insurance for the client but failed to do so. Some of the client’s property was stolen under covered circumstances. The court held the broker liable for the value of the property stolen under a breach of contract theory.
It is also possible for the agent and the insurance company to be sued for failing to act promptly on an application for insurance. This is sometimes presented as a negligent cause of action, but it has also been presented as a breach of an implied agreement to act promptly or as breach of contract.
Breach of an Implied Agreement Theory
Under the theory of breach of an implied agreement to act promptly, it has been found that the course of conduct of the agent, including solicitation of the application and acceptance of the premium, constitutes an implied agreement that the insurance company will act upon the application without unreasonable delay.
Breach of Contract Theory
Under the theory of breach of contract, it has been found that the application is the offer and silence on the part of the insurance company or silence coupled with retention of the premium forms a contract. This makes the insurance company liable for any unreasonable delays in acting on the application.
Legally Binding Insurance Contract
It is important to understand exactly when an insurance contract becomes legally binding. As stated before, the application is considered an offer of insurance. The acceptance occurs when either the agent binds coverage, or the policy is issued. By law, an insurance contract does not actually have to be in writing. However, it is normally in written form. While there are many reasons for this, one main reason is to determine when the contract was formed so that one may know when a loss is covered. For example, client ABC applies for coverage with XYZ insurance company on his car. By accepting the offer of the client, the agent creates a written contract. If client ABC is involved in a car accident before he receives a written contract, the loss is still covered by XYZ insurance company.
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By accepting the offer of the client, the agent creates a written contract. If the client is involved in a car accident before he receives a written contract, the loss is still covered by the insurance company where application was made. |
Relevance
The relevance of determining when a contract comes into existence relates to when and if a breach of contract occurs. It is obviously stated that no breach of contract can occur unless a binding contract actually exists.
In the past, a life insurance agent could not bind the insurance company. However, in the case of Smith v. Westland Life Insurance Company, the court stated this opinion:
“... an ordinary person who pays a premium at the time he applies for insurance is justified in assuming that payment will bring immediate protection, regardless of whether or not the insurer ultimately decides to accept the risk.”
In the case of Young v. Metropolitan Life Insurance Company, the courts stated a similar opinion:
“... the very acceptance of an advance premium by the carrier tends naturally toward an understanding of immediate coverage though it be temporary and terminable.... In short to the ordinary layman, payment of the insurance premium constitutes payment for insurance protection....”
A Contract of Adhesion
In the first case mentioned, payment of the premium had been made. The courts are leaning toward viewing the insurance contract as a contract of adhesion and tend to be harder on the agents and insurance companies in finding a contract early in the negotiations. A contract of adhesion basically means that the insured has no option to change or negotiate policy terms. The policy is presented to the insured on a take it or leave it basis. In viewing courts cases and decisions, it can be understood that any ambiguities in the insurance contract will be construed against the insurance company.
For Review:
· Many financial planners start out as insurance agents or brokers and continue to sell insurance after they move into the financial planning field. For this reason, financial planners will have the same liability problems that they did in the insurance field as well as additional liabilities as financial planners.
· Even if the financial planner did not start out in the insurance field, they would be involved in providing clients with the risk management advice and even perhaps, would begin selling insurance products. This would thus mean that a financial planner would need to know their liabilities in this field they are expanding to.
· Financial planners can look to court cases involving insurance agents to gain a better idea of how their field will be likely treated in the courts. Like the insurance agent, the financial planner will be viewed as a fiduciary, holding themselves out to the public as having special skills and/or knowledge.
· Like the insurance agent, the financial planner can be held liable for negligence, breach of contract and statutory violations.
Accountant’s Liabilities
Looking at how accountants open themselves up to different liabilities will accomplish two things:
1. Help determine the liabilities that need to be covered.
2. If an insurance agent is an accountant also, it will help them determine where they may need to provide adequate coverage for themselves.
Quite often, accountants expand their field and become financial planners. Accountants deal with the finances of clients and performing such tasks as analyzing financial statements and preparing tax returns. However, unlike insurance agents and stockbrokers, accountants do not sell products, unless they have obtained a license to do so. It is their services that they sell. An accountant’s services involve the use of judgment when deciding what to do with the numbers. It is not hard to understand, then, that an accountant that negligently makes an error in the figures can be found liable.
There have been two important developments in the area of accountant liability:
1. The courts increasingly have become willing to find accountants liable to their clients for their negligent acts. Prior to the 1950s, the courts were much stricter in awarding damages to clients.
2. Accountants are now being held liable to third parties. These third parties represent non-clients and people with whom the accountant has not contracted. As a result of this liability, the exposure to liability claims for an accountant has significantly increased.
When Are Accountants Not Liable to Third Parties?
An accountant’s full liability exposures can be understood by reviewing a few court cases that deal specifically with this issue. A court case in 1931, Ultramares Corporation v. Touche, where the defendants were Certified Public Accountants who audited a company and supplied the company with 32 serially numbered copies of a certified balance sheet. The defendants knew that these copies would be used by the company to obtain future loans. The balance sheet showed a net worth of more than $1 million when actually, the company was insolvent and later had to declare bankruptcy. As a result, the plaintiff, who was considered the third party and relied on the balance sheet of the company, sued the accountants for negligently and fraudulently performing the audit. The court decided that the accountants could not be held liable for negligence to a person or people who were not parties to the original contract.
On the surface, the decision appears to be very straightforward. If a person is not a party to the original contract, they cannot claim damages for negligence. However, the court did go on to state:
Our holding does not emancipate accountants from the consequences of fraud. It does not relieve them if their audit has been so negligent as to justify a finding that they had no genuine belief in its adequacy; for this again is fraud.
The court went on to state that an accountant can be liable to a third party who had not entered into the contract if the involvement of the third party was foreseeable. For example, if a client asks an accountant to prepare financial statements for the client to show a specific party with whom they do business, the accountant then knows a third party is involved and this involvement could be considered foreseeable.
The Ultramares case states two distinct views. On the one hand it states that an accountant is not liable to third parties with whom they have not contracted. On the other hand, the accountant can be liable to a third party if it is foreseeable that a third party will be involved or if the accountant acts in a fraudulent or grossly negligent manner.
Since it is not always clear when a third party involvement is foreseeable, or when the accountant has acted in a fraudulent or grossly negligent manner, the Ultramares precedent could be followed by various courts, yet very different judgments could be reached.
The two most common trends resulting from the Ultramares case are as follows:
Accountants can be held liable to a third party lender since they prepare financial statements for their client knowing they are to be used by the lender. From this, one could assume that a duty of reasonable care is owed to all actually foreseeable third parties. Or the accountant must actually know a third party will be using the documents. This is a narrower view of third party liability and has been the most common view held by the courts.
Accountants can be liable to all reasonably foreseeable third parties who will rely on the accountant’s work. This is a broader view of third party liability. As the court stated, the accountant can be found liable when he or she “knows the recipient intends to supply the information to prospective users.” This allows anyone who might rely accountant’s work product to have a financial interest. Courts are now becoming increasingly likely to follow this broader view of liability.
Accountant Negligence
The area of liability for professional negligence is more relevant than is liability for breach of contract. This is particularly true since many of the duties required to meet an accountant’s professional standard of care are the same duties required for financial planners. The most basic duty of these is the fiduciary duty. Like the financial planner/client relationship, the accountant/client relationship is “one founded on trust or confidence reposed by one person in the integrity and fidelity of another.” The fiduciary must always place the interests of the client above their own. If a potential conflict of interest arises, the client must always be informed and be given opportunity to seek another accountant. This duty would include reporting to the client signs of such things as embezzlement, check-kiting (in commerce, this means any negotiable paper not representing a genuine transaction, so check-kiting might be thought of as “flying a check before funds are available”), and cover-ups of delinquent accounts. However, the accountant as fiduciary is not required to be a policeman or a detective. He or she is a watchdog, so their duty is more like an auditor. As such, they are required to alert clients to suspicions, but if nothing seems suspicious then he or she is not required to track down each element involved.
Insurance agents are required to have continuing education in most states to keep their insurance license active. The accountant has a similar requirement in that they have a duty to keep current or abreast of recent developments in accounting and auditing practices. To help provide guidelines to accountants, there are the Generally Accepted Accounting Principles (GAAP), the Generally Accepted Auditing Standards (GAAS) and the Standards for Accounting and Review Services Number 1 (SSARS 1). These standards state the minimum professionally acceptable conduct for accountants. This means that if the accountant does not follow these standards, it could be viewed as evidence of negligence. However, the fact that an accountant follows these standards does not necessarily prove that they are not negligent. In the case of Securities Exchange Commission v. Seaboard Corporation, the court held that compliance with GAAP did not protect the accountants from a liability claim. In a similar case in the US Supreme Court, Thor Power Tool Company v. C.I.R. the court state that GAAP did not necessarily reflect what was considered income for tax purposes. An accountant should be aware that they must at least follow the state of the profession. Although, what may be required over and above that is open to debate by the courts.
One of the areas most difficult areas for an accountant and agent alike is that of providing tax services. With all the various changes in the tax laws, it is an enormous responsibility to be aware of these changes and their impact on clients. It is not hard to understand that if an accountant is not careful in giving tax advice to a client, the client could be audited by the Internal Revenue Service (IRS) and have to pay additional taxes and penalties. If this is a result of the accountant’s negligence, the accountant can be held liable for the financial losses that the client incurred. Typically, the accountant is not responsible for the actual taxes due, but only for interest or penalties levied.
All professionals must avoid overstepping their boundaries of authority. The accountants and financial planners must not practice law, for example (give legal advice). If this happens, civil and criminal penalties could be the result. Offering tax advice is the most likely area of stepping over the boundaries of expertise.
Accountant Breach of Contract
Breach of contract is perhaps the most straightforward of the three areas of potential liability. It is imperative for the accountant to be as clear and specific as possible in order in a contract of service. If this is done, the likelihood of a lawsuit for breach of contract based on a misunderstanding or difference of interpretation is reduced. However, the accountant’s failure to perform a duty that is specifically named in the contract would also be more obvious thus making it easier to prove a breach of contract in court.
Most of the breach of contract lawsuits has been brought against accountants due to vague or ambiguous wording in their contract and situations in which failure to perform is not quite so obvious.
Accountants’ Civil & Criminal Violations
The final area of potential professional liability for an accountant is violations of a statutory duty. This is very important to the accountant since it typically involves the imposition of criminal sanctions against the wrongdoer. The obvious areas of criminal liability for accountants would be embezzlement, check-kiting, fraud and similar crimes that could result from having access to a company’s books. To add to this, an accountant can also be found guilty of violating the securities laws if they give a client investment advice. We can see how this situation might arise quite easily if an accountant receives a fee or commission from a dealer for recommending certain securities. The American Institute of Certified Public Accountants views this as a conflict of interest on the part of the accountant and will subject them to professional discipline. Additionally, under the Investment Advisors Act, if the accountant accepts the commission, they may be considered an “investment advisor.” The Securities and Exchange Commission could further discipline the accountant if they failed to disclose the fact that they received a commission. This could be considered to be an omission of a material fact, thereby subjecting them to discipline for breach of fiduciary duty.
Investment Advisor’s Liabilities
The term “investment advisor” covers a broader range of activities than those performed by a stockbroker. It does not cover as broad a range of activities as those performed by a financial planner. It must considered, however, that since most financial planners would be deemed investment advisors, the court’s treatment of investment advisors clearly points out the standard to which a financial planner is likely to be held.
The case of Securities and Exchange Commission v. Suter in 1984 set a trend: The Securities and Exchange Commission (SEC) is very likely to bring a lawsuit against an investment advisor deemed to have violated a securities act. This adds then to the category of people whom an investment advisor, insurance agent, or financial planner can be liable to.
The case of Levine v. Futransky in 1986 was a very important case because it was brought by individuals, not the Securities Exchange Commission (SEC). This case held the advisor to a strict standard of care since it allowed damages to be awarded against the investment advisor even though overall there was no loss.
The plaintiffs in the case were trustees and beneficiaries of various trusts. Over a period of five years, the defendant was employed as their investment advisor to manage certain investment portfolios containing trust funds. The defendant was hired based on his representation that he could invest the funds in relatively conservative covered options. However, he invested in riskier, uncovered options which resulted in a substantial loss to the portfolios.
The defendant disputed that damages could be established by the plaintiffs since the aggregate earnings of the other profitable trust fund portfolios he managed for the plaintiff’s exceeded the aggregate loss of the others. He claimed there was no damage since the overall result was a net profit to the plaintiffs.
The court disagreed. It stated:
In the instant case, this Court holds that plaintiff’s suffered damages even though the investment portfolios incurred a net gain. Plaintiffs may be entitled to recover the difference between the losses incurred on the sale of the speculative securities and the greater amount the plaintiffs would have received had they not been defrauded and the more conservative securities had been bought and sold.
We can see the importance of this case since it points out the rights of individuals against investment advisors. If it can be established that the investment advisor made a material misrepresentation that the clients relied on, which in the above case, was found to constitute fraud, the investment advisor can be liable for the difference between the amount lost (because of the investment vehicles and the amount that would have resulted had the funds been invested as represented.
As stated earlier, the cases involving investment advisors are particularly relevant since investment advisors are performing the same functions as financial planners, though the financial planners duties may involve a wider range of activities. Like so many cases, similarities will exist for the financial planner and the agent.
Stockbroker’s Liability
Stockbrokers’ or security dealer’s professional liability problems are particularly relevant to financial planners. Since financial planners wear many hats, including insurance agent, investment advisor and even security dealer, it is very important to understand the liability problems faced by security dealers.
When a client goes to a financial planner, he or she typically goes for the purpose of receiving investment advice. This is viewed as the primary function of a financial planner - to help the client handle their money and invest it wisely. This includes providing insurance coverage, solving tax problems, saving for retirement, and planning one’s estate. When a client purchases a cash value form of insurance, they are investing in an insurance policy. When a client invests money in a tax shelter, they are investing their hopes that at the same time, a tax problem is being resolved. The same is true for retirement and estate planning. In order to plan for these things, it is necessary to invest the money for those goals.
Many stockbrokers have moved into the financial planning field in the same way agents have, so their potential problems reflect those of insurance agents. Initially the majority of financial planners were either insurance agents or stockbrokers. Stockbrokers were already involved in the business of investment planning, so it easily expanded into financial planning for their clients. One of the primary functions of a financial planner is to invest the client’s money or to provide the client with an appropriate plan to invest their money. Therefore, even if a financial planner did not start out as an insurance agent/stockbroker, they would still be involved in recommending and/or selling such investments. Some areas of products may require specific licenses and it goes without saying that agents must obtain these.
Like an insurance agent or broker, the stockbroker must be extremely careful to avoid potential conflicts of interest. Also like the insurance agent, the stockbroker will be making a commission on the sale of a product. The stockbrokers could be in a more precarious position than agents since the products they recommend have a greater chance to lose large sums of money. Insurance agents tend to deal with products that do not lose money; rather they “insure” some element of the client’s life against loss. Even so, insurance products do have what is termed a “guaranteed loss.” Do you know what that is? If you said premium payments, you were right.
Stockbroker Negligence
The courts continually refer to the terms “willful” and “reckless” when describing what behavior on the part of a stockbroker would be responsible for wrong. Mere negligence of a broker or his agent in a sale of stock, or a mere breach of fiduciary duty without deception does not always constitute a violation. The distinction between negligent behavior and willful or reckless behavior can be illustrated in the following two hypothetical situations:
Let’s assume that Mr. ABC places an order with his stockbroker to buy 50,000 shares of a limited offering. His stockbroker misunderstands him and instead purchases 5,000 shares. A week later, when Mr. ABC discovers the error, the offering is no longer available. Mr. ABC could claim that his stockbroker’s negligence resulted in a monetary loss to him since he is no longer able to add the offering to his investment portfolio.
Let’s assume that Mrs. XYZ, a 63-year-old widower who plans to retire in two years, explains to her stockbroker that her major concern is with safety and provision of a steady income flow for her retirement years. In response, her stockbroker purchases aggressive growth stocks and speculative common stocks. As a result, Mrs. XYZ loses a major portion of her investment.
In both these situations, the stockbroker lost money for the client. There are, of course, situations where the stockbroker acts in good faith and the client still loses money. Of course, stock investments are risk vehicles to start with. The stockbroker cannot guarantee what the market or stock performance will do. In both the situations listed above, the clients lost money due to the stockbroker’s actions. In the first situation, the stockbroker did not intend to act negligently. There was no intent to deceive or defraud. In that situation, it is unlikely that the court would find his behavior willful or reckless. In the second situation, the stockbroker knew that his client had a low risk tolerance and that she needed the income for her retirement goals in a couple of years. The stockbroker completely disregarded her needs and placed the client’s money in an inappropriate investment vehicle. It is possible that a court would find the stockbroker’s behavior to be willful and/or reckless.
In some circumstances, the brokerage firm employing the stockbroker may repay the monetary loss to the client. This might happen when an incorrect number of shares were bought even though, in order to purchase the correct number, additional costs are involved because the price of the share has risen since the time the original order was placed by the client. In many situations the monetary losses are too great for the brokerage firm to absorb voluntarily. In this instance, the client may opt to sue. The broker would likely be deemed a fiduciary of the client since the stockbroker holds themselves out to the public as having special skills and knowledge and therefore will be held to a higher standard of care. This standard of care would make it easier for a client to prove the stockbroker was negligent.
Stockbroker Breach of Contract
When a stockbroker is sued it is usually for violations of a statutory duty, although it is certainly possible to be for breach of contract also. In the previous hypothetical situations, Mr. ABC wanted his stockbroker to purchase 50,000 shares of stock, but instead the stockbroker only purchased 5,000 shares of stock. He could claim that the broker breached their oral contract even though it was unintentional. Stockbroker breach of contract is similar to insurance breach of contract. With insurance agents, the client’s offer is the application. The acceptance comes when either the agent binds coverage, or the policy is issued. With a stockbroker, the offer is made when the client requests a particular stock and the acceptance occurs when the stockbroker agrees to buy the stock or actually purchases it. It is very difficult to prove exactly what was said in oral contracts. It usually comes down to one person’s word against another or one person’s perception of the facts against another. For this reason, the client may find it preferable to bring suit for a statutory violation. Many breach of contract situations are simply sub-categories of a broader statutory violation.
In a case where a financial planner relies on a broker-dealer to actually handle any securities transactions the financial planner has recommended an interesting problem arises. Is it sufficient for the financial planner to rely on the broker-dealer’s due diligence? Should the financial planner also perform due diligence? Who is ultimately responsible for this task? Certainly, the financial planner wants to use only individuals they trust to complete their client recommendations. Even so, the recommendations should only be made where the financial planner feels confident. how can confidence exist if the planner has not personally performed due diligence?
For Review
· The biggest problem for stockbrokers is violation of statutory duty. Stockbrokers are regulated by the Securities and Exchange Commission (SEC) and can be convicted of violations of the Securities Act of 1933, the Securities Exchange Act of 1934 or Rule 10 b-5.
· The stockbroker can also be found guilty of breach of contract, though this is less common.
· The stockbroker can also be sued by third parties if their fraudulent statements were made to the public at large, not to just individual clients.
· If the brokerage firm is sued because of the actions of the stockbroker, like the insurance agent, the firm may sue the stockbroker if the firm itself was neither involved in the wrongdoing nor negligent in hiring or supervising the stockbroker.
· It is important to realize the relevance of accountants’, insurance agents’ and stockbrokers’ liability problems to financial planners. These three professions presently make up the majority of practicing financial planners and the individual duties of each profession, when combined; comprise many of the duties of a financial planner.
End of Chapter 2