When Are Advisors Liable For Negligent Investment Advice? (2024)

There's a whole area of law that exists around defining who is and isn't allowed to make stuff up. On the one hand, freedom of speech is one of our bedrock individual liberties, and courts have historically given individuals broad leeway in what they can legally say, even when some of those things are misstatements, half-truths, or even outright lies. But, on the other hand, there are many cases where a person's health and wellbeing require them to rely on another person's expertise (e.g., when listening to a doctor, lawyer, or financial advisor), and it would be hard to have a functioning society if those experts were allowed to simply say whatever they felt like with no legal or financial consequences for any harm they might cause by offering misguided advice.

It's no surprise, then, that the concept of holding self-professed experts – that is, professionals – accountable for their actions and advice dates back almost as far as society itself. The Code of Hammurabi, written down around 1750 BCE, prescribed punishments for physicians who inadvertently maim or kill their patients, up to and including cutting off the physician's hands.

Even though the punishments have gotten less severe over the years, the concept remains that professionals are liable for any harm that they cause to the people they serve, either through negligence, error or omission, or simply failing to provide the service they've been paid for. In tort law (the area of civil law concerning harms that are inflicted on one person due to the actions of another), courts have found over the years that individuals who reasonably rely on incorrect information given to them by professionals are entitled to financial compensation for any harm that they incur as a result.

There are lots of fields where professionals give advice that they are subsequently held accountable for. Medical professionals are accountable for their medical advice, lawyers for their legal advice, accountants for their tax advice, and so on. And of course, financial advisors are accountable for the investment and financial advice that they give.

Financial Advisors Are Financially Accountable For Their Advice

At a high level, the way that professional liability works for financial advisors is that when an advisor fails to exercise due care when making a recommendation to a client – e.g., to buy a particular investment product or pursue a certain strategy – that causes the client to lose money due to poor performance, the client can seek compensation from the advisor to make them whole.

In practice, the process by which the client seeks this compensation nearly always plays out via arbitration, which involves an ostensibly neutral third-party 'arbitrator' serving to resolve the dispute privately and is included as a standard clause in many advisory contracts (although client advocate groups and some regulators have been pushing back on the use of arbitration clauses in more recent years).

Professional Liability For Financial Advisors In Practice

It would be helpful to have a few examples from actual cases to show what it has meant in practice for an advisor to fail to exercise due care. But in fact, the reality that so many cases of advisor negligence have gone through arbitration rather than the court system means that there are relatively few records of the types of negligence that have actually led advisors to be sued (since, unlike court case records, arbitration proceedings remain private between the parties involved). However, there are at least a few cases that can illustrate what "negligence" can mean in an investment advisory context.

In one 2012 case (Antilla v. L.J. Altfest & Co.), a client accused her financial advisor of ignoring her stated extreme sensitivity to risk in recommending a retirement portfolio, while also miscalculating a Monte Carlo analysis to overstate the chances of the portfolio's success and misrepresenting the firm's historical investment performance, all of which amounted (per the client's claim) to professional negligence by failing to meet the standard of care required of financial advisors. In a different case from 2005 (Maliner v. Wachovia Bank), another client similarly claimed that his financial advisor failed to exercise reasonable care in ascertaining the client's risk tolerance and investment goals in proposing and implementing an investment strategy.

In both cases, extreme market declines (the 2008 financial crisis in the first case and the 2000 dotcom crash in the second) led to portfolio losses that the investors claim wouldn't have happened (or at least, wouldn't have been as severe) except for the advisors' negligence.

Extrapolating a bit from the 2 cases above, it seems that there's a common set of circ*mstances that can lead to a negligence claim against a financial advisor: First, there's a miscommunication between the client and advisor about the degree of risk that the client is truly willing to take and the amount of risk that is needed to achieve the client's stated goals (which only becomes apparent after the fact); second, a market downturn occurs and the actual decline in the portfolio turns out to be more than the client was willing to accept; and third, the client sells their assets and locks in the losses (fearing even further declines).

Notably, even though the advisor might later advise the client to "stay the course" and avoid panic-selling during a market decline, courts have still been willing to listen to the argument that because the advisor didn't properly account for the client's risk tolerance in recommending the portfolio in the first place, they bear the financial liability for losses incurred by the client as a result (despite the client going against the advisor's recommendation in selling their investments).

Although disputes around risk tolerance and market declines can be a prominent source of negligence claims against advisors, they could also plausibly arise from other instances, including trading errors, failure to properly monitor clients' investments, or failure to practice due diligence in choosing or working with specific funds or asset managers.

Which Types Of "Advisors" Are Liable For Negligent Advice

So, it's clear that a financial advisor can be held liable if they've been found to have been negligent when giving financial advice. But here we get into the familiar question about who exactly is the "advisor" liable in these cases? The terms advisor and adviser have notoriously defied strict definition, with financial planners, investment managers, broker-dealer representatives, and insurance salespeople all often putting the title of "Financial Advisor" on their business cards. Meanwhile, from a regulatory standpoint, "Registered Investment Adviser" is a firm-level distinction: The "adviser" is the firm that employs the people who call themselves "advisors". Simply saying that advisors can get sued for giving negligent advice doesn't make it clear whether this refers only to the advisors who work for RIAs (i.e., the Investment Adviser Representatives, a.k.a. IARs), those who use the "financial advisor" title, or the firms that the advisors work for, who are actually at risk.

The very short answer is "all of the above", although there is some nuance involved. Courts often rely on the "Restatement of Torts", a detailed guide and discussion of the principles around tort law in the U.S. published by the American Law Institute, when deciding whether a person can be found liable for professional negligence. The "Restatement" specifies that someone who, "in the course of his business, profession, or employment… supplies false information for the guidance of others… is subject to liability for pecuniary loss caused to them by their justifiable reliance upon the information, if he fails to exercise reasonable care or competence in obtaining or communicating the information."

In other words, if a person is in the business of giving information to others, and if that information turns out to be wrong because the person didn't make adequate efforts to ensure its accuracy, they will be liable for any harm it causes to those who rely on that information to guide their actions. More specifically, in a financial advisor context, any "advisor" who is in the business of giving information – i.e., financial and investment advice – is accountable for the accuracy of that information.

Notably, although advisors who only provide advice (e.g., employees of RIAs) are clearly in the business of giving information and thus liable for any inaccuracies in the advice they give, broker-dealers and insurance producers could also be considered to be in the business of giving information, despite their primary function as sellers of financial products. Because they still give their customers information about the products they sell that those customers reasonably rely on to make decisions about whether to buy them (or about which product to buy among several options), courts have found that individuals in the product-sales arm of the industry may still be responsible for the accuracy of the information they provide, and can be found liable if the information that a client relies on to buy a particular product is inaccurate because of the salesperson's negligence. (Although in those cases, there might still be a dispute about how central the inaccurate information was to the business transaction, and whether there was a duty for the salesperson to take reasonable care to provide accurate information).

Put more simply, advisors who are only in the business of advice are always accountable for that advice when relied on by their clients to make financial decisions, while those in a product sales role may be accountable for the accuracy of any information that they provide in the course of recommending a particular product, if the client relies on that information to decide whether or not to buy the product (even if the salesperson isn't held to a fiduciary standard or required to make recommendations that are in their clients' best interests).

Liability Of Advisory Firms Vs Advisory Employees

As covered above, advisors – the individual humans advising clients – are liable for any negligent misinformation that they provide to clients. But advisory firms – the capital-letter Registered Investment Advisers (RIAs) that employ individual advisors – can also be on the hook for information provided by their employees or representatives. By the doctrine of respondeat superior, employers can be held legally responsible for the actions of their employees or agents for actions that occur within the scope of their job duties and can be held jointly liable with the employee for claims like negligent misrepresentation.

This means that while individual advisors can be held personally liable for any negligent advice that they give, their advisory firm can also be named in any claim made by a client if an advisor's actions were done in the course of carrying out their duties as an employee of the firm. And, in practice, since an individual advisor may not have the personal assets needed to pay restitution to a client for a sizeable liability claim, it's almost always the advisor and the firm who are named as the defendants in a professional liability case (and indeed sometimes it's only the firm – and not the individual advisor – who is named in the case). Which makes sense, because an advisory firm is far more likely than any of their individual advisors to have the ability to pay – either from their own assets or, more realistically, from an Errors & Omissions (E&O) insurance policy – for any liability imposed on them. As a result, E&O insurance is almost always held at the firm level instead of at the individual advisor level, since a firm can cover not only its own liability claims but also those of any employee acting on their behalf under a single policy.

It's worth noting, however, that the extension of liability to an employer for its employee's actions only applies when the employee has acted within the scope of their employment. So, for instance, if a financial advisor doesn't take proper steps to determine the client's tolerance for risk before recommending a portfolio, they and their employer could both be liable for any losses incurred by the client as a result. If the advisor starts offering sports betting tips as a side business, however, his employer likely wouldn't be liable for any resulting claims for any money that was lost since that presumably is not within the scope of his employment at a financial advisory firm.

The key point is that although individual advisors are accountable for the advice that they give – and can be sued by their clients if they are negligent in giving that advice – it's almost always the firm that they work for (or, more likely, the firm's E&O insurance) that pays any resulting liability claims. And while there can still be legal, financial, and career consequences for advisors themselves (as discussed more below), that reality means that most advisors don't need to purchase their own individual E&O policies (other than solo advisory firm owners who necessarily would have to purchase their own policy to cover their firms and themselves).

Why It's Important For Advisors To Understand Liability

While most financial advisors may not be personally responsible for financial liability arising from a negligence claim (since it is usually the employer's E&O policy that ultimately pays the claim), there is still the potential for significant consequences for advisors who don't exercise due care in advising clients. These consequences extend to the advisor themselves, the firm they work for, and their colleagues at that firm.

Implications For Individual Advisors

For individual advisors, the most immediate concern about giving negligent advice would likely be the other types of charges, either civil or criminal, that might accompany a liability claim. An advisor who was found to have knowingly given misleading information could be guilty of fraud, which, if serious enough, could come with jail time and criminal (as opposed to civil) fines that the employer would not be jointly liable for, and that wouldn't be covered by their E&O policy.

The second concern for advisors would be the regulatory and professional consequences. For example, a failure to make a reasonable inquiry about an investor's goals and risk tolerance before recommending a portfolio strategy might constitute both negligence (from a professional liability standpoint) as well as violation of state or SEC securities regulations – violations that can result in both additional fines for the advisor and/or advisory firm, as well as the suspension or revocation of securities licenses. Additionally, other professional organizations may have their own standards that could be breached by a professional negligence claim – for example, CFP Board's Code of Ethics requires CFP professionals to, among other things, "act with honesty, integrity, competence, and diligence", and "exercise due care", which means that negligence in giving financial advice could also cost CFP certificants their ability to use the CFP marks.

The third concern is simply the fact that just because an advisor's firm or their E&O insurance might pay a liability claim on their behalf doesn't mean that the advisor's job will continue to be safe. Even if an advisor doesn't lose their legal ability to give financial advice, an instance where they are found to be negligent in giving financial advice could be grounds for losing their job and may (given the public disclosure of regulatory and investment-related legal history on FINRA's BrokerCheck site) make it difficult for the advisor to find other work in the industry.

Implications For Firms

While it's obviously individual advisors who are immediately responsible for exercising due care in giving financial advice in order to avoid client losses that could lead to a liability claim, the fact that employers can be found liable for the actions of their employees means that the advisory firm is the one that bears much of the risk. Even if it's covered by E&O insurance, a liability claim involving the firm can have far-reaching consequences, including higher insurance premiums, suspension or revocation of the firm's investment adviser registration, and the disclosure of regulatory discipline on the firm's own BrokerCheck page. Which means that firms can and should take their own steps towards minimizing their liability exposure.

The first and most obvious step towards minimizing firm-level liability is obtaining adequate E&O coverage. Although most states require RIAs to hold a surety bond that can pay out in the event of a client's liability claim against the firm, the reality is that those bonds provide little or no protection for the firm: Not only is the size of the bond grossly inadequate to cover many potential liability claims (with most states requiring only $10,000 in coverage), but when a surety bond provider pays out a client claim, it's allowed to seek repayment from the advisory firm's assets (and the firm owners' own personal assets as well!). Meanwhile, only 2 states – Oregon and Oklahoma – require advisory firms to carry E&O insurance (though major custodians like Fidelity and Schwab, filling the gap that most regulators have failed to address, now mandate that advisory firms have at least $1 million of E&O coverage in order to use their platforms).

But while buying E&O coverage is easy, the fact remains that it only provides liability protection after the fact – it does nothing to reduce the risk of a firm being found liable for its advisors' actions in the first place. To do that, firms need to invest in training their advisors in what it means to exercise reasonable care in giving financial advice – for example, clarifying the firm's rules for advice given around taxes to remain consistent with IRS regulations, ensuring that the firm's advisors understand the workings behind any technology they use to create and deliver recommendations to their clients, and creating a framework for advisors to satisfy their fiduciary obligations to their clients.

Why What Other Advisors Do Matters

For an individual advisor, avoiding the consequences of being found liable for negligent advice seems simple enough: Just don't give negligent advice, right? That might be the case for an owner/advisor of a solo practice who is ultimately only impacted by their own actions as an advisor, but for anyone who works on a team where other advisors are involved, it's not enough to simply mind one's own business.

This is because what affects a firm as a whole impacts everyone who works for that firm. An advisor can be perfectly diligent in how they give advice themselves, but if one of their co-workers is found liable for giving negligent advice, they could still suffer some of the negative consequences. Most severely, if the firm they work for doesn't have proper E&O coverage, a liability claim could impact its financial stability, putting the jobs of each of that firm's advisors at risk even though most of them may not have been to blame. In any event, the reputational risk of having worked for a firm that was found liable for the negligent advice of one of its advisors could dog an employee for the rest of their career.

Which is why, ultimately, when exploring whether to join a firm, it's incredibly important to consider the firm's culture. A firm is more than an office space, a tech stack, and a corporate letterhead design – it's also a collection of other employees and advisors, and what those colleagues do matters to everyone else at the firm. It's only fair for an advisor considering whether or not to tie their own career to that firm to want to know how the firm is protecting itself and its employees from professional liability, not only via adequate E&O coverage but also by creating a culture where its advisors are trained and encouraged practice their profession with care and diligence.

In other words, even when an advisor is perfect in how they give advice, they won't be as happy or successful in their careers if they're the only ones doing so, because it's much more fulfilling to be surrounded by others who take the same care in advising their clients as they do!