There is a theme that seems to repeat itself in the broker/dealer industry: quality advisors join shops that, deliberately or not, peddle bad investments and get caught, and those good advisors suffer for it. We've written about this before, in fact, back when Allen Stanford's shop blew up and was shut down by the SEC in 2009. Turned out Stanford's operation was a Ponzi scheme.

But a wave of collapsing broker/dealers seems to be cresting now, with too many firms broken by bad products and/or lack of capital. As our staff writer Diana Britton reports on page 41, it's ugly out there. Dozens of b/ds have gone belly up or put themselves on the block. Good advisors, the ones who didn't sell fraudulent investments, are scurrying for cover.

I would like to remind those who are jumping ship: Your new firm may not cover any bad activity from your old house. More precisely, your new firm's E&O insurance generally doesn't cover any potential liabilities incurred from your old firm.

Put more precisely, advisors are generally unaware that unless they take appropriate action when they move to a new broker/dealer, they typically will no longer be covered for business transacted at their former firm, until they are faced with a claim made against them. (Then they learn the hard way.) The result is typically damaging and expensive.

When evaluating an E&O plan, most advisors assume that plans with similar costs will have similar coverage. Most advisors look at price as the determining factor in quality of coverage, when in fact, cost is far from an indication of the quality or extent of coverage. In reality, even plans from the same company with similar costs can have notably different coverage.

Advisors are also typically unaware that most policies today are written on a “claims-made” basis, which means that you'll only be covered for what's in your policy at the time a claim is made, rather than at the time you sold the product. For example, if you were served with arbitration in 2010 for something that happened in 2008, only your current 2010 policy would cover you for that arbitration. That coverage may be quite different from the coverage you had in 2008.

Advisors who don't know or understand the details of their E&O policies can end up in financial trouble. “Between 0.5 percent and 1 percent of advisors will have claims filed against them in a good year for the markets,” according to Rob Erzen, vice president and E&O broker with Arthur J. Gallagher & Co., a risk management services firm. “That number will increase to between 3 and 4 percent in a bad year. And while these may not seem like high percentages, over a 20-year career these odds stack up against you.”

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