The recent actions of errors and omissions insurance carriers should serve as a major red flag to investors. Many of these carriers are refusing to issue coverage for sales of certain alternative investments. In other words, these carriers have determined that the risk of loss associated with the sale of certain alternative investments is too great to insure. If the risk of loss associated with sales of alternative investments is too great for insurance carriers, one would think that the risk of loss would be too great for all but the most speculative investors.
Many alternative investments are illiquid and speculative products that are unsuitable for most investors and are on regulators’ radar screens. A broad array of investments are classified as alternative investments including non-traded REITs, promissory notes, structured products, exchange traded products (including ETFs and ETNs), high yield junk bonds, hedge funds, closed-end funds and variable annuities, among others.
E&O carriers are exercising greater control over the coverage they will provide for alternative investments that their broker-dealer clients sell. Among other things, FINRA’s new suitability rule requires selling brokers to perform due diligence sufficient to understand the risks of a product before selling it.
E&O insurers are demanding heightened due diligence alternative investments such as non-traded REITs, and are apparently doing their own due diligence before approving a product for coverage. For instance, many insurers are refusing to cover the sale of products for which there are no audited financial statements (“E&O underwriters screen alt products,” InvestmentNews).
Insurers are also imposing lower claim caps and much higher deductibles for alternative investments. Deductibles have reportedly risen from $25,000 to $50,000 in many policies, and claim limits have been cut in half.
These developments follow massive losses, litigation and regulatory scrutiny involving alternative investments, such as the fraudulent promissory note investments issued by Medical Capital Holdings Inc. and Provident Royalties LLC, and the dramatic devaluations and problems associated with nontraded REITs.
Numerous smaller broker-dealers that sold private (Reg D) investments were forced to shut down in the past few years, unable to bear the expenses of litigation following implosions of these products.
Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.