With great growth comes great conflicts for RIAs

Where Wall Street goes, trouble is sure to follow.

For years, the registered investment advisor side of the financial advice industry has preached it was cleaner in spirit and practice, and had fewer conflicts, than the brokerage side of the street.

RIAs charge clients fees, so they always have their clients’ best interests at heart, the common wisdom goes, while broker-dealers charge clients commissions on transactions, a relationship fraught with potential conflicts.

Twenty years ago, that line of thought may have been more true than false. The RIA industry was still in its infancy, and a firm with $500 million to $1 billion in assets was considered a giant.

Today, an ever-growing number of RIAs have tens or hundreds of billions of client assets under management. Wall Street, via private equity managers, is throwing gobs of money at the industry in pursuit of purchasing RIA firms.

And where Wall Street goes, trouble is sure to follow. With such tremendous growth in assets, and potential wealth for financial advisors who own RIAs, comes the potential for an increase in the dreaded conflicts of interest with advisors’ clients.

One way to examine conflicts of interest between financial advisors and clients is to look at complaints, meaning lawsuits, that investors file against financial advisors and their firms when something goes wrong with their portfolio, a common experience for many. Markets don’t always go up, and some investors are likely to sue brokers and financial advisors when markets experience severe shock, as they did in 2008 and again in 2022.

Investor lawsuits against broker-dealers are disclosed publicly by the Financial Industry Regulation Authority Inc., while those involving RIAs are private affairs. But data just released by an insurance brokerage that works with RIAs and other financial service companies, Golsan Scruggs, open a window on RIAs and how they weathered the severe market downturn of 2022.

That year, the S&P 500 dropped 19.4%, fueled by fears of a global recession after Russia invaded Ukraine.

According to Golsan Scruggs, RIAs saw a 213% increase in total errors and omissions liability claims paid by their insurers in 2023, as they faced a sharp uptick in investor complaints as a result of 2022’s broad market slump.

“The three-fold increase in claims paid overall is attributed to a 500% increase in claims for suitability, primarily investor complaints that investments were not appropriate for their portfolios,” according to the insurance brokerage. “Because suitability claims typically have higher payout amounts, the severity of all claims paid by insurance companies against RIAs rose 85%.”

“We know from experience that claims follow the market, so we expected to see an uptick in actions against RIAs and claims paid given the historically poor market environment in 2022,” Kenneth Golsan, managing director of Golsan Scruggs, said in a statement. “But the size and severity of claims paid should be a wake-up call to advisors that liability claims can have an impact on their business.”

Claims data were drawn from Golsan Scruggs’ 2023 aggregated “insured risk pool” of 2,042 U.S.-based RIA firms, which had an average of $400 million in assets under management and a median of $200 million.

“RIAs have never been conflict-free,” said Scott Silver, a plaintiff’s attorney. “We’re seeing more complaints involving RIAs and products like GWG bonds, and RIAs creating their own proprietary investment funds. Plus, there’s been a boom in bad brokers leaving the Finra world of broker-dealers to work at RIAs.”

A common complaint in the brokerage industry is that RIAs, which are overseen by the states and the Securities and Exchange Commission, are much more lightly regulated than brokers, who must answer to Finra.

To coin a phrase from the Spider-Man comics, with great growth comes great conflicts for RIAs. The industry has grown, and grown up, over the past two decades, a development much for the better for the investing public as well as to the good of financial advisors.

There’s no doubt about the growth. As InvestmentNews reported at the end of 2022, the fee-only registered investment adviser industry surged that year despite the terrible stock market, totaling more than $3 trillion in client assets for the first time in a tally of RIAs by region.

But conflicts of interest are settling in at RIAs much as they have at broker-dealers, particularly as Wall Street’s private equity dollars chase returns. The industry needs to recognize this change.