MANAGING FINANCIAL PLANNING RISKS.

RIDING THE WAVES THROUGH CALIFORNIA'S ECONOMIC SWELLS ANDTROUGHS

All through the '90s and into the new millennium, California CPAs have been riding the wave of financial gain as they transition away from traditional tax and audit services and into the world of personal financial planning and investment advisory services. Why? It may have been the forces enumerated in the AICPA Vision Process, a chance for economic success, or simply a desire to try something new.

As long as the economy continues to grow and clients are fairly happy, the professional liability risks associated with investment advice and PFP tend to be manageable. But if the economy recedes and the stock market gets bearish in a way that causes clients to suffer substantial losses--watch out. Your wave may come crashing to the shore as your clients start looking for someone to make them "whole" again. That someone could well be the professional who is held to a higher standard than all the other financial advisers--the CPA.

California law adds an extra dimension: CPAs' ability to accept commissions. The commissions law went into effect Jan. 1, 1999. You can find the provisions that detail the circumstances under which a CPA can accept a commission in California Business and Professions Code Sec. 5061. The strong economy and relative youth of the law make it too early to determine its consequences.

CONTROLLING LOSSES

Although the commissions law may still be a babe in arms, PFP services have been around long enough for risk management experts to identify several time-tested techniques for controlling losses. To better understand how some of those techniques are applied, consider the following:

Dennis Geary, a 65-year-old actor with an increasingly successful career, generates a six-figure income. He has a reputation as a talented but demanding professional with high expectations and a temper that explodes when things go awry.

Geary has little interest in (or understanding of) financial concepts. His CPA, Patrick Bigelow, has prepared Geary's tax returns for years and has provided advice about business deductions, loans, SEP IRAs, and various other financial items, as well as personal financial planning services. Although Geary was too busy to sit down with Bigelow and draft an investment plan, he was receptive to Bigelow's recommendation to a significant portfolio shift from fixed income to equity, and a referral to an investment adviser.

Geary enlisted the adviser and ended up with several portfolios, including a group of high tech stocks earning about 25-30 percent a year. The other, more diversified portfolios chugged along at 10 percent, 15 percent and 20 percent. Geary was so fond of his high techs that he had the 10-percent-return portfolio converted into more high tech stocks. Bigelow was surprised that Geary wanted to get even more aggressive, especially at 65, but the CPA figured he was informed of the risks.

When the stock market's big downturn of April 2000 came along, it wiped out $1 million of Geary's high tech values. A series of increasingly malicious computer viruses created further downturns during the remainder of 2000.

Higher short-term interest rates and real estate prices in California caused Geary and thousands of others to postpone major purchases, impacting the "real" economy of retail sales. More downturns and cutbacks in consumer spending created a disappointing retail season for Christmas 2000 and a gloomy economic scenario by January 2001.

As Geary's portfolio went from about $3 million to $2 million in less than one year, his temper shot up. He felt that his financial experts should have averted this disaster. Geary recalled that his CPA had referred him to the adviser with the recommendation that he invest more aggressively.

Geary's files included Bigelow's PFP engagement letter, which made no mention of investment risks. This confirmed to Geary that the CPA was wrong to have referred him to an adviser who would eventually lead him astray. The actor sued the accountant, alleging that Bigelow had a total responsibility for his overall financial well-being and should have warned Geary of all the risks he had taken.

This scenario illustrates common risk factors with PFP engagements that increase the likelihood of losses when investments, such as stocks, take a downward turn.

CLIENT RISK FACTORS

CPAs learn to work with most clients, regardless of their personal traits. However, the personal nature of financial planning, and the money involved, increase the importance of evaluating client characteristics. Such an evaluation may lead to a decision to reject or withdraw from an engagement or may just cause you to increase attention to documenting and communicating with the client

Age: The older your client, the greater a jury's expectation of your performance. This is partly because a 65-year-old doesn't have as much time as a 30-year-old to rebound from any adverse impact of a high-risk investment. Also, older individuals often are protected by laws designed to curb financial abuse by opportunists and crooks. Such laws also can be used to punish financial advisers in hindsight, and CAMICO's jury studies indicate that these laws are supported by strong public perceptions about the duties of advisers.

Personality: Look objectively at your clients' personalities. Ask yourself, "Are my clients too demanding? Are my clients reasonable, or inflexible? Do they seem to understand that life holds no guarantee, or do they look for someone to blame?" CPA malpractice cases frequently involve individuals who place unrealistic expectations on both their CPA and investments.

Financial knowledge: There is a close correlation between clients' unrealistic expectations and their financial knowledge. The less a person understands about basic concepts of the financial market, the less tolerant the individual is of returns that don't meet expectations, and therefore the more dangerous. CAMICO has found it much easier to defend a CPA in front of a jury when the client is perceived as knowledgeable. A client who has little financial knowledge may take a CPA's advice more readily, but that same lack of knowledge will tend to increase the jury's expectations of the CPA's responsibility.

Client involvement: Clients who want a CPA to just "take care of" their financial affairs without "bothering" them with details pose a higher risk than clients who want a team approach, to make decisions and hear details. It's not unusual for the uninvolved client to suddenly have a change of heart once things go wrong. This may be in spite of the CPAs significant attempts to ensure client involvement in the process and consent of transactions.

INVOLVEMENT WITH OTHER PROFESSIONALS

Another major risk factor is the CPAs involvement with other professionals. When investment or insurance professionals make mistakes, the CPA is sometimes named as a defendant simply to bring additional compensation to the client. In other cases, clients might hold the CPA responsible for failure to exercise due diligence over their entire financial picture.

Bigelow's mistake was to see himself as just the CPA planner and the investment adviser as the professional managing the investments. The CPA felt that he was not responsible for the decisions made between the client and the adviser, and therefore not responsible for return on investments. This perception generally is not shared by clients nor the public, and "not responsible" can easily become "irresponsible" in a jury's eyes.

A good risk management technique is to refer clients to more than one investment adviser, suggesting that the clients choose the one with whom they feel the most comfortable. Juries believe that clients are partly responsible for their own finances, and if the clients ultimately decide who will work best with them, it helps insulate the CPA from liability.

LOSS PREVENTION MEASURES

Based on claims statistics, CPAS new to PFP services will be exposed to greater risks than experienced PFP professionals, but implementing the following loss prevention measures can help make the risks well worthwhile. Following are some of the PFP professional's more important tools:

Due diligence: Take time to obtain sufficient background information on clients to ensure that they match your skills and that you have evaluated their risk factors. Risk factors can be determined in interviews or by checking with the client's prior accountant, who can indicate the degree of involvement, financial knowledge, expectations and timely bill payments. Negative responses to one or more factors indicate a need for increased attention to documentation and may be reason to decline the engagement.

White-collar criminals do not appear to be dishonest, which is why you should run background, reference and credit checks. Pay special attention to an individual's integrity and competency, or lack thereof.

Perform due diligence with respect to any investments made on the client's behalf, and approach new investments with a great deal of skepticism. Any situation that looks "too good to be true" probably is.

Engagement Letter: An updated engagement letter, signed by the client, is essential. Clearly spell out the nature of the work that you and any other professionals will perform. Describe the limitations of financial planning and what you expect from the client. You also should clarify that the client understands the assumption of risk in any investment, and that you are not responsible for the outcome of investments. CAMICO has written a guide to effective engagement letters, including several sample letters for PFP services. For an order form, call [phone], or go to http://www.camico.com/htm/engagement_book.htm.

Investment Plan: An investment plan is often the central component of a financial plan. Richard M. Goldstein, CPA, of San Ramon-based Goldstein Enright Financial Advisers, first spends time:

* interviewing the client to determine interests, objectives and concerns;

* conducting financial analyses;

* devising appropriate tax minimization and investment strategies to address the client's needs;

* coming to a consensus with the client; and

* documenting the plan with a written statement of investment policy, signed by the client and adviser.

Goldstein notes, "Our statements of investment policy clearly describe the approach being taken with the client's investments in terms of risk tolerance, asset allocation (with periodic rebalancing), investment objectives, time horizon, liquidity, securities, performance histories and expectations."

Documentation: Document the planning process and the advice given to the client, particularly investment advice. This becomes even more important when other professionals are involved, or when additional risk factors are present. Use letters and other forms of documentation to keep the client informed. Try to include beneficiaries in the communications loop when performing estate planning services. CPAs can be held liable for losses unless they can prove that their advice was given and declined, ignored or forgotten.

Quarterly reviews: Quarterly reviews are effective in deflecting problems proactively. Meet with clients to make sure they understand any new developments impacting their financial and investment plans. Periodic re-balancing of asset allocation also can be conducted. Update the documents to reflect changes and obtain client signatures. If the CPA doesn't hold a review until a problem crops up, it's already too late.

Insurance coverage: Insist that any professionals involved in related financial planning functions have errors and omissions insurance. This will help insure the client against losses and help protect you from claims directly related to their work.

Most accountant's professional liability policies do not provide coverage if a commission is involved, so you may need to purchase additional coverage for securities and insurance-related services. CAMICO's policy provides coverage as long as the commission is "legal." When dealing with a high-value trust, consider higher limits. In any event, ask for coverage clarification in writing from your carrier to avoid misunderstandings.

Investment Advisory Services: Many CPAs who provide PFP services have taken the next logical step and provide investment advisory services, which may range from making specific recommendations to complete management, including execution, of a client's portfolio. These services will increase liability risk, due to the potential for improper execution and the risks associated with investments that fail to perform according to the client's expectations. If you provide investment advisory, services, these loss prevention measures become even more important.

You need to be especially careful to avoid any situation that would appear to be a conflict of interest. With the exception of publicly traded securities, do not recommend investments with which you have a financial relationship. In fact, most professional liability policies will not cover suits over investments in which the CPA has more than a minor relationship.

Commissions: If you provide financial products and receive commissions from a third party, California Board of Accountancy Rule 56, "Basic Disclosure Requirement on Commissions," provides a model for good documentation that always is signed and dated. Rule 56 requirements include:

* a specific description of the product or services (commissions cannot be accepted solely for referrals-a consultation with the client must be provided),

* the commission arrangement (including dollar amount, value, or basis on which the payments shall be computed), and

* signatures by the licensee and the client, including an acknowledgement that the client has read and understood the information in the disclosure.

Checklists related to CPAs accepting commissions can be obtained via CAMICO's fax-on-demand system at [phone]; Ext. 5, Option 2, Document Number 13028.

Financial planning and investment advisory services require significant amounts of ongoing study and consulting. The demand for such services also can be significant, as clients often want their CPAs to take more control over their financial planning and investment needs. For the CPA, that means making a large commitment to mastering and staying on top of the ever-changing complexities of those fields.

CAMICO's experience is that CPAs who commit the time to develop and maintain their own expertise are generally "doing it right" and well compensated. Those who casually dabble in a particular field often are not doing it right and are generating losses for themselves and their clients. By adhering to the high professional standards imposed on CPAs by the accounting profession and public, accountants can well manage the relatively high risks involved in this highly rewarding field.

John A. Dodsworth, CPA, has been president and a director of CAM/CO Mutual Insurance Co. since its inception in 1986.