Managing Risks in Investment Programs
Credit unions manage risk all the time: asset – liability risk, regulatory risk, operational risk, employee liability risk, and reputation risk. That is the nature of a financial institution. When credit unions decide to offer investment services to members, it is simply a matter of understanding how to manage a different set of risks. There is no doubt that the business of providing investment services has risks. The regulations are complex and the penalties for non-compliance can be significant. There are many opportunities for customers to raise claims that they suffered losses due to real or imagined negligence of the investment services provider. However, thanks to a number of factors for the credit union many of these risks are mitigated.
The good news is that the broker/dealers are 100% responsible for compliance with securities laws and the operation of the investment services business. Unless a credit union decides to form a CUSO and register the CUSO as a broker/dealer, a credit union can manage the risks of providing investment services away from the credit union, with one exception; reputation risk. Whenever a credit union provides a product or service whether using outside service providers or internal resources, a mistake can have a negative impact upon the credit union’s reputation with that member. This is true in investment services too regardless of whether the networking program is a managed plan or dual employee plan.
In a managed plan, the registered representative is an independent contractor and agent of the broker/dealer and paid by the broker/dealer. The advantage is that in a managed plan it is a turn key operation that requires minimal credit union involvement and commitment to start operations. The down side is that there is often little credit union involvement and commitment to the program which typically translates into mediocre results in integration, penetration and revenue.
In a dual employee plan, the registered representative is an independent contractor and agent of the broker/dealer but the representative is also an employee of the credit union. The registered representative is paid by the credit union through the commissions paid by the broker/dealer to the credit union. This arrangement is made possible under the authority of the SEC no-action letter to Chubb Securities. The advantage of the dual employee program is that the message to the credit union staff is that the credit union’s commitment to the investment program is significant and while the dual employees have a different role, they are co-employees. This typically results in the credit union staff becoming more involved and committed to the success of the investment program. This translates to more integration with the credit union, staff support and typically referrals. The representative also more closely identifies with the credit union as a result of the credit union’s enhanced commitment. When and if the credit union changes broker/dealers, the representatives in dual employee programs typically stay with the credit union and affiliate with the new broker/dealer. The credit union staff sees the representative as being on the same team and this usually results in more support and referrals to the representative. Another important consideration is the greater share of revenue received by the credit union in a dual employee program. The net result is much greater upside potential and contribution to non-interest income. There is no doubt that industry data shows the more successful investment programs being structured as dual employee programs.
For some credit unions evaluating the investment services area, there has been concern that the dual employee arrangement is inherently more risky than a managed plan and are concerned about being liable for mistakes by the representative. There is no evidence that the dual employee plan is riskier than the managed plan and any risks can be successfully managed by the credit union.
In its comments to the proposed IRPS on Non-Deposit Investment Products NCUA expresses concern that the dual employee status of some registered representatives may create liability for the credit union. In the two cases cited in the proposed IRPS, the customer/member was involved in a loan with the financial institution which became an integral part of the plaintiff’s claim. Scott v. Dime Savings Bank, 886 F. Supp.1073 (S.D.N.Y.), aff’d 101F.3d 107 (2d Cir. 1996), cert. den. 520 U.S. 1122 (1997) and Conte v. U.S. Alliance Federal Credit Union, 303 F.Supp.2d 220 (D. Conn. 2004). In the Dime case, a bank employee encouraged the customer to borrow more so he could make investments which were recommended by the dual employee investment representative. This was a collusive scheme between the bank employee and the investment representative who happened to be a dual employee. In the US Alliance Federal Credit Union case, there was a loan secured by securities. The member claimed the credit union caused the sale of the securities in a manner so as to cause a loss to the member. It was not the fact that the employees were selling securities as dual employees that caused the claim. It was the involvement of the bank/credit union as a lender and its actions as a lender in concert with the securities transactions that allegedly caused the losses. I submit that the same claim in each case could have asserted in a managed plan. As an aside, the member in the US Alliance case was granted judgment in the approximate amount of $12,000 on a $10 million claim. The credit union had appealed the decision.
One important indicator of risk is the availability and price of liability insurance. I am told that the current errors and omissions premium to insure the credit union’s risk in employing a dual employee is under $1400 per year for a million dollars in coverage (with $25,000 deductible for trade corrections and $50,000 deductible for other claims). The fact that the insurance is readily available and inexpensive is recognition of the minimal risk by the entities most in position to know, liability insurance companies.
I have consulted with over one hundred credit unions concerning their investment programs over the past twenty-five years. I have interacted with all the major broker/dealers in the credit union industry on compliance issues as General Counsel to NACUSO. I served on CUNA’s Brokerage Advisory Task Force which acted as a liaison between the credit union industry and the SEC. I have consulted with bank counsel who provides similar legal services to bank investment programs. There has been only one incidence that I know of personally where the credit union was sued due to the action of a dual employee and that was an attempt to avoid the broker/dealer’s arbitration clause on a claim. The claim against the credit union was eventually thrown out. I do not know of any claim where a dual employee has provided investment services and a financial institution has incurred liability for the actions of the dual employee absent some affirmative interference by the credit union in the process as in the cases cited above. The lesson is that if the credit union does not interject itself in the sale of investment products, there is no demonstrable risk.
To the extent that there is risk, the risk of the dual employee model can be managed by (1) providing the required Letter 150 disclosures to members to inform them that it is the broker/dealer and not the credit union that is selling investments, (2) contractual provisions that confirm that the representative is exclusively managed by the broker/dealer when involved in investment activity, (3) indemnification by the broker/dealer for the representative’s actions (4) errors and omissions insurance coverage and (5) selection of a reputable broker/dealer that manages risk well and is financially responsible if an error occurs that must be rectified.
Samples of contractual language in the networking agreement which will manage the risk to the credit union are as follows:
Representatives, when selling Products under the Program, will inform Customers: (i) that the Products being offered are not insured by the National Credit Union Share Insurance Fund or any other deposit insurance; (ii) that the Products being offered are not deposits with or obligations of or guaranteed by the Credit Union; (iii) if applicable, that the Products are subject to investment risks, including possible loss of the principal amount invested; and (iv) the Products being offered are provided by Broker/Dealer, and not the Credit Union. No unlicensed Credit Union employee shall accept funds from Customers to purchase the Products. Such disclosures will be made orally and in writing by the Representatives to each Customer who desires to purchase Products under the Program at or before such purchase. Representatives will require any Customer who desires to purchase Products or Services to provide his or her written acknowledgment of such disclosures at the time of opening an account with Broker/Dealer, the form of which will be provided by Broker/Dealer and comply with NCUA Letter Number 150. Broker/Dealer will provide the Credit Union with copies of written acknowledgments provided by Customers upon the request of the Credit Union.
Each Representative will be under the sole control of Broker/Dealer with regard to performance of the securities regulatory duties of the Representative contemplated by this Agreement.
Broker/Dealer will indemnify and hold harmless the Credit Union and its directors, officers… arising out of any negligent act or omission, gross negligence or willful misconduct of Broker/Dealer in carrying out its duties or obligations contemplated by this Agreement, including the acts or omissions of the Representatives when serving as registered representatives, insurance agents or registered investment advisors.
The offering of investment services in networking afflation with a broker/dealer is a risk that is reasonable and can be effectively managed either in a managed plan or a dual employee plan.