A War Story

By John A. Dodsworth

Editor’s Note: “War Stories,” drawn from Camico’s claim files, illustrate some of the dangers and pitfalls in the accounting profession. All names have been changed.

Subject: PFP/Investment Advisory Services

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

Geary has little interest in (or understanding of) financial concepts. His CPA, Patrick Bigelow, has prepared his 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 (PFP) services. Although Geary was too busy to sit down with Bigelow and draft an investment plan, he was receptive to Bigelow’s recommendation for a significant portfolio shift from fixed income to equity, and a referral to an investment advisor.

Geary enlisted the advisor and ended up with several portfolios, including a group of high tech stocks earning about 25 percent to 30 percent a year. The other, more diversified portfolios chugged along at 10 percent and 15 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 age 65, but the CPA figured the actor was informed of the risks.

When the stock market’s big downturn of April 2000 came along, it wiped out almost $1 million of Geary’s high tech values. A series of increasingly malicious computer viruses created further stock market downturns during the remainder of 2000. Higher short-term interest rates and real estate prices 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. He recalled that his CPA had referred him to the advisor 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 advisor who would eventually lead him astray. The actor sued the accountant, alleging that the CPA had a total responsibility for Geary’s overall financial well-being and should have warned him of all the risks he had taken.

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

Client Risk Factors

CPAs learn to work with most clients, regardless of their personal traits. The personal nature and the money involved in financial planning, however, increase the importance of evaluating client characteristics. CPAs may decide to decline or withdraw from an engagement, or may just increase attention to communicating with the client and documenting the communication.

Age: The older your client, the greater the 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 persons are often protected by laws designed to curb financial abuse by opportunists and crooks. Such laws can also be used to punish financial advisors in hindsight, and are supported by strong public perceptions about the duties of advisors.

Personality: Look objectively at your clients’ personalities. Ask yourself, “Are they too demanding? Are they inflexible or reasonable? Do they seem to understand that life holds no guarantees, 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 clients understand about basic concepts of the financial market, the less tolerant they are of returns that don’t meet expectations, and therefore the more dangerous they can be. 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 more readily take a CPA’s advice, 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 decision making. 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 CPA’s significant attempts to ensure client involvement in the process and client consent to the transactions.

Involvement with Other Professionals

Another major risk factor is the CPA’s 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 in seeing himself as just the CPA planner while seeing the investment advisor as the professional managing the investments. The CPA felt that he was not responsible for the decisions made between the client and the advisor, and therefore not responsible for the return on investments. The problem with that perception is that it is not generally shared by clients or 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 advisor, suggesting that the clients choose 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 loss prevention measures will help make the risks worthwhile. Due diligence toward other professionals and clients, adequate insurance coverage, an engagement letter, investment plan, good documentation and quarterly reviews are all important tools in these services.

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John A. Dodsworth, CPA, has been president and a director of Camico Mutual Insurance Co. since its inception in 1986. He is the 2001 recipient of the California Society of CPAs’ Distinguished Service Award.