New Zealand: The Hayne interim report: financial advice misconduct
Brief Counsel

Overview

Financial advice misconduct, which is the subject of the longest chapter in the Australian Royal Commission's interim report, focuses on five principal areas:

• Fees for no service under ongoing service arrangements – charging trail commission without additional services has recently been prohibited in Australia, and some financial services providers had not addressed past practices in line with the new law.
• Platform fees – whether clients using investment platforms were being charged reasonable fees and receiving appropriate advice.
• Inappropriate financial advice – failure to provide advice that took proper account of the client circumstances or was consistent with the client's best interests.
• Improper conduct by financial advisers – a wide array of misconduct, including falsifying documents, misappropriating customer funds and engaging in misleading or deceptive conduct.
• Disciplinary system – whether suitable penalties for misconduct were being imposed.

The Commissioner found that sales-based remuneration and vertical integration create inherent conflicts between the interests of the adviser/licensee and the interests of the client, and that in practice, these tended to be resolved in favour of the provider.

He considers that sales-based remuneration is permissible for sales staff, but not for advisers; and is unconvinced that there is a commercial need for grandfathered remuneration to continue, as it creates misaligned incentives that could lead to clients not receiving the best financial advice.

Fees for no service

The Commissioner identified this as a "large and endemic problem", the root cause of which was "greed" on the part of both licensees and advisers. This diagnosis was based on the following findings:

• licensees treated the provision of services as a matter between the client and the adviser, and did not stop the misconduct but instead benefited from the proceeds
• advisers often treated ongoing service arrangements as nothing but trail commissions for advice already given, which is prohibited in Australia
• the client was seldom aware that fees were being charged so was not in a position to complain
• although "the most basic standards of honesty" had been breached and some of the conduct had been "inexcusable", no-one had been formally investigated or punished, and
• licensees had ignored their obligation to identify and compensate affected clients.

Contributing factors to the misconduct arising ongoing service arrangements identified by the Commissioner included:

• the services to be provided were not well-defined or commensurate to the fees charged, being typically set as a percentage of the funds under management (FUM)
• the arrangements created a financial advantage for the adviser which became greater the less work that was done, and
• licensees did not have systems in place to ensure that services were provided in return for the fees (only to record the incoming revenue), and did nothing to prevent advisers from taking more customers on to their books than they could handle.

The Commissioner acknowledged that some entities had moved to address these issues, changing system controls and altering record keeping and oversight, but this was not enough as it did not deal with the root cause – the "enticing call of profit, the uncertain content of what was promised and the capacity to deduct the fees invisibly."

Practice changes which the Commissioner has signalled are under consideration include:

• requiring ongoing service arrangements to be renegotiated annually
• limiting the operation of that authority to the period fixed by the ongoing service arrangement, and
• requiring the express authority of clients for any deduction of fees.

Platform fees

Findings based on the platform fees case studies include:

• the default setting "seemed too often to be set and forget" so that platform operators remitted ongoing service fees from clients to licensees without any authority beyond the licensee's claim to be entitled to payment
• general industry practice was to calculate fees by reference to the FUM, not as a fixed fee, suggesting a lack of strong competitive pressure
• due to the grandfathering provisions, platform operators continued to receive remuneration that would otherwise be banned as conflicted, and
• although the approved product lists maintained by the platforms contained third party products, advisers "more often than not" recommended products from affiliated entities.

Inappropriate financial advice

The Commissioner acknowledged the inevitability that advisers will sometimes give advice that is wrong or would not have been given with the benefit of hindsight, that not all advisers are equally skilled or diligent and that there will be times when subjective judgements are required.

But even allowing for these realities, he considered that the inappropriate advice case studies revealed "some large and deep-seated issues", in particular:

• advisers proposing actions that benefitted themselves, their employing entity or their licensee
• advisers lacking skill and judgement, and
• licensees being unwilling to explore whether poor advice had been given and, if it had, to take timely steps to put it right.

The Commissioner considered that the Australian legislation did not deal adequately with the inherent conflict between clients' interests and the interests of advisers and that it was too focussed on process rather than outcome.

In most cases, advisers and licensees made little or no effort to conduct a "reasonable investigation" into whether a product would achieve the client's objectives, instead considering that this obligation was satisfied by selecting from the licensee's approved products list.

But reliance on these lists led them to disproportionately recommend in-house products, the sale of which conferred on them a financial benefit.

One provider had responded to the Commission evidence by removing all sales incentives in favour of an assessment system based on customer satisfaction, adopting a termination policy if planners failed two audits, and committing to compensate 9,000 inappropriate advice cases by the end of this year.

The Commissioner commented that all three changes "invited close examination of claims that sales-based incentives cannot, or should not, be removed, that it is difficult to encourage good advice, or that remediation is an intrinsically protracted process".

Improper conduct

The Commissioner observed that the prevention of improper conduct begins with education and training, reinforced by detection (achieved through regular, random and efficacious auditing of advisers' files), with significant consequences for breach.

Examples from the case studies of ineffective auditing systems included:

• allowing departures from legal obligations to be treated as "immaterial", and
• erasing point deductions for poor audit results before the next audit was due so that no significant remuneration or career consequences were incurred by consistently poor grades.

The Commissioner placed some of the blame for the improper conduct on ASIC's enforcement processes. ASIC had preferred to rely on banning orders, which took a long time to secure. It had seldom invoked the civil penalty provisions and had not prosecuted any licensee for failing to comply with legislative reporting obligations.

Disciplinary system

The Commissioner found that the disciplinary system suffered from segmentation.

The Financial Planning Association of Australia and the Association of Financial Advisers had processes and systems for disciplining members but membership was not compulsory and:

• they played no significant role in maintaining or enforcing proper standards of conduct
• they applied different approaches, creating a situation where advisers could shop around and switch their membership to the association with the least demanding approach, and
• licensees were not sharing information of misconduct with either the industry Associations, or with ASIC or with each other.

The Commissioner stated that some of these issues would be addressed by requiring advisers to be members of a Code of Ethics monitoring body and preventing them from switching membership if under investigation.

Themes

Themes that will inform the Commissioner's final recommendations in relation to financial advice are:

• culture and incentives – with a focus on the influence of remuneration structures
• conflicts of interest and duty and the confusion of roles – the legislative emphasis on managing rather than eliminating conflicts of interest, that in the Commissioner's view conflicts were resolved in favour of self-interest more often than not, the need to address the consequences arising from entities being vertically integrated, the confusion of roles and responsibilities of, for example, mortgage brokers and mortgage aggregators, and
• regulator effectiveness – the responses ASIC might have made and whether the responses that it did make were satisfactory.

Chapman Tripp comment

Good policy making requires being open to the possibility that, while the status quo might have undesirable consequences, these may be outweighed by countervailing benefits. In such cases, the response should be to ameliorate the undesirable consequences rather than root and branch reform.

This may be particularly true of vertical integration, where the focus should be on transparency and more effectively managing of conflicts of interests, rather than mandatory separation.

Even comparatively minor reforms like requiring financial service providers to obtain annually the customer's agreement to pay fees under ongoing service arrangements can impose significant costs (including technical and systems adjustments) which may be passed on to customers or result in a reduction of services, thereby decreasing customers' access to suitable financial products.

In the policy round, the Commission should focus on what reforms would achieve better customer outcomes, by evaluating the practical impact of the available options.

Eliminating misconduct is a valid policy goal but so are ensuring that customers are able to access financial advice at a reasonable cost, that competition and innovation are encouraged and that financial advisers are adequately compensated.

The information in this article is for informative purposes only and should not be relied on as legal advice. Please contact Chapman Tripp for advice tailored to your situation.