Welcome to Part 2 of our mini-series on professional ethics in practice in which we’re exploring ethical dilemmas for financial advisers based on real life situations. In Part 2, Ray Griffin sets the scene of an adviser who has backed himself into an ethical dilemma and is faced with serious disclosure issues to clients and a business partner.
(Click here to see CPD: Professional Ethics #1 and here for CPD: Professional Ethics #3)
Graeme is the founding principal of a modest financial planning firm that employs two advisers and two support staff and which has its own Australian Financial Services License. The firm has just over two hundred clients with around $120 million of portfolios under management. Many of the firm’s clients have been with Graeme since he established the business in the mid-1980s and as such, are well into their retirement years. He has a very strong professional relationship with his clients and some have become good friends with him.
He regards his nephew Mark as the ‘son he never had’ and they are very close with Graeme filling the paternal void left in Mark’s life after his father died when he was just nine years of age. Mark is employed with a technology company as its Director of Marketing and he holds 12% equity in the business. The company, ‘TeckEth’, listed on the share market last year with an initial pubic offering that saw 40% of the company sold to investors. The IPO price resulted in a day one market capitalisation of TeckEth of $350 million that saw Mark’s equity valued at around $42 million.
Revised forecasts
However, since listing, TeckEth’s share price has fallen dramatically due to ongoing market concerns about the company’s recurrent failure to meet forecast new product launch dates. On the back of statements to the market by TeckEth, analysts have revised their earnings forecasts downward and the resultant decline in share price now sees Mark’s equity valued at just $5 million. In effect the share price has been savaged and the company is going to be hard pressed to meet market expectations unless it can raise $20 million to finalise the Beta testing and subsequent marketing of its new software product.
During their regular ‘last Friday in the month lunch’, Mark explains to Graeme the predicament that TeckEth is facing. He explains how he believes the company’s share price should return to a substantially higher level once the new software is launched and earnings improve. Mark delicately raises the question of whether or not Graeme would be able to assist with the raising via recommending it to clients of Graeme’s firm.
Overly pessimistic
Mark goes on to explain that due to falling support for the share price, all of which in Mark’s mind is overly pessimistic, the underwriting broker is not confident of getting all the otherwise modest capital raising filled. From previous discussions Mark knows that Graeme’s firm manages over a hundred million dollars for clients and suggests to him that a $5 million allocation would represent a relatively small amount of the firm’s overall portfolios.
Graeme explains to Mark that he would need to give the idea very detailed consideration because of the risks involved in technology companies. As he says that he sees Mark’s facial expression change from one of warmth to one of concern. It prompts him to say to Mark: “Don’t worry, mate – I’ll see what we can do – but I can’t promise anything – you know that don’t you?”
Subsequently, Graeme begins to think the request through more fully as he drives back to the office. He knows that there is risk involved with a company like TeckEth but on the other hand, he tells himself, it would be nice to have an investment that is a real winner – an investment that really delivers on capital growth during what has otherwise been a difficult period for portfolios in terms of growth.
Graeme’s clients are mostly retirees and his approach to portfolio construction for them for very many years has centred on allocations to assets that deliver consistent, competitive, income streams in a tax effective manner. His much-stated mantra to clients of ‘income over growth’ rings loud in his ears as he ponders the discussion with Mark. He thinks about the extra cash all portfolios have held for several years now and the return on which is declining as the central bank continues its easing program. He begins to justify such a recommendation to clients on the basis that it would represent a small proportion of portfolios – less than 5%.
Recommendation
Three weeks later and Graeme is writing a letter of recommendation to all clients to apply for shares in TeckEth via the capital raising. In his advice document Graeme goes to great length to point out that the investment is high risk with no guarantee of success. He explains that there is a chance that the company could fail completely and that could result in the total loss of capital. However, he goes on to say that the forecast earnings for the company, once the new product is released, is expected to result in a fully franked dividend of 3.50% p.a. and that this will see the investment fall into line with the firm’s preferred requirements. Graeme pointed out, in the letter of recommendation, that he too was going to personally invest in TeckEth as he knew this would give clients, particularly the more cautious clients, the final piece of comfort they would need to follow his advice.
In the back of his mind, as he drew closer to completing the letter of recommendation, was the issue of his relationship with Mark. Graeme knew he was conflicted but justified his actions by the fact that he was also going to be taking the risk – right alongside his clients.
In the following weeks almost all of Graeme’s clients accepted his recommendations and TeckEth was successful in getting all but a million dollars or so of funds required with the shortfall being met by the underwriting broker. After the raising, the share price initially remained relatively stable, in line with overall market movements.
However, several months later the share price moved 25% lower in one day’s trading following Tecketh’s announcement that its Director of Product Development has resigned citing a ‘desire to pursue other endeavors’. The market knows how to read resignation code and instinctively discounted the share price knowing that there were serious internal problems at TeckEth. The share price languished for several more weeks while the company commenced a recruiting process and during this time Graeme was under considerable duress as he worried about his clients and the value of their TeckEth holdings. He constantly agonised over whether or not he should recommend that clients sell their holdings or simply ‘ride it out’?
Mark missed the last two ‘last Friday in the month’ lunches with Graeme and so Graeme phoned him to see if all was well. Mark was harsh in his criticism of the market’s pessimism about TeckEth and went on to say that he was facing a pay cut because it had become obvious that the product launch would now face further delays.
Graeme, thought it time to front Mark with the question: “Do you think I should sell?” Mark advised in the negative citing the big lift the price should enjoy once the product launched. Mark claimed that independent analysts have confidentially reported to the board that a product launch that achieves 75% of targets should underpin a substantial lift in the share price – well beyond the IPO price. On current pricing, on average, clients are facing a loss of around 30% of an investment that originally represented around 4% of their portfolios.
Added complexity
The other adviser in Graeme’s business, Susan, has 10% equity in the firm and has been increasingly concerned about the TeckEth situation. She is is perplexed as to why Graeme wanted to recommend it in the first instance and why he is now equivocating over whether or not to recommend a sale now. Susan believed that Graeme had ‘railroaded’ the Investment Committee meeting when he proposed that they recommend it to clients. She could not understand why Graeme had stepped outside an asset selection process that had been successful for very many years but, as a minority shareholder in the firm, felt she could not override his strident push to recommend it to clients.
Postponed
Over the last three months Graeme has postponed the monthly Investment Committee meetings telling Susan “There is too much on right now – it’ll just have to wait.” Ordinarily, a matter such as TeckEth would be on the agenda at such meetings and the two advisers would form a consensus view to either confirm a ‘Hold recommendation or a ‘Sell’ in regard to assets on the Approved Products List which were causing concern.
In recent meetings with clients, Susan has found it increasingly difficult to speak with conviction about TeckEth. Some clients, those who are more attuned to what’s happening in general in markets and who read the daily commentary in mainstream media, have asked her what is the firm’s view on TeckEth given its problems? She has struggled between telling clients what she really thinks about TeckEth – that they should sell it – and what the current ‘House View’ on the company is which is, based on an Investment Committee meeting four months ago, Hold.
Disclosure, finally
Susan final manages to pin Graeme down to hold an Extraordinary Investment Committee meeting to specifically focus on TeckEth. As Graeme opens the meeting, she can’t help but notice how reserved he is – how reticent he seems to be about getting the discussion started. After a minute or so of hesitation, Susan cuts straight through and says: “Look – I’ve got no idea why you wanted to recommend this in the first place but you’re the boss so you always get the final say. It’s bizarre, Graeme, TeckEth is completely left-field of what we normally do for clients – why on earth are we in it?”
Graeme is stumbling to find the words he’s wanted to say for months now but resisted hoping that things would improve for TeckEth and save him from the certain professional and personal embarrassment a full disclosure would cause. Finally, he comes clean to his business partner and tells her of his relationship with Mark at TeckEth. She is furious with him but doesn’t say so to him and the meeting concludes with a decision to review the issue next week after, at Graeme’s suggestion, he speaks to Mark again.
A rock and a hard place
That night, as she confides in her husband about the conflicted position she unwittingly finds herself in because of Graeme, Susan contemplates resigning from the firm but is worried about the impact on her 10% equity in the firm. Over the last three years Graeme has transitioned more than half the clients to her and if she leaves there might be cash flow issues for Graeme’s business if the clients were to follow her to another firm. This would undoubtedly deleteriously impact on the value of her investment in the firm.
Simultaneously, she knows there are restraint of trade clauses in her partnership agreement with Graeme. She is between the classic ‘rock and a hard place’ – if she resigns on a matter of professional principle she has no certainty of income and risks losing value in her 10% equity in Graeme’s business. On the other hand, she knows the firm has breached disclosure requirements and that in order to become fully compliant, clients will have to be notified of the conflict. She knows that would jeopardise the professional relationships with clients and the fees they pay which makes the business solvent.
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