CPD: Ethics and financial practice

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What are advisers’ duties of care under law and the new FASEA standards?

The recent Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Royal Commission) highlighted numerous situations in which best practice – and arguably, an ethical approach to financial advice – was absent. This article, the first of a series of five brought to you by GSFM, will examine the adviser’s duty of care under law and the new FASEA standards, as well as good business practice.

Consumers expect the best of their professional service providers. They expect their medical practitioners to diagnose illness and dispense medicine as appropriate. They expect their dentist to only undertake necessary works and their accountant to complete tax returns with honesty and timeliness.

In the same way, consumers expect their financial advisers to act with their best interests front and centre. For most advisers, that is exactly how they run their business – acting in clients’ best interests and with competence, honesty, integrity and fairness at all times. Unfortunately, over the years a sufficient number of licensees and individuals have overlooked their obligation to clients; this led to ‘best interests’ being enshrined in legislation, with ASIC charged to monitor and enforce this requirement. More recently, FASEA has released its Code of Ethics, with twelve standards enforceable by law.

What is ethical practice?

Ethics can be defined as: ‘moral principles that govern a person’s behaviour or the conducting of an activity’

In financial planning, it can be distilled into acting in the client’s best interests at all times, acting with competence, honesty, integrity and fairness. In short, the way any one of us would like ourselves and our family members and friends to be treated by a professional service provider.

The Future of Financial Advice Reforms (FOFA) introduced an amendment to the Corporations Act 2001, one which enshrined the best interest duty into law. It was an extension of the existing fiduciary duty owed to clients by financial advisers, the one which covered the need to ‘know your client’, know the products you recommend and always act with the interests of those clients front and centre. This amendment came with an addition – penalties, including banning and disqualification orders.

Section 961B of the Corporations Act 2001 (as amended) lists the steps an adviser must take to satisfy the ‘best interests’ standard. In brief, these are:

  1. To identify the client’s financial situation, objectives and needs.
  2. To identify the subject matter of the advice sought by the client (whether explicitly or implicitly).
  3. To identify the client’s relevant circumstances – the objectives, financial situation and needs that would reasonably be considered as relevant to advice sought on that subject matter.
  4. To ensure this information is complete and correct; enquiries should be made if gaps or inconsistencies are apparent.
  5. When considering the advice sought, whether it would be reasonable to consider recommending a financial product; if it is deemed relevant, they should only recommend a product after thoroughly investigating the most appropriate products relevant to the client’s circumstances.
  6. When advising the client, the financial adviser must base all judgements on the client’s relevant circumstances.
  7. Take any other step that, at the time the advice is provided, would reasonably be regarded as being in the best interests of the client, given the client’s relevant circumstances.

This last and catch all statement encapsulates the spirit of the legislation; regardless of the client’s requirements, the advice must be underpinned by knowledge of the client, their circumstances, and any financial product recommended as part of the advice process. While the best interest duty applies to retail clients, a similar fiduciary duty is required for dealings with wholesale clients. To meet obligations under section 961B of the Corporations Act 2001, is arguably, to act ethically in dealings with clients.

The Royal Commission

Round two of the Royal Commission, which ran from 16-27 April 2018, heard that of the 626 disputes about financial advice accepted by the Financial Ombudsman Service (FOS) in 2016-2017, approximately half were in relation to a financial adviser.

The most common complaints to FOS fell into two distinct categories:

  1. Inappropriate advice and failures to follow customer instructions, such as risk profiling and procedures that hadn’t appropriately addressed the client’s attitude to risk or capacity for loss
  2. Instances where the financial adviser did not fully understand the financial product he or she was recommending, and therefore, was unable to adequately explain its features and risks to the client.

The Credit and Investments Ombudsman also receives complaints about financial advice; it informed the Royal Commission that complaints it received could be categorised as follows:

  1. Inappropriate advice, approximately 39 percent of complaints
  2. Excessive or incorrectly charged fees, approximately 28 percent of complaints
  3. Conflict of interests, around 15 percent of complaints
  4. Failure to follow a customer’s instructions, made up around 11 percent of complaints.

Examples of systemic issues or serious misconduct provided to the Royal Commission included:

  • advising clients to borrow against the equity in their homes to invest in managed funds without any reasonable basis
  • advising the establishment of a self-managed superannuation fund where inappropriate for the client’s personal financial circumstances
  • advising clients to switch from one financial product to another without considering whether it was in the client’s best interest to do so
  • charging clients fees for ongoing service that was not provided
  • clients were impersonated, or their signatures forged or falsified
  • financial advisers falsely witnessed documents or facilitated documents to be falsely witnessed
  • the transfer of client funds into a financial adviser’s personal bank account.

In many cases of misconduct, whether at the corporate or individual level, came down to money. In such instances, ethical behaviour was nowhere in evidence. In his final report, the Commissioner, the Honourable Kenneth Madison Hayne AC QC, commented:

“All the conduct identified and criticised in this report was conduct that provided a financial benefit to the individuals and entities concerned. If there are exceptions, they are immaterial. For individuals, the conduct resulted in being paid more. For entities, the conduct resulted in greater profit.”

Other cases of misconduct could be described as incompetent, or a careless approach to dealing with clients; a failure to understand their needs, circumstances and objectives, and a consequential failure to dispense appropriate advice.

A new regime

At the same time that the Royal Commission was hearing from a broad range of people, from distraught consumers through to company CEOs, the Financial Adviser Standards and Ethics Authority (FASEA) was consulting with industry on its new code of ethics for financial advice. FASEA received in 18 submissions during the final consultation period for this standard in November and December 2018.

The Corporations Act was amended in 2017 to improve the standards of education, training, ethical behaviour and professionalism for financial advisers. Included is the obligation to abide by section 921E of the Act, which requires all relevant providers to comply with FASEA’s Code of Ethics, which comes into effect from 1 January 2020.

The Code of Ethics imposes ethical duties on financial advisers and has been designed to encourage higher standards of behaviour and professionalism in the financial services industry.

According to FASEA: “The Code of Ethics imposes ethical duties that go above the requirements in the law. It is designed to encourage higher standards of behaviour and professionalism in the financial services industry.”

The Code of Ethics addresses five core values:

  1. Trustworthiness
  2. Competence
  3. Honesty
  4. Fairness
  5. Diligence

The code requires that financial advisers must act at all times, in all cases, in a manner that is demonstrably consistent with FASEA’s twelve ethical standards, summarised in figure one. These will be monitored by ASIC’s approved compliance schemes.

 

Case studies

The following case studies are based on real events; however the names of people and organisations have been changed, and some details altered. The case studies have been drawn from FOS and the Royal Commission. For each, potential breaches of FASEA’s Code of Ethics will be identified.

Case study one: Keep it simple

Ninety-one year old Margaret is a widow with an uncomplicated financial situation. She receives sufficient income from her Age Pension and a small annuity to meet her needs.

Margaret received a $175,000 bequest from her sister’s estate; it was the first time she had received a large sum of money. She had previously obtained financial advice about her annuity from a financial adviser, but she was otherwise inexperienced in financial matters.

Margaret sought financial advice from her regular adviser, Julia; she said she wanted to use $100,000 of the bequest to top up her annuity and sought Julia’s advice about how to invest the balance of the inheritance to leave to her grandchildren.

Julia recommended Margaret invest the balance of the inheritance in a managed growth fund. The SOA prepared by Julia stated that investment in the managed growth fund was “not capital guaranteed”, “the balance may fluctuate daily due to changes in unit prices” and there was a risk of capital loss if Margaret withdrew from the investment early.

Margaret accepted the advice and made the recommended investment. The investment performed badly and suffered significant losses.

Margaret later lodged a formal complaint, claiming she did not understand the advice Julia had provided to her and the managed growth fund was not an appropriate investment in her circumstances.

Breaches of FASEA’s code of ethics

Margaret is clearly a retail client. From the details provided in the case study, Julia potentially would have breached the following standards in the Code of Ethics.

 

Case study two: Appropriate asset allocation

Paul and Louise Walker were in their early sixties when they received an inheritance of $1,000,000. They planned to retire in the following year. It was early when 2006 they sought financial advice about how to invest this money. Their financial adviser Jim recommended that Paul and Louise each invest $500,000 in an allocated pension and advised them to invest 90% in growth investments and 10% in defensive investments.

Although the allocated pensions initially performed well, the global financial crisis caused capital losses. Concerned about the poor performance of their investments, in October 2008 Paul and Louise withdrew $340,000 and $315,000 respectively, incurring capital losses of $160,000 and $185,000.

Paul and Louise complained about the financial advice they received; they believed their investment was 40% in growth investments and 60% in defensive investments and were shocked to learn they had in fact been invested 90% in growth investments and 10% in defensive investments. They had experienced sleepless nights and were very stressed about their ability to fund their retirement.

A dispute was lodged and found in favour of Paul and Louise; the financial advice was considered to be inappropriate because it exposed the couple to a greater level of investment risk than they were prepared to take on.

Breaches of FASEA’s code of ethics

From the information provided in the case study, Jim potentially breached the following standards in the Code of Ethics.

 

 

Case study three: Conflicted remuneration

A small dealer group of twenty advisers left their licensee to move to another group. As part of the transition, the advisers were encouraged to move clients from the platform used under the previous licensee to one owned by the new licensee.

For this, each adviser – and the dealer group – received a transition payment from the new licensee.

An ASIC review found that transition payments were likely to influence advisers to switch their clients to the new platform, causing the clients to incur fees and charges. In some cases, where the same financial products were not available on the new platform, a switch of financial product was required, which again can incur costs and may crystallise capital gains or losses that may negatively impact each client’s overall financial position.

The review identified concerns in relation to the management of conflicts of interest relating to advice provided to clients to switch their investments to financial products associated with or related to the new licensee; ASIC found that the clients were not made aware of this conflict of interest. ASIC also expressed a range of other concerns, including:

  • Failure to meet the requirements of a compliant dispute resolution system
  • Poor monitoring and supervision of staff and representatives
  • Non-compliance with the requirements of section 945A of the Corporations Act, the requirement to have a reasonable basis for advice provided to clients
  • Non-compliance with section 947D of the Corporations Act, the requirements when advice recommends replacement of one financial product with another.

Breaches of FASEA’s code of ethics

From the information provided in the case study, both dealer group and advisers potentially breached the following standards in accepting transition payments from the new licensee.

 

Case study four: The ‘one size fits all’ approach

Paul is a senior financial adviser employed by a large financial institution. He has a large client base, many referred to him internally from other business units within the organisation.

He uses a single strategy that he recommends to all of his clients, which includes investments that are often too risky for his clients’ financial circumstances and risk profiles; these include direct shares, hybrids and hedge funds. He tells all his clients they’ll have a great outcome but does not go into detail about the investments in their portfolio. He typically uses a platform operated by his employer without disclosing the fees his employer receives.

Paul considers he is doing his clients a favour by minimising their paperwork – he undertakes transactions in his clients’ names without their authority, signs paperwork on their behalf and has, on occasion, impersonated them when contacting third parties to seek information or issue instructions.

Paul also charges an ongoing advice fee without providing any ongoing advice. His files are badly kept and his attention to ongoing education has been patchy.

Breaches of FASEA’s code of ethics

Paul would have potentially breached a number of FASEA’s codes, including:

 


Financial advisers are required to act ethically and in the best interests of their clients at all times. While that might seem an obvious requirement to most people, the Royal Commission, along with other notable and public examples of unethical behaviour, demonstrates that it’s a requirement overlooked by some practitioners and businesses.

The best interest duty underpins both the operations and provision of advice by financial planning practices and enshrines it in law. Similarly, FASEA’s code of ethics now makes ethical practice a binding requirement for financial advisers. This is a positive step towards true professionalism for the industry.

Australian Treasurer Josh Frydenberg has told both ASIC and APRA that the government will set up a follow-up independent inquiry in three years’ time to assess the response of the entire sector to the Royal Commission. This will include changes in industry practice and consumer outcomes. All in the financial services industry will hope for a much better report card next time around.

 

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