A revolution is coming for conflicted advisers

In one of the biggest shake-ups of the financial advice industry in years, the government’s Financial Adviser Standards and Ethics Authority has blanket-banned conflicted sales commissions, including previously acceptable “stamping fees”, for advisers recommending listed investment funds to both retail and wholesale clients. Read the full column here or AFR subs can click here. Excerpt only:

Under FASEA’s new Code of Ethics, which becomes legally binding on all Australian advisers from January 1, 2020, this will no longer be possible.

Standard 3 of the code says an adviser “must not advise, refer or act in any other manner where you have a conflict of interest or duty”. It then provides specific case studies under a guidance note of what represents an illegal breach.

One case study deals explicitly with the stamping fees advisers capture from IPOs of LICs and LITs. The guidance states that an adviser “keeping the stamping fee rather than…rebating it [is] unfair to [the adviser’s] clients”.

“The option to keep the stamping fee creates a conflict between [the adviser's] interest in receiving the fee and his client’s interests. Standard 3 requires [the adviser] to avoid the conflict of interest. It is not sufficient for him to decline the benefit as it may be retained by his principal. Either the firm must decline the stamping fee altogether, or [the adviser] must rebate it in full to his clients.”

The ban on stamping fees for LICs and LITs for all advisers is therefore black and white.

Some advisers have speculated that FASEA’s code might only apply to retail, not wholesale, clients, thereby allowing them to still capture conflicted sales commissions when recommending products to wholesale customers.

This column has confirmed that all registered advisers must comply with the code’s standards irrespective of whether they deal with wholesale or retail customers.

This means FASEA’s code extends well beyond FOFA's reach, which only protects retail investors.

The guidance note then provides a direct case study covering a client who technically qualifies as a wholesale investor because she has a $3.4 million home. The adviser, who is also her stockbroker, recommends a listed investment that subsequently falls by 25 per cent in value.

The client relied on the adviser’s recommendation and seeks to sue them for compensation covering losses in the listed investment. The adviser counters that he “did not prepare a statement of advice, nor does his advice need to comply with the best interests’ duty or the code of ethics” because the client qualified as a wholesale, not retail, investor.

The guidance note clarifies that the adviser still “breaches Standard 1 – by treating [the client] as a wholesale investor and relying on the accounting certificate, he ignores her lack of competence in financial matters”.

This will not be welcome news for any advisers who have predicated their business models on generating conflicted sales commissions by recommending LICs and LITs to clients who are not technically caught by FOFA because of their status as wholesale investors.

Since roughly 80 per cent of all LICs and LITs are trading below their net tangible assets, with many inflicting large 10 per cent to 20 per cent losses on clients who bought them in the original IPO, advisers open themselves up to catastrophic compensation claims for losses incurred by any clients other than the most sophisticated institutional-style investors.

It would be straightforward for many normal wholesale clients to argue that they do not fully understand hedge funds or leveraged junk bond funds, and relied on their adviser’s recommendation with or without a formal statement of advice.

It would also be easy for them to make the case that the adviser’s recommendation was being influenced by the large conflicted sales commission they received for pushing the product.

Here the guidance note explains that a key legal test is whether “a disinterested person, in possession of all the facts, might reasonably conclude that the form of variable income (eg, brokerage fees, asset-based fees or commissions) could induce an adviser to act in a manner inconsistent with the best interests of the client or the other provisions of the code”.