Note: an abridged version of this paper was published in the AFR on 29 January 2020.
The furore that has erupted over the revelation of a loophole that allows the use of selling fees to promote LICs and LITs has sparked an enormous debate across the wealth industry. There is a great deal at stake and earlier this week the Treasurer announced a four week industry consultation on the issue. Whilst the focus of the debate so far has been the merits – or otherwise – of listed investment structures, the real issue is the tolerance of conflicts of interest that compromise the integrity of the system.
Under the 2012 Future of Financial Advice (FOFA) regulatory reforms, fund managers are banned from paying sales commissions to advisers who sell their products. But in 2014, listed funds were exempted from this rule - and the extent to which that exemption has been exploited is startling. Nearly $50 billion of capital is now invested in LICs and LITs – mostly on behalf of mum and dad investors. And advisers are being paid very lucrative incentives, called “stamping fees” by fund managers, to sell their clients these funds. These incentives create a conflict of interest for the adviser.
We hear a lot about the need to restore trust in the advice process – both from government and from the industry. As long as conflicts are allowed to exist, “restoring trust” will remain hollow words.
The Best Interests Duty
One common argument from those defending the use of selling fees on LICs is that, regardless of a selling fee, there is a requirement that the adviser must act in the best interests of clients.
It is this requirement – set out in Part 7.7A of the Corporations Act – that is held out as the reason why conflicted advice models remain acceptable. Because, despite those conflicts, the advisers must act in a client’s best interest.
One of the best ways to understand the best interests duty is to understand what it is not. The best interests duty is not a fiduciary duty. A fiduciary duty exists where a person or company, acting for another, is required to put the interests of the other party ahead of their own. In a legal sense, a fiduciary obligation is of the highest standard and there are very strict legal obligations imposed on a fiduciary. A fiduciary cannot act with a conflict of interest.
The FOFA reforms began in the Joint Parliamentary Committee Inquiry led by Bernie Ripoll in 2009 following the collapse of Storm Financial and Opes Prime. Whilst there was consideration of imposing a fiduciary obligation on financial advisers, the inquiry (and legislation) stopped short of requiring an adviser to act as a fiduciary and instead set out a lesser standard – that of a duty of care. This resulting duty of care is what we now know of as the best interests duty.
The lesser standard of care was a pragmatic legislative response to massive industry resistance to the notion that an adviser couldn’t act if they had a conflict of interest.
The legislation sets out the process an adviser must follow (the safe harbour steps) to demonstrate they have met this duty. The fifth step of the best interests duty process clearly states that an adviser must “conduct a reasonable investigation into the financial products that might achieve the objectives and meet the needs of the client that would reasonably be considered relevant to advice on that subject matter”.
This obligation has its challenges. In an almost limitless set of financial products available, is it feasible for an adviser to assess all of them? Of course not. But what might a “reasonable investigation” consider? The law requires the adviser to exercise some level of professional judgement.
Here is the precise point at which a selling fee, which creates a conflict of interest, has the potential to cause the best interests duty framework to break down. Because when an adviser is required to exercise professional judgement, a conflict of interest will, inevitably, compromise that judgement. To argue otherwise is to ignore the very nature of financial incentives and human behaviour.
ASIC’S Information Report 562
In January 2018, ASIC released Information Report 562 – “Financial Advice: Vertically integrated institutions and conflicts of interest”. The report was a bombshell and highlighted the way conflicts of interest undermine the best interests duty. In reviewing the advice files of five of the largest advice institutions in Australia, ASIC found that whilst inhouse products represented only 21% of the approved product lists, the inhouse products attracted 68% of the advised clients’ funds. Furthermore, in 75% of the cases reviewed, ASIC concluded the adviser had not demonstrated compliance with the best interests duty.
ASIC summarised that “the high level of non-compliant advice, combined with the high proportion of funds invested in in-house products, suggests that the advice licensees we reviewed may not be appropriately managing the conflict of interest associated with a vertically integrated business model.”
Yes, an adviser does have a duty to act in the best interests of their client. But where a conflict of interest exists, a client cannot be certain the best interests duty is affording them the protection they would expect. The professional rigour of “a reasonable investigation” is utterly compromised.
As Kenneth Hayne noted in his final report of the Royal Commission, “Experience shows that conflicts between duty and interest can seldom be managed; self-interest will almost always trump duty”.
Selling fees on LICs create a conflict of interest that actively works to undermine the consumer protections afforded by the best interests duty.
Earlier this month the AFR’s John Kehoe reported that ASIC intends to conduct an audit of brokers to a number of LIC/LIT IPOs in order to ascertain if the recommendations to clients breached the best interests duty law (read more at afr.com). This approach by the regulator is to be lauded, however a retrospective approach has its limitations. The damage will have already been done. The experience of Information Report 562 would suggest that we prepare for a sobering outcome from the ASIC investigation.
It’s not just about LICs, or the best interests duty - it’s about tolerating conflicts of interest
Which brings us to the nub of the issue. The debate isn’t really about the merits of listed investment structures, nor is it really about the efficacy of the best interests duty. It’s about our tolerance of conflicts of interest – such as selling fees on LICs - that compromise the integrity of the system.
Any legislative framework will only work if those governed by the framework don’t just apply the letter of the law; they must also apply the spirit of the law. A conflicted adviser cannot do this. A conflicted adviser compromises their professional judgement on what constitutes a “reasonable investigation”. A conflicted adviser compromises their ability to meet the best interests duty they have to their clients.
And a conflicted adviser undermines trust and confidence in the integrity of the advice process.
Ultimately, it’s the community who will decide if they will trust the industry or not. We all have an obligation to call out inadequacies in a system that, when exploited, undermine trust. As long as the industry tolerates and defends conflicts of interest and continues to exploit loopholes in the legislation, that trust will not be granted.
A lack of trust in the system is a terrible outcome for everyone – the government, the regulator, advice institutions and the advisers themselves but, most importantly, it’s a terrible outcome for the consumer of financial advice. And that’s in no-one’s best interests.