30 million reasons not to give bad advice

The courts will apply prevailing standards. There are lessons to be learned from the recent Financial Wisdom case. The main one is that this will not be a stand-alone event. It is part of a fundamental shift in regulation to a consumer-centric view, which industry participants ignore at their peril.

The case can be summarised as follows:

* Financial Wisdom failed to adequately supervise its advisers;

* recommendations were inconsistent with the conservative and properly researched products that the advising company’s brochures and materials promised;

* recommendations were inconsistent with the client’s risk tolerance; and

* clients lost money through the recommendations.

The judgement was in three parts: compensate clients for the money they lost; compensate clients for earnings foregone on the recommendation they should have been given; and compensate clients for anxiety and stress.

The judgement that clients should be compensated for money they lost is expected.

However, the process for calculating earnings foregone is instructive. The clients undertook a self-assessment of risk tolerance, being asked to pick a point on a line marked 1 to 5 with 1 being low and 5 being high. All the clients said they were of average risk tolerance.

An expert witness created three indices — residential property, equities and bonds. The judge then assessed what he thought the client should have been recommended, given the client’s risk tolerance, personal circumstances and historical investment behaviour.

He then determined what position the clients should have been in if they had received appropriate investment advice, and required the dealer group to put them into that position.

Finally, there was a compensatory amount for anxiety and stress.

In the end, the Commonwealth Bank was held responsible because it is the current owner of Financial Wisdom, even though it was not the proprietor when the problems occurred in the 1990s when Colonial owned the business. Financial Wisdom was found responsible, even though the products sold were not on its approved recommended list.

Where were you in 1996?

Financial advisers: What was your client base like? Are they still your clients now? What products and services were you offering? Who did you work for? What software were you using? How were you assessing risk tolerance? Were you doing annual reviews? What were your files like? Do you still have them? Who was the ultimate owner of the dealer group? What other dealer groups did they own?

Dealer groups and corporate owners: What dealer groups do you own? How long have you owned them? What due diligence did you do before you purchased them? How sure are you that you know what authorised representatives have been selling? Have you been facilitating annual reviews? Do you have any way of analysing your total client base and their exposure to authorised and non-authorised investments? What is your complaint handling like? Do your advisers and staff know what a complaint is?

Do you know where your risks lie?

The judge and the expert witness clearly applied a standard of professional practice as it prevailed at the time of the incidents. It is worthwhile to look at the present situation and assess what the current standard of professional practice is. Among other sources, the Financial Planning Association’s (FPA) policy position on risk tolerance would be a major input:

“5.B.2 Financial planners are in the best position to explain and educate clients on [sic] the investment risks associated with the recommendations being made and the relationship of these investment risks to the client’s risk tolerance assessment.

“5.C.3 Financial planners would be expected to be able to advise clients about the range of outcomes they could reasonably expect to experience and to advise and discuss with clients, in terms they can easily understand, the financial implications of returns being at the bottom end of the possible range. For example…to allow clients to form a view about whether they value the potential benefits enough to justify the risk.

“5.C.5 Information about the investment risk should be a feature of the statement of advice so clients can make an informed decision about their attitudes concerning the investment risk that is implicit in any recommendation.

“6.7. Best practice will include evaluating the downside risk to both capital and cash flow in the short term and also over the period of investment. Advisers will consider the implications of poor performance on the financial well being of clients and advise the clients of these risks in terms that are easily understood.”

There is a consistent message to financial advisers that they must clearly explain the consequences of the alternative financial decisions a client can make. This goes to the very heart of the definition of a financial plan.

A financial plan is the outcome of a process where clients decide what in their lives is important to them and then identify those aspirations that have a financial dimension. They have to decide on what actions they need to take and establish a road map, showing the milestones along the way to achieving their goals. A statement of advice summarises the outcomes of this process.

Clearly, a financial plan is a dynamic set of needs and expected behaviours, which will alter as clients’ lives and circumstances change.

The quality of life for clients, now and in the future, will be determined by the quality of financial advice they receive.

The results of the Financial Wisdom case show that dealer groups and the owners of dealer groups will pay a threefold penalty for not providing this quality advice.

What must you prove?

The emerging standards for financial planning are built around PS 175, the common law obligations of planners to clients, the Standards Australia’s Handbook of Personal Financial Planning, the FPA’s code of ethics and rules of professional conduct and a number of court cases. These may be usefully summarised as the following five proofs.

1. Prove you know your clients, specifically through a separate lifestyle needs analysis and a defensible risk tolerance assessment.

2. Prove you know your products by having them appropriately researched, with evidence that you understand the range of possible performance outcomes. If you construct portfolios for clients, you should have historical evidence of your competency and success in doing so.

3. Prove that you explained all relevant information to the client including risks, any conflicts of interest and fees, particularly if there are alternative strategies to explore. This is a very real issue when there is product substitution.

4. Prove that you received the client’s properly informed commitment to the plan as a consequence of them working through their lifestyle trade-offs.

5. Be certain that the Financial Services Guide, any terms of engagement, any lifestyle plan and statement of advice establish a coherent and consistent contract between the adviser and the client.

As a consequence, there will be a clear liability shift to the client, who makes the final informed decision to accept the plan and any product recommendations.

Where does this leave dealer groups and corporate owners?

Monitoring and supervision can no longer be ‘tick and flick’.

A full audit of the financial advice process needs to be done. It will incur costs, but nothing like the triple cost of an unfavourable determination.

If done properly, the audit will increase business and reassure the professional indemnity (PI) insurer.

Immediate actions would include:

* confirming that clients’ risk tolerance is formally assessed as part of an annual review;

* statement of advice documents are rewritten to meet PS 175 requirements to justify advice, thoroughly explain risks and meet the Australian Securities and Investments Commission’s (ASIC) requirement of effectiveness, clarity and conciseness; and

* where advisers construct client portfolios, ensure they can prove competency and success.

There can be no clearer message to the industry to review how financial planning is undertaken. If ASIC does not get you, the courts or the spiralling cost of PI insurance will.

Paul Resnik is principal of Paul Resnik Consulting Group. He reads court cases, interprets them and provides industry solutions. You can contact him at [email protected].