Transition to regulation

Richard Klipin

Jim Minto

The high-profile collapse of property debenture investment company Bridgecorp has sparked calls for tighter regulation of New Zealand’s financial advisory market.

But would a more highly-regulated environment, perhaps similar to Australia’s, have lessened the impact for investors? Or are there other issues that need to be addressed?

New Zealand’s financial advisory market has historically been largely unregulated — mostly as a result of the open market economic practices of the governments of the 1980s and 1990s.

But, when the International Monetary Fund (IMF) Financial Sector Assessment Program rated New Zealand’s regulatory framework well below par in 2004, the New Zealand Ministry of Economic Development (MED) determined that increased regulation was perhaps necessary.

Fast-forward to today and the MED has devised a co-regulatory model that will theoretically improve standards and increase confidence in the industry.

The major changes include:

> advisers will have to register with an Approved Professional Body (APB). APBs will be appointed by the Ministry of Commerce;

> advisers will have statutory conduct and disclosure obligations; and

> APBs and the Securities Commission (New Zealand’s equivalent of the Australian Securities and Investments Commission) will share responsibility for regulating advisers.

The timeline for the rollout of the proposed regime is as follows:

The bill will be introduced to Parliament this year, the Act will be passed in 2008, regulations for APBs will be finalised in 2009, APBs will be approved in 2010, and financial planners will be required to register with an APB by 2012.

Benefits for investors

David Hutton, chief executive of New Zealand’s Institute of Financial Advisers (IFA), said while the proposed regulatory changes should bolster advice standards, they will not necessarily avert Bridgecorp-style crises.

In his view, professional organisations are often in the best position to monitor advisers and foster their development.

“There is not much evidence that intrusive regulation achieves gains that exceed the costs. Regulation tends to be about processes, formats and disclosure rather than value judgments about economic substance.”

He points out that Australia has had its fair share of high-profile investment scheme failures, including Westpoint and Fincorp, despite its comparatively highly-regulated industry, indicating that regulations, on their own, do not prevent large-scale fallout from failed investment schemes.

The proposed regime will require non-bank, deposit-taking organisations such as Bridgecorp to have credit ratings by approved agencies — which Hutton agrees is a good idea — although he said it won’t necessarily improve security for investors.

“This may have helped investors [in Bridgecorp] to get better information at the time of investment, but it may not have prevented receivership. Also, once an investor has made a deposit, they are locked in until maturity, during which financial circumstances and credit ratings may change.”

Hutton believes that the real key to preventing Brigecorp-style mistakes from being repeated is to require advisers to meet (and preferably exceed) minimum education and advice standards, to foster their development and to educate consumers about the various types of investment and their associated risks.

As such, he supports the proposed regime’s increased disclosure requirements. These will enable investors to make more informed decisions, he said, provided advisers express this information accurately, clearly and concisely.

“In the case of Bridgecorp, it appears some investors didn’t understand the difference between capital notes (unsecured and lower-ranking in priority) and secured debentures. Other [investors] mightn’t have consulted an adviser at all. So, consumer education is also essential.”

Of course, this necessitates that consumers have faith in their advisers, something that may not always be warranted under the current regime.

At present, advisers who are not members of a professional association such as the IFA do not have to meet formal education requirements, adhere to a code of ethics, undertake professional development courses or heed the decisions of the independent disputes resolution processes.

“Even if the IFA disciplined a member and cancelled its membership, they could continue to practice. But this wouldn’t be allowed under the proposed regime.”

Hutton stressed the importance of following the accepted rules of risk management, that is, advisers should always create diversified portfolios for their clients that reflect their individual risk profiles.

“No financial portfolio should be expected to never have a fall in value. The object is to achieve overall gains over the period of investment.”

Because of Australia and New Zealand’s very different philosophies to regulating their respective financial advisory industries, Hutton does not envisage them unifying in the foreseeable future. However, in light of the Trans-Tasman Mutual Recognition Arrangement and the potential move towards a unified economy, he said they need to work in harmony.

“Essentially, the New Zealand model is one of co-regulation whereas Australia’s is more heavy-handed. ASIC takes a more intrusive role than is proposed for [the Securities Commission] in New Zealand. But while the different approaches remain, the key will be the level at which minimum standards are set.”

Inherently risky business

Jim Minto, managing director of Tower, also does not believe increased regulation will avert large-scale fallout from failed investment schemes.

He said while due diligence of approved lists could have been better in the case of Bridgecorp, increased regulation would not have had an impact.

Errors in approved lists occur from time to time on both sides of the Tasman and, according to Minto, are somewhat inevitable.

“This is the nature of investment risk. I do believe though that, given the history of [Bridgecorp], advisers should have been on note of the heightened risk, but many were misled.”

Like Hutton, Minto stresses that higher risk investments should comprise a limited portion of a client’s total portfolio.

In Australia, advisers would have been obliged to disclose Bridgecorp’s heightened risk to clients with a formal Statement of Advice. Whether clients would have read and understood this information, however, is another matter entirely.

Minto said that in his experience, the New Zealand retail investment market has historically underplayed the credit risk associated with fixed-return investments.

“This leads to business owners being able to recruit cheap funds from investors and encourages riskier behaviour that investors simply don’t understand.”

In Minto’s view, the key to minimising the impacts of failed investment schemes is twofold.

Firstly, advisers need to explain clearly to investors the nature of investments, including their risky characteristics. They should, he said, fight for higher returns for higher-risk investments.

And secondly, investors need to ensure they fully comprehend the concepts of risk and return.

“A higher return reflects a higher risk of failure. Often people are simply naive or in some cases greedy. If they have all their money in a risky investment, it is not the role of the government (of any country) to completely protect them.”

Like Hutton, Minto points out that Australia has had its fair share of failed investments, proving that education — not just regulations — is needed to ensure better outcomes for all key players.

“Public education in both countries needs to play an important role in future … [This] will go a long way, but will never remove failures entirely.”

Too much regulation?

Richard Klipin, chief executive of the Association of Financial Advisers (AFA), argues that Australia’s relatively highly-regulated financial advisory industry is warranted given the significant — and growing — amounts of money at stake, the proliferation and sophistication of products on the market and the need to attract overseas investors.

However, a major drawback to this regime has been the associated compliance costs. Advisers are obligated to provide clients with lengthy disclosure statements that take up a substantial amount of their time and, ironically, may confuse clients further.

According to Klipin, the obligation to provide such statements has also driven the cost of professional advice well beyond the reach of many Australians.

“The cost of putting together a 60-page document, for example, means that advisers are now dealing with mainly high-net-worth clients. Mainstream clients either have restricted access or no access at all.”

He said this effectively pushes mainstream investors into adopting a DIY approach, investing in schemes they may not fully understand.

Klipin said that the Financial Services Reform Act, currently under review, is intended to improve access to financial advice and make it more consumer-friendly.

However, he said there needs to be a meaningful industry-wide campaign to educate both advisers and consumers about the nature of investments, products available and why certain investment schemes failed.

“The educational framework for advisers is currently under review. The [FSR] introduction of PS 146 was a start, but advisers need to adopt a lifelong approach to learning. The AFA is calling for a balance of technical skills (which constantly need to be updated) with client engagement skills. The latter are no longer a part of the national curriculum, but they’re critical. They’re the skills advisers need to fully engage with their clients and educate them.”

With regards to educating consumers, Klipin said including financial literacy in the school curriculum from 2008 is an excellent start, but a lot more needs to be done.

“AFA has always advocated that the best outcomes arise when investors come to the table well-informed, ask the right questions and are able to actively engage in the process. That really is the key to preventing more Bridgecorps and Westpoints.”