Will two out of three be good enough?

The broker made money. The firm made money. Two out of three is not bad — stockbrokers’ joke.

Why is it so few of us are surprised by the Hartley Poynton case? Or that Merrill Lynch is being prosecuted by the New York attorney-general and others for something akin to corrupt practice?

Well, for a start, most of us have read Michael Lewis’Liar’s Pokerwith its exposé on the predatory nature of Wall Street firms.

And we knew from experience that this sort of behaviour, or something approaching it, was rife here.

In fact, we knew what went on in the same way the insurance industry and others knew what was going on at HIH and FAI.

So we knew, but we didn’t say anything. Well, not publicly anyway.

It wasn’t our problem. After all, we’re financial planners. We’re a profession. We have ethics and standards. We’re not like them at all. We don’t give bad advice ... or do we?

Is bad advice something that only stockbrokers give? Or is it more widespread? Are the contributing factors in the Hartley Poynton case — the adviser’s financial incentive to act against the client’s interests and a failure in duty of care by adviser and dealer — applicable more generally?

Bad advice results when advisers either don’t know or don’t care or both.

As financial planners, we promise to help clients achieve their life goals through proper management of their financial affairs.

Suppose for a moment that our role was to feed the hungry. We could feed them anything they’d eat, provided it satisfied food regulations. Or a generally balanced diet. Or a life-stage related diet. Or an individually specific diet.

As planners we promise an individually specific diet. How well do we live up to that promise?

Let’s look at gearing as a case in point. Gearing has been booming in recent years — $9 billion in margin-lending alone.

There is a huge financial incentive for advisers to gear clients. It increases funds under management and generates financing fees.

With negative gearing, money that otherwise could have gone into a savings plan generates many times the income for the adviser. With positive gearing, advisers can earn income even when the client has no savings capacity.

So planners have a very strong incentive not to care.

Despite this, perhaps gearing is only ever recommended where it is an appropriate strategy for that client.

In a recent DFP8 exam, the facts of the case study on a pre-retirement couple made gearing possible. But it was not needed to achieve the clients’ stated goals. However, the great majority of plans recommended gearing, some to the limit of the clients’ borrowing capacity.

And we all know anecdotally of instances where the client’s ability to borrow has seemed to be theraison d’etrefor the gearing recommendation. If they can eat it, feed it to them!

Then there are the instances where part of a portfolio is geared even though there are fixed interest investments elsewhere in the portfolio. In some circumstances, accepting the inherent inefficiency of this arrangement makes sense. But the fact that the occasional client is geared into a balanced fund would suggest a lack of adviser knowledge as a more likely explanation.

What about the risks of gearing? Have you ever seen a gearing example that canvassed the range of possible outcomes? No, they’re done on average returns or for carefully selected instances.

At a gearing conference, I asked an audience of 200 industry professionals to estimate the likelihood, historically, of making a loss over five years on a typical, fully geared equities investment. Only a handful got close to the historical average of 25 per cent.

The problem is that modelling gearing is complicated. Very few do it. But if you don’t model realistically, how can you understand the range of possible outcomes, let alone advise?

None of this is to suggest that gearing is always an inappropriate strategy. But the evidence points to much gearing being done for the wrong reasons, inefficiently and without an appropriate understanding of the risks by advisers, let alone an adequate explanation of the risks to clients.

Which brings us to fund managers, margin lenders and equity lenders, standing gleefully on the sidelines egging on advisers and clients alike.

Remember BT’s use of the 10 years to 2001 in last year’s advertising campaign? Did anyone at BT actually think that was likely to be repeated?

What about the Commonwealth’s current side-of-bus campaign for their loan that “builds equity 24/7?” And all the others have done or are doing something similar.

Where are the regulators? The Australian Securities and Investments Commission’s (ASIC) primary focus is on blatant scams and frauds. But perhaps more importantly in the long run, FSR regulation is product-oriented.

With gearing, it’s not the products that are the problem but the process by which they are combined into a strategy. Maybe it should be a matter for Alan Fels and the Australian Competition and Comsumer Commission (ACCC).

Where are the professional bodies? They’re nowhere to be seen. Likewise with consumer advocates.

I see parallels with the foreign currency loans saga of the 1980s. If you weren’t around then, talk to someone who was. It’s similar, but there are differences.

Then the banks were the instigators and were eventually called to account, though not fully. Interestingly, as far as I know, not one of the senior or middle managers responsible lost their jobs. They’re probably still there, somewhat further up the hierarchy.

If (when?) the proverbial hits the fan over gearing, those in the front line will be the clients, the advisers and the dealer directors. You won’t see the fund managers or the lenders for dust.

“There was nothing wrong with our products. If advisers used them inappropriately, that’s the advisers’/dealers’/professional indemnity insurers’ problem.”

You have a duty of care to your clients but, in your dealings with fund managers and lenders, it’scaveat emptor. You won’t have a fund manager or lender standing beside you in court.

So what do you do now if you’re an adviser?

If you’ve been a sinner, you have three choices. You can cross your fingers and hope that the investments perform and interest rates behave — you might just be lucky! Or, you can undo past sins before too much damage can be done.

With either of these first two, a decision to change your ways would be a good idea.

Or, you can switch to an exit strategy. You probably have two to three years before the first court case.

If you haven’t been a sinner, but others in your dealer group have, and your dealer’s ongoing reputation and ability to operate are important to you, switch dealers now or get your own dealer’s licence. Reformed sinners should do likewise.

In choosing a dealer, look for one that has rigorous compliance. This protects the value of your business against the actions of other advisers. Think of compliance as quality control. Make sure it goes beyond satisfying ASIC. Your legal obligations extend far beyond Corporate Law. In future, being able to obtain PI insurance will be critical and PI insurers will be focused on current processes, as well as claims history.

And if you’re a dealer director?

If your advisers have been sinners, you have a big problem. Your choices are similar to those faced by advisers with past sins. Good luck!

Whether or not your advisers have been sinners, for the future you need to ensure that the planning processes your advisers use and the compliance processes you use to monitor your advisers’ planning processes, protect the value of your business and of your advisers’ businesses.

Gone are the days of the independent planner network, where independent meant planners were free agents, subject to only a bare minimum of scrutiny. PI premiums will price such networks out of business.

Insofar as gearing is concerned, planning as a whole could be said to have been profiteering by feeding clients whatever they will eat within the constraints of an inadequate regulatory system. The courts will not look kindly on such behaviour if it comes before them.

The judgement in the Hartley Poynton case makes it clear that the courts take very seriously the duty of care to “know the client” and advise accordingly.

Those who are inclined to argue that this was about a “rogue trader”, and is not generally applicable, would be well advised to read the judgement.

Geoff Davey is the managing director of ProQuest.