A Rocky Road to Improved Investor Protection
For most of 2018, the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry captured the attention of many in Australia. Through seven rounds of televised and livestreamed hearings, many problems in the industry came to light, including, among others, advisers providing inappropriate advice, advisers failing to act in the best interest of their clients, conflicted remuneration structures leading to poor outcomes, and firms charging clients fees without providing associated services. In February this year, the Commission published a final report containing 76 recommendations. If implemented in full, these recommendations would lead to significant changes across a number of fronts, including stricter disclosures, elimination of grandfathered commissions, changes in remuneration structures of both front-line and senior executives, and a revamp in culture and governance.
Of course, Australia is not alone in its concerns about investor protection. In Singapore, the failure of Hyflux Ltd, a water treatment company, has led to substantial losses for those who invested in Hyflux’s preference shares and perpetual securities. Ever since it emerged that many of these investors were individuals, the question as to why and how they were sold these risky instruments has been raised. After all, it has been a decade since the Lehman mini-bond saga; surely the problem of mis-selling should have been well and truly vanquished?
Mis-selling and Remuneration Structure
Unfortunately for many, mis-selling is not a new problem. The issues encountered in Singapore and Australia are symptomatic and only reinforce the negative image some of the public has of the financial services industry. Since the global financial crisis, regulators around the world have responded with a number of policy initiatives to combat mis-selling.
Inevitably, any discussion of mis-selling leads us to the topic of sales commission. Commissions and other monetary inducements are paid to financial advisers if they are successful in pushing products to their clients. Even though, in some markets, financial advisers owe a duty of care to their clients and should only be selling products that are in their clients’ best interest, very often many are tempted to promote products that bring them the highest revenue, rather than recommend those that best meet their clients’ needs. Sales commissions also incentivize churning of portfolios.
Several jurisdictions have taken steps to address this conflict of interest. India introduced a commission ban in October 2018, and similar regulation has been introduced in South Korea. Taiwan recently eliminated commissions paid to fund distributors for marketing campaigns. On the other hand, market regulators in Hong Kong and Singapore have opted against the banning of commissions. Instead, they have adopted measures intended to improve fee transparency and to mandate disclosure of potential conflicts of interest.
Further afield, regulators in South Africa, Netherlands, and the UK have banned sales commissions paid to advisers outright. European jurisdictions subject to the Markets in Financial Instruments Directive (MiFID II) have also, in effect, instituted a partial ban on commissions, which applies to independent financial advisers. Instead of sales commissions, these markets have moved to a fee-based system.
In the UK, the widespread cases of mis-selling prompted the Retail Distribution Review (RDR) of distribution of financial products that led to a ban on commission payments. The ban relates to retail clients only and covers a range of retail investment products including equities, structured products, investment trusts, and pension policies. As a result of the ban, advisers in the UK can only be paid for their services by their clients.
Ahead of the ban, many commentators believed that the market would shrink, as advisers would leave the retail market altogether, creating an advice gap, or that retail investors would be reluctant to pay for advice. Some worried that even though a ban on commission would create better alignment between advisers and clients, new conflicts may arise. Even though the RDR reform was enacted in 2013, there isn’t yet any conclusive evidence as to how effective it has been and whether it achieved its legislative intent; however, a review undertaken by Europe Economics in 2014 found, among other things, that a ban on commissions had reduced product bias, product charges have been falling, advisers were more professional, and there were better disclosures. The Financial Conduct Authority is expected to conduct a post-implementation review this year.
Full and Fair Disclosure
Regardless of remuneration structures, potential conflicts may exist in a relationship between advisers and their clients. This is due to information asymmetry, which may create intentional or unintentional biases. A number of research studies have shown that conflicted advisers give significantly more biased advice to the detriment of their clients.
Many regulators have sought to strengthen disclosures and enhance transparency requirements as a means of managing and reducing such conflicts. For example, in Hong Kong, following a consultation initiated in November 2016, the Securities and Futures Commission decided to strengthen the governance of the conduct of intermediaries who marketed themselves as independent and enhance the disclosure of monetary benefits received or receivable.
A frequently heard criticism of increased disclosures is that the increase in volume of disclosures does not necessarily translate into usefulness to the end user. Very often disclosures are boilerplate and written in legalese. It is critical that investment advisers provide clear, concise, and clearly understandable disclosures, both about their company’s or their personal relationships with investment funds and product managers and how their remuneration is structured. Investors should be able to ask about and understand the fees they are paying, and the level of professionalism of their adviser, in addition to understanding the potential gain and related risk factors. Without this knowledge, investors cannot make an educated decision on how and when to invest.
There also needs to be recognition that some conflicts of interest cannot be managed and should be completely eliminated. Certain incentives, such as winning sales contests and achieving internal sales targets, are irreconcilable with the concept of a best-interest standard if indeed this is the standard that advisers are held to.
Making It Work Everywhere
Clearly, there is no “one size fits all” solution to the problem of mis-selling. The way in which each jurisdiction responds will reflect current standards in force and the events that took place in their own countries during the last financial crisis. Each market has a different legal and regulatory environment and has different approaches to policy design. However, there are common themes that we can draw on, such as transparency.
In addition to transparency, governments should continue working with regulators and the industry on investor education. People who are financially literate make better financial decisions and manage money better than those without this knowledge. Higher financial literacy also alleviates the problem of asymmetric information between advisers and investors.
Creating Value for Our Clients
Amidst the negative perceptions and realities we often face, it is important to emphasize that the investment industry creates real value for its clients and for the communities it serves. However, for clients and regulators to understand this value, we must act, and be seen to act, as professionals.
Ultimately, advisers must be driven by what is best for their clients. Only by committing to the highest standards of professional and ethical behavior can we develop into a profession which creates tangible value for our clients and ensures finance has a purpose.
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