Brent Sheather: Fiduciary duty has gone out of fashion

Photo / Thinkstock

An article in the London Financial Times caught my eye the other day. It was entitled "Trust me I am a financial adviser, is not good enough". The article was by John Kay, author of a 2012 review on the UK equity markets for the British Government.

He noted that the Law Commission had just produced a report on fiduciary duty in the financial services sector. In his story he looked specifically at the poor management of conflicts of interest in the global banking scene and compared the current bad behaviour of banksters with the higher standards that prevailed 100 years ago.

He made that point by recounting the details of a court case a century earlier. A certain Mr Jackson, a stockbroker, appeared before the Court alleged to have sold dubious shares from his own portfolio to a client, Mr Armstrong.

Unlike today's situation where an appropriate page or two of disclosure documentation enables principal trading and would thus mean no worries for Mr Jackson the Judge, Sir Henry McHardy, said that the law will not allow an agent to act in a manner that was not best for his client.

Naughty Mr Jackson was ordered to make good Mr Armstrong's losses. Mr Kay contrasted that result with the current situation in the finance area and as an example cited a recent case in which Goldman Sachs was involved.

Goldman Sachs has hit the headlines a few times over the last few years including one regrettable instance where internal emails revealed some of its investment bankers referred to clients as "muppets". Of course many clients are "muppets" but there is no way you go public with this info.

GS was accused of constructing and selling to naive clients (muppets) CDOs which another client, a hedge fund (not muppets), viewed as likely to default. In the article Mr Kay quotes an excerpt from a Goldman Sachs Executive's testimony to US Congress as follows: Senator Susan Collins asked "Could you give me a yes or no to whether or not you considered yourself to have duty to act in the best interest of your client?" After a long pause the Goldman Sachs Executive said "I believe that we have duty to serve our clients well".

In NZ Code Standard number whatever in the Financial Advisers Code of Conduct says you have to put client's interests first. This sounds great until you dig a bit deeper into matters financial and you realise that frequently it is an impossible dream.

Consider first the particular case of stockbroking where investment banking and retail banking co-exist under the same roof. Here the investment banker acts, in the case of an IPO, for a seller who wants to maximise the sale price of the company being sold to institutional and retail investors. The retail brokers at the same company act for the retail client so putting both clients' interests first poses a problem. Inevitably one of the parties interests are going to be put further first than the other.

Reminds me of a story by George Orwell. Then there is the case of "qualifying financial entities" like all the major banks. They are required to put client's interests first too and in the UK the Financial Conduct Authority has quite sensibly determined that putting clients' interests first involves choosing from the entire universe of products but when mum and dad rolls into the local branch of XYZ bank whose KiwiSaver products do you think gets sold to them? Do they get advised on the basis of what their adviser thinks is best? Of course they don't', they get sold that bank's KiwiSaver product.

Former investment banker and now Minister of Commerce, Craig Foss, argues that major progress has been made in the last five years reforming the financial markets and it is now safer for Mum and Dad to invest.

That may be so but despite the "progress" huge conflicts of interest between advisers/fund managers/investors have been permitted to remain. Think commission payments, investment banking and retail banking under the same roof, unfair performance fees, principal trading, the IPO market, paying for order flow etc etc.

So despite the FMA's laudable objective of ensuring fairness in financial markets the legislation, rather than compel any of the major players to make changes that would substantially impact their profitability, instead principally relies upon the disclosure of conflicts of interest to protect retail investors. Good luck with that strategy!

It assumes that Mum and Dad will read the disclosure statement, understand it and act upon it. Research and anecdotal evidence suggest this is not always the case and a cynic might observe that this method of regulation provides a convenient way out for institutions and advisers who understand that "putting clients' interests first" means company profits and, more importantly their bonuses will be reduced.

Put very simply the rules are that you must not rip your client off but if you tell them you are going to rip them off then that is fine.

The research on the impact of disclosure in decision making doesn't really validate regulatory authorities' (including the FMA) reliance on disclosure as the main safety mechanism protecting retail investors. We discussed the "disclosure" anomaly a few years back in a story entitled "Spotlight On The Dark Side Of Disclosure" (Weekend Herald Saturday 21 November 2009).

Findings included the fact that "people generally do not discount advice from biased advisers as much as they should when conflicts are disclosed because they think financial adviser XX is a great person and he or she wouldn't rip them off. Secondly the study showed that high levels of disclosure make advisers feel "morally licensed and strategically encouraged" to behave even more badly.

Disclosure rules have created a huge industry within the finance sector. Indeed many of the disclosure statements accompanying research notes from stockbrokers actually comprise more pages than the research, which is perverse.

Naïve investors will believe that the more detailed the disclosure statement the safer they are. The opposite is in fact the case. It is ironic that whilst disclosure statements are designed to protect investors a good rule of thumb is that the larger the disclosure statement the more wary one should be of the institution involved.

Whilst the finance sector has increasingly found itself on the wrong side of the law this hasn't stopped some of its members using the law to silence its critics. Brian Gaynor commented a week or so ago about how in NZ the threat of legal action occasionally tends to stop journalists from commenting on controversial issues and he noted that both he and the Herald had been the subject of defamation actions.

In the thirty or so years that I have been writing for newspapers I have had my fair share of legal threats too. Many years ago Australian fund manager, Armstrong Jones, engaged Bell Gully to keep me quiet. This was particularly annoying at the time because my family trust had been a long term client of Bell Gully.

A few other local fund managers have also alluded to Court action when they haven't agreed with stories and it's a little ironic that in these cases the Court action is funded by the unit holders in the funds despite the fact that presumably these investors would benefit from the public airing of how they were being ripped off.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request.