Brent Sheather: Finance industry tries to decode new rules

Study for an ethics exam still leaves financial advisers in the dark about good behaviour. Photo / Thinkstock

A fortnight ago in this column, we spent some time feeling sorry for the 5000 or so stockbrokers and financial advisers compelled to take three or four days out of their lives to study what does and does not constitute good behaviour.

They then have to sit an exam to test their competence.

Fair enough, I hear some readers muttering; as a group, financial advisers have ruined many people's retirements recommending finance company debentures and other risky products paying high fees - so let them suffer.

And suffering we are. The ethics test is more problematic than most.

When you sit an exam, there's a pretty good chance that the right answer is beyond doubt and widely accepted by most people including, most importantly, the examiners.

In the ethics exam, what constitutes good behaviour is set out in some detail in the Code of Professional Conduct For Authorised Financial Advisers (The Code).

Included in this intimidating document is Code Standard 3, which says an adviser "must not state or imply that he is independent or that any financial adviser services provided are independent if a reasonable person in the position of a client would consider that the financial adviser or the services provided are not independent".

The key words are "reasonable" and "independent". Despite the code giving some examples of what is not considered to be independent, there's still a large element of doubt as to what is independent.

Furthermore the powers that be - that is, the Securities Commission - are not really willing to make individual determinations on which firms are independent, or not, at this stage, although they may make some comments in the future to clarify the matter.

What the commission does say is that the "reasonable person" test must be made. This means putting yourself in the client's shoes whenever advice or a service is provided and, taking into account all the circumstances, considering whether the client would view the adviser to be independent.

Not wanting to be the first financial advisory firm before the code disciplinary committee, our firm asked the commission to make a determination on whether we were independent.

The commission said "We cannot provide you with a definitive answer as to whether an AFA is independent or not because this will depend on the particular circumstances of the adviser and the context in which the advice or service is provided."

Duh! - if the chief regulatory body can't decide who is independent, then who can? God, perhaps?

In the absence of divine intervention, Code Standard 3 provides us with a few clues about the nature of independence including these:

• If the adviser or the adviser's employer manages funds, he or she can't say they are independent.

• If the adviser has made a deal with a particular product provider to recommend its products, or has an arrangement that limits his or her choice of products, or has agreed to sell a certain volume of products, he or she can't say they're independent.

The standard does add that if you use a WRAP account, which permits your clients access to a wide range of products, that's okay. This is a bit strange because many WRAP accounts tend to have a limited number of (usually high-cost) instruments on them and it may be that some product providers actually pay to get their products on the shelf.

• You can't call yourself independent if you get paid by someone other than the client you are dealing with. So getting commission on the sale of a unit trust or Feltex shares or trailing fees is a no-go for an independent adviser. It is okay, however, if you then transfer this benefit back to the client.

The process of formulating the code looks to have been heavily influenced by members of the financial planning and insurance industries and it may well be that the word "independent" has been defined to suit some people's interests at the expense of others - although, until and unless the commission sheds more light on this, it's anyone's guess.

For example, a reasonable person might think "independent" in a financial advisory sense means independent to recommend any financial product that best meets the client's needs; that is, to include a liberal amount of the lowest-cost investment instruments and avoid too many high-cost products.

This is the approach the Financial Services Authority (FSA), the chief regulatory body in Britain, appears to have taken. But in New Zealand, under Code Standard 3, independence seems to be all about how you get paid.

For example, it appears you can use an expensive WRAP service for your clients which is limited to high-cost managed funds and still call yourself independent.

But if you're a financial adviser using a stockbroker to buy the cheapest managed funds on earth (exchange-traded funds) and share the fee with the stockbroker, you may not be able to call yourself independent. It is thus about how you charge your clients and get paid, not what you recommend.

This seems to be at variance with Code Standard 1, "to place the interests of the client first". In Britain, the FSA almost always has regard to whether the adviser advocates the use of low-cost exchange-traded funds when assessing independence.

This is no doubt part of a drive to get annual fees down and, with shares likely to outperform bonds by just 3 per cent a year in the next 100 years according to the experts, it seems very much the way to go. In other words, the FSA is equating independence with low fees.

But Britain also seems to be having trouble defining independence. All is apparently revealed in the 110-page FSA Policy Statement 10/6.

The FSA approach appears to be that financial advisers must have the capacity to properly research the entire marketplace; that is, not just high-cost unit trusts but also low-cost options such as investment trusts and exchange-traded funds.

The deal is if advisers don't research the entire market, they cannot call themselves independent and are deemed to be restricted advisers. According to the Policy Statement, the official definition of independence is "to be able to provide independent advice, firms would need to make recommendations based on a comprehensive and fair analysis of the relevant market and to provide unbiased, unrestricted advice".

It appears that in Britain, unlike New Zealand, the use of one platform would preclude advisers calling themselves independent as most platforms do not meet the "comprehensive" definition. In informal discussion, the FSA frequently cites exchange-traded funds as needing to be included in any comprehensive, and thus independent, service.

Perhaps the FSA's motivation is to ensure consumers are confronted with the low-cost option, encouraging them to become more price conscious. That consumers don't pay enough attention to cost is a criticism the FSA has made in the past, and it's no bad thing because fees in the financial planning and investment advisory industry are far too high relative to reasonable estimates of returns.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.