In brief
ASIC has released its report on financial advice provided by 'vertically integrated institutions', which is likely to be read with great interest by Commissioner Hayne and his team. Senior Regulatory Counsel Michael Mathieson and Partner Michelle Levy report.
Vertically integrated institutions
ASIC describes 'vertical integration' as 'the business model of combining activities at two (or more) different stages of production'. ASIC's report deals with five 'vertically integrated institutions' – AMP, ANZ, CBA, NAB and Westpac. ASIC says a vertically integrated business model 'gives rise to an inherent conflict of interest' and its report is largely devoted to addressing how that perceived conflict of interest adversely affects the financial advice provided.
It is worth pondering these notions of vertical integration and conflicts of interest. A great many businesses are vertically integrated. You could say that the banks are vertically integrated in that they issue banking products and they also distribute them through branches. Apple is vertically integrated in that it makes iPhones and it also distributes them through Apple stores. Many not-for-profit participants in the financial services sector are vertically integrated, although they are not covered in ASIC's report.
It is worth asking whether vertical integration results in 'conflicts of interest' in any meaningful sense of that term. Certainly, it does not necessarily result in a conflict of interest that is recognised by the law. An important question is whether, when ASIC speaks of conflicts of interest resulting from vertical integration, it means anything more than the tension between the interests of the customer and the interests of the shareholder (or of some other stakeholder) that is inherent in almost any enterprise or organisation.
These are not mere philosophical reflections. They go to the heart of the Royal Commission's task. What is the right balance to be struck between those sometimes competing interests? But that question is far removed from singling out some, but not all, of the vertically integrated institutions operating in the financial services sector and suggesting they are somehow particularly 'conflicted'.
Having got that off our chests, we return to what ASIC said in its report.
Approved product lists and product sales
ASIC looked at the ratio of 'in-house products' to 'external products' on the advice licensees' APLs and then compared it with the ratio of 'in-house products' to 'external products' recommended by the advisers. ASIC found that while the APLs comprised mainly external products, the advisers recommended mainly in-house products. ASIC suggests that this is evidence of the conflicts inherent in vertical integration.
But what inferences can safely be drawn from the result? One is that APLs are less important than many (including ASIC) make them out to be. The result suggests that APLs do not, themselves, drive 'conflicted' advice. Quite the opposite – provided an APL is reasonably broad, its relevance quickly diminishes. There must be something else at work. (The points just made did not stop ASIC from saying – improbably, given its finding – that the conflict inherent in vertical integration is 'acute' when the licensee decides which products to include on its APL.)
So, why do advisers recommend mainly in-house products? While suggesting the reason lies in vertical integration and conflicts, ASIC also says advice licensees 'should assess why their advisers are recommending such a large proportion of customer funds to be invested in in-house products'. A question is why ASIC did not require licensees to perform this assessment, and then review their assessments, before issuing its report. ASIC also suggests that adviser remuneration may be relevant – and says undue weight should not be given to 'sales-related measures'. However, if any sales-related measures are product-neutral, they logically cannot be the cause of the preponderance of in-house product recommendations.
Advice reviews
ASIC also reviewed 100 files and engaged a consultant to review 100 more. All of the files involved cases where an 'in-house superannuation platform' was recommended to a new customer. In 10 per cent of cases, ASIC had 'significant concerns about the impact of the non-compliant advice on the customer's financial situation'. The concerns related mainly to the new 'superannuation platform' resulting in 'inferior insurance arrangements and/or a significant increase in ongoing product fees'.
ASIC also concluded that a further 65 per cent of cases involved advice that did not comply with the FoFA 'best interests' and related obligations. But this conclusion needs to be carefully understood. ASIC tested the advice by considering whether the advisers relied on the safe harbour. ASIC concluded that they all did but that most of them failed to satisfy each of the steps in the safe harbour. ASIC then looked at whether, despite failing to bring themselves within the safe harbour defence, the advisers nonetheless satisfied the best interests duty. ASIC concluded that they did not, but ASIC does not say how it formed that view. That seems to us to be a material omission from the report. ASIC also said that most of the advice was not appropriate and that most of the advisers did not give priority to the client's interests. The first is a qualitative judgment, and the second is based on the view that when an adviser recommends switching products (superannuation funds) where there are 'no demonstrated benefits for the customer' and the switch benefits the adviser or a related party, 'the interests of the customer will not have been prioritised'.
ASIC says that, in these cases, its conclusion 'does not mean that the advice, if implemented, would result in negative outcomes'. Rather, the 'files did not demonstrate that the customer would be in a better position following the advice'. Again, ASIC is looking for a tangible benefit to the customer in order to conclude that advice is in the customer's best interests, is appropriate and gives priority to the customer. Readers of Unravelled and our Client Updates will be familiar with our views on ASIC's 'better position' test, so we will not repeat them, other than to say that the law says nothing about leaving the client in a 'better position'. It does require personal advice given to a retail client to be 'appropriate'. If ASIC was unable to conclude that the advice would result in 'negative outcomes', on what basis did ASIC conclude that the advice was not 'appropriate'?
Again, what inferences can safely be drawn from the results? One is that a material proportion of financial advisers give bad advice. That may be so, but surely the more important question is whether the proportion of financial advisers giving bad advice is higher in the case of the five institutions under review than it is in the case of any other sector of the financial advice industry.
Can an inference as to the cause of the bad advice be identified? ASIC thinks so. In its cornerstone conclusion, ASIC says:
… the high level of non-compliant advice, combined with the high proportion of funds invested in in-house products, suggests that the advice licensees we reviewed may not be appropriately managing the conflict of interest associated with a vertically integrated business model …
In fairness, ASIC puts this no more highly than as a 'suggestion'. But it does seem to be a rather speculative statement. We are not financial researchers ourselves, but we suspect the explanation for bad advice is more mundane and less nefarious than ASIC suggests. In every field of human activity, there are cases of incompetence, and financial advice is no different. That is the issue at which the professional standards requirements are directed.
Conclusion
Towards the back of its report, ASIC provides two examples of bad advice. No one could disagree that the advice given was bad, perhaps woeful. No doubt the Royal Commission will be presented with many such cases. That is the obvious bit. The more difficult bit is working out the true causes and the real solutions.