This article is Part Two in a series. Subscribe to Financial Services Updates to receive each part of our Royal Commission Series. Parts One, Three and Four can be found at the bottom of this article.
The Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Royal Commission) has brought both condemnation of, and drawn public attention to, the conduct displayed by financial entities. The reason for this conduct seems to be the pursuit of short-term profit at the expense of basic standards of honesty. But, as we discuss below, conflicted remuneration is not a simple matter of greed. From the executive suite to the front line, staff were measured and rewarded by reference to profit and sales rather than the best interests of their clients.
In Part One of our Royal Commission Series, we discussed the overall landscape and reactions to the Interim Report, focusing in general terms on the key issues raised by Commissioner Hayne. In Part Two of our Royal Commission Series, we look at the Commissioner’s observed causes of misconduct and the actions of financial institutions that fell below community expectations in relation to financial advice provided to retail investors/customers. We also delve into what outcomes we could expect to see when the final report is delivered in February 2019.
Financial Advice Focus Topics
As has been widely reported since the commencement of the Royal Commission’s second round of hearings on financial advice, shocking evidence of misconduct by financial institutions was laid bare before the public. Fees for no service, inappropriate advice that does not comply with the legislated ‘best interests’ obligation, advice that doesn’t take proper account of the client’s circumstances, misleading and deceptive conduct and other improper conduct such as falsifying documents, led to Commissioner Hayne identifying two recurring themes in the Interim Report: dishonesty and greed.
This conduct was found to be prevalent and persistent in all major financial entities, so that the Interim report concludes that this conduct “cannot be explained as ‘a few bad apples’.” Instead of distancing the financial services entity from responsibility for the misconduct, Commissioner Hayne found that it was the very culture cultivated by a financial systems entity in its systems, processes and structures which caused the misconduct.
As identified in the Royal Commission submissions and evidence and laid bare in the Interim Report, issues of conflicted remuneration, grandfathering provisions and conflicts of interest were a key concern in the systems, processes and structures which caused the misconduct.
Conflicts of Interest and the Watering Down of FoFA
As we have discussed in a previous article, the 2012 Future of Financial Advice (FoFA) reforms were introduced to provide what was seen as critical in the post GFC world - required regulation of the financial advice industry. The FoFA reforms, as initially designed:
- imposed a ‘best interests obligation’ on financial advisers giving personal advice to clients
- banned conflicted remuneration
- required consumers to provide written consent to ongoing advice fees, with enhanced disclosure of the fees and services for ongoing advice fees.
A series of changes to FoFA between 2012 and 2016 ‘watered down’ the FoFA reforms so that:
- conflicts of interest between the financial advisor and client were permitted but required to be ‘managed’
- some forms of conflicted remuneration were ‘carved-out’ from the ban and allowed to continue through so-called “grandfathering” provisions.
In the Interim Report, Commission Hayne describes the inherent conflict succinctly as “a conflict between the financial interests of the adviser or licensee and the duty that each owes to the client”. The Interim Report goes on to observe that, given the evidence submitted to the Royal Commission and ASIC’s January 2018 report Financial Advice: Vertically Integrated Institutions and Conflicts of Interest, in practice, management of conflicts of interest produced outcomes which were aligned with the advisers’ and/or licensees’ interests and did not commonly advance the interests of the client. Commissioner Hayne goes on to conclude in the Interim Report that the evidence and the results in the ASIC report reflect “a basic observation of the world: that the choice between interest and duty is resolved, more often than not, in favour of self-interest”.
Once this basic observation is accepted, it’s possible to see where Commissioner Hayne is going with the rest of the inquiry as outlined in the Interim Report in relation to conflicted remuneration. It doesn’t seem possible to manage the inherent conflict of interest between a financial advisor’s financial interests and their ‘bests interests obligation’ to the client. Instead, as Commissioner Hayne points out, more often than not, “advice that benefits the advisor ‘commonly’ does not advance the interests of the client and in a significant number of cases does actual harm to the client”.
The remuneration structure for financial advisors was subjected to an attempted overhaul by the FoFA reforms, in recognition of the basic truths that Commissioner Hayne addresses in the Interim Report – that people, when faced with a choice between self-interest and doing what is right, will almost always choose the avenue where self-interest is preferred. With the compromises, exceptions and exclusions in the FoFA legislation, the result was, and still is, a significant pool of ‘conflicted remuneration’ across the financial services industry.
Commissioner Hayne, in the Interim Report, rightly poses the question that if licensees engage financial advisors, rather than sales staff, why the remuneration of the advisor must be tied to any extent to the value or volume of sales made. This approach inherently decreases the quality of advice given. The Interim Report suggests that the financial services industry should be on notice that conflicted remuneration may soon become a thing of the past, and that the only way to manage the inherent conflict involved is to remove it altogether. Internal structures to assess a financial advisor’s performance should be changed to focus on consumer satisfaction, risk and compliance standards and values, rather than volume or value of sales made, and financial services entities should begin preparing for this change.
Conflicted Remuneration and the Grandfathering of Commissions
According to the Interim Report, poor culture and conduct in banks have been driven by their remuneration policies, with almost every instance of misconduct being directly linked to monetary benefit. In relation to financial advisors, the Interim Report states “any exception to the ban on conflicted remuneration, by definition, has the ability to create misaligned incentives which can lead to inappropriate advice”.
This is the unchallenged basic premise for the conflicted remuneration provisions in the FoFA legislation.
On their face, the conflicted remuneration provisions in the FoFA legislation may appear to be comprehensive. However, a series of exceptions, exclusions and benefits or the circumstances in which a benefit is given, may take certain payments outside the definition of conflicted remuneration.
Grandfathering provisions, which allow what would otherwise be conflicted remuneration arrangements to continue despite the FoFA reforms, are one of these exceptions. Despite these forms of payments being readily identifiable as conflicted remuneration, charging and receiving these forms of remuneration have been permitted to continue by the regulators.
In the evidence and submissions to the Royal Commission, Westpac submitted that any move to change the grandfathering provisions must have appropriate regard to the impact that it may have on access to advice as costs for consumers would increase and the viability of advice businesses that are largely built on these kinds of revenue streams would be threatened.
But this ignores the intent of the legislation, the interests of the customers and the professionalisation of the financial services industry.
Since the hearings about financial advice, Westpac, Macquarie, NAB and ANZ have all announced that they will cease paying grandfathered commissions to the advisors they employ, so the financial disadvantages of being the first mover in this area have been largely eliminated.
The clear movement for the financial services industry is that grandfathered payments are on the way out, because of the ability, by definition, for conflicted remuneration to create misaligned incentives which can lead to inappropriate advice. It now becomes a question for those licensees who choose to keep grandfathered commission payments to justify their decision against the benefits of improving the overall quality of advice that is given to clients.
Conflicts of Interest and the Vertical Integration Model
One of the biggest areas of focus in relation to conflicts of interest during the Royal Commission was vertically integrated business models. Having been championed for their efficiency and lower costs to consumers, the “one stop shop” financial model was nevertheless brought into sharp relief early by case studies like CBA, NAB, ANZ, Westpac and AMP, which illustrated that the idea of management of conflicts of interest within the vertical integration model was not even a remote possibility.
The Royal Commission stated that the conflict was better phrased as one between “the financial interests of the advisor or licensee and the duty that each owes to their client”. When reshaping the conflict this way, it is easy to see that the position of the advisor and their conduct becomes an issue.
Despite ASIC still sitting on the fence regarding the benefits of the vertical integration model, CBA, NAB, and ANZ have all announced they will either de-merge or sell their financial planning businesses. The Interim Report suggests that conflicted remuneration, however it is propagated, is something which should not be part of the advice model employed in the financial services industry. Financial services organisations should expect greater checks and balances and greater requirements for improved governance practices in the future.
What can Financial Services Organisations do now?
Financial services organisations need to look at their remuneration structures for their financial advisors and follow the lead of the big banks. Grandfathered commissions are sure to be abolished, as ASIC has proposed it should happen “as soon as reasonably practicable” and there will be greater checks on governance structures for the management of conflicts of interest.
Without commissions and incentive based bonuses, financial advisors should have less incentive to engage in improper conduct, which leaves room for wholescale cultural and governance change within the organisation.
The financial advice industry is still also caught in this structural link between product issuers and the adviser’s legal obligation to act in the best interests of the client, with the evidence being clear that the vertical integration of the industry may harm clients by protecting entities associated with advice licensees from competitive pressures. The Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Powers) Bill 2018 (Cth), if enacted, would introduce obligations to promote the provision of suitable financial products to consumers of these products. When a financial services entity provides advice into the future, it will need to be the voice of risk and the customer that must equally remain in control.
Other articles in this series: