Bernie Ripoll’s parliamentary committee handed down its long-awaited report (pdf) into financial services this week. The report commissioned in the wake of the Storm Financial collapse identified several shortcomings with the current market-based regime of financial services regulation. It has proposed legislative changes to ensure financial advisers place their clients’ interests ahead of their own. However it stopped short at calling for an immediate outright ban on financial commissions. These commissions are often the subject of severe conflicts of interests which are not disclosed to customers.
The current regulation of financial service providers is governed by the so-called "efficient markets theory" of the 1997 Wallis Report. This is the “light touch” belief that markets drive efficiency and that regulatory intervention should be kept to a minimum to allow markets to achieve maximum efficiency. The only regulation that protects investors is limited to conduct and disclosure requirements on Australian Financial Services Licence holders. ASIC issues these licences which are mandatory for all financial services businesses but are easy to get.
The Corporations Act 2001 has conflict of interest disclosure provisions but did not include margin lending until October this year. Margin calls are the practice of lending for the purpose of investing with the loan secured against the value of the borrower's portfolio. When the value of the equity falls below an agreed proportion of the portfolio value, a margin call requires the borrower to either contribute additional equity or sell shares.
There are 18,000 financial advisers in Australia, the vast majority of which rely on commission-based remuneration rather than fee for service. They get their money from product manufacturers on the funds invested by retail investors. The manufacturers recover the costs from the overall charges within the investment products. Storm Financial were past masters at hiding their fees.
Ripoll said the Storm Financial collapse had a “catastrophic effect” on many investors. These are the people who did not get an opportunity to respond to margin calls and were sold out of their portfolios at the very bottom of the market in late 2008. 3,000 out of Storm’s 14,000 clients had leveraged investments. The Townsville-based company encouraged these people to take out loans against their equity to generate a lump sum to invest in the share market.
Clients had a margin loan with an 80 to 90 percent loan to value ratio (LVR) and Storm charged a fee of seven percent for their services. Storm tendered out the margin loans to either Commonwealth Bank or Macquarie Investment Lending. Clients were encouraged to increase the size of these loans on the basis of increased home value. The paperwork left a lot to be desired with many signing blank loan applications or had their income figures or asset values overstated.
The problem was that leveraged investments work well in a rising market but losses are also magnified in the event of a sudden fall. When world markets collapsed in September 2008, many loans fell into margin call territory. The 90 percent LVR suddenly became Storm's Achilles heel. The remaining 10 percent was not enough to clear home loan debts. In addition, many clients said they might have been able to repay but neither Storm nor the bank issued a margin call warning them of the problem. They didn’t find out until December when they moved into negative equity after their portfolios have been sold down at the bottom of the market without their knowledge, maximising their losses. They were bankrupt.
Storm and the banks could not agree whose fault that was. Storm said bank information during this time was outdated while the banks said Storm were unresponsive with margin loan queries. The banks said they used the same approach with other financial groups, none of which had the same issues as Storm about advising clients. The banks said it was the advisers’ responsibility to resolve the margin call with the end customer. Storm, meanwhile, used a 2002 margin call precedent to claim it was the banks’ responsibility to inform the customer.
In December Storm co-director Emmanuel Cassimatis met senior Commonwealth staff to arrange to consolidate client debt into a large corporate debt facility to be repaid over three to four years. Cassimatis asked for a further loan to cover his customers’ margin calls. Commonwealth turned this proposal down. Cassimatis blamed this decision on Storm’s demise. But Commonwealth’s hands were tied - Storm had already been pronounced insolvent. The bank called in a $10 million loan.
This did not stop Cassimatis paying a $2 million dividend to himself and his wife and co-director Julie Cassimatis. The payment was frozen after an ASIC-initiated court action in February. Storm then sacked its 115 strong workforce and Worrells were appointed liquidators in March. Despite the collapse, there were plenty of rich pickings to be had. The Cassimatises had boasted a fortune of about $450 million and were listed at number 22 on the 2008 Sunday Mail's Queensland Top 100 Rich List. Everyone scrambled for a bite of a juicy cherry.
In February, Federal Parliament appointed a Joint Committee on Corporations and Financial Services. Its role was to examine the role played by financial advisers in collapses such as Storm and Opes Prime. It would also look at the role of commissions in the financial services industry and licensing and consumer protection measures in place. The inquiry was announced a day after ASIC chair Tony D'Aloisio noted an "inherent conflict" concerning financial advice in Australia's corporations law.
Ripoll’s committee noted a major flaw in Storm’s “one size fits all” financial advice irrespective of client circumstances. This aggressive leveraged investment strategy was inappropriate for people on average incomes or about to retire. Ripoll also noted Storm downplayed the risk customers could lose their family homes while overselling the notion of professional indemnity insurance.
The report called for the legislation of fiduciary duty which would require financial advisers to place their clients’ interests ahead of their own. Wikipedia defines a fiduciary duty as a legal or ethical relationship of confidence or trust between two or more parties. This law would address the issue of the conflict of interest of financial advisers. However Ripoll stopped short at calling for a ban on commissions from product manufacturers and supported the banks’ view they subsidise the cost of advice. Instead it called for more self-regulation and a longer term shift away from commissions.
The Institute of Actuaries was blunt in its submission and rejected complaints about expensive commission-free advice. Advice is expensive, it said, and not required by the 90 percent of people whose best investment advice is to pay off the mortgage or put money into super. However, people who do need it ought to be able see what that advice is. “The profession has to stand on its own two feet,” they said. “People need to understand that this is the cost of that advice.”