One of the topics gaining the most attention in December and over the Christmas break was the proliferation of listed investment companies that have emerged in recent years. The sector has doubled in size following its exemption from the Future of Financial Advice Reforms, as they allowed fund managers to pay advisers, stockbrokers and accountants ‘stamping fees’ of up to 6% of the amount invested by their clients. Sounds very similar to the likes of Great Southern and Timbercorp doesn’t it.
As we have seen in history, whenever there is a loophole available, it will be leveraged by interested parties. The sector attracted attention after Chris Joye from Coolabah Capital provided an in-depth analysis (below) whilst news was released about Treasurer Frydenberg’s briefing on the subject in 2019. Interestingly, little has been done about the issue and ASIC is essentially powerless from protecting investors from being ripped off due to the loop hole. What follows is Chris Joye’s most recent column on the sector and recent changes.
A revolution is coming for conflicted financial advisers – Coolabah Capital
In one of the biggest shake-ups of the financial advice industry in years, the government’s Financial Adviser Standards and Ethics Authority has blanket-banned conflicted sales commissions, including previously acceptable “stamping fees”, for advisers recommending listed investment funds to both retail and wholesale clients. These conflicted payments were already banned under the 2012 Future of Financial Advice (FOFA) laws, which reshaped the financial planning market by ensuring advisers were only ever paid by their clients and not by product manufacturers, like fund managers, trying to motivate them to sell their wares to retail and wholesale customers.
The presence of sales commissions paid to advisers created endless mis-selling crises where inappropriate products were foisted on consumers in the name of capturing the associated fees, which FOFA brought to an end. The 2019 royal commission firmly reinforced FOFA’s intent by concluding that “there must be recognition that conflicts of interest and conflicts between duty and interest should be eliminated rather than managed”. Yet in 2014 the Coalition granted listed investment companies (LICs) and listed investment trusts (LITs) an exemption from FOFA.
In contrast to normal unlisted managed funds and exchange traded funds, this meant that a fundie launching an LIC or LIT could pay unlimited sales commissions to retail advisers promoting these products. This has unsurprisingly led to an explosion in fund managers raising tens of billions of dollars from mums and dads for complex hedge funds and junk bond funds by paying advisers enormous upfront sales commissions of between 1 per cent and 3 per cent of the money they source from their clients.
Under FASEA’s new Code of Ethics, which becomes legally binding on all Australian advisers from January 1, 2020, this will no longer be possible. Advisers are already talking about how the code will eliminate the gargantuan sales commissions paid by LICs and LITs and force them to compete purely on their merits like all normal investment products that have been bound by the FOFA laws.
FASEA’s code will also apply to many stockbrokers who these days are more often than not required to be RG146 qualified as a retail adviser.
Magellan presciently anticipated this development by recently raising $860 million for an LIT that paid no commissions to brokers and advisers.
Standard 3 of the code says an adviser “must not advise, refer or act in any other manner where you have a conflict of interest or duty”. It then provides specific case studies under a guidance note of what represents an illegal breach.
One example involves an adviser’s firm taking “advantage of the carve out from the conflicted remuneration provisions introduced by the FOFA reforms” for stockbroking fees. It then says that where an adviser recommends a product to earn extra stockbroking commissions, they breach the standard and cannot do so.
Another case study deals explicitly with the stamping fees advisers capture from IPOs of LICs and LITs. The guidance states that an adviser “keeping the stamping fee rather than…rebating it [is] unfair to [the adviser’s] clients”. “The option to keep the stamping fee creates a conflict between [the adviser’s] interest in receiving the fee and his client’s interests. Standard 3 requires [the adviser] to avoid the conflict of interest. It is not sufficient for him to decline the benefit as it may be retained by his principal. Either the firm must decline the stamping fee altogether, or [the adviser] must rebate it in full to his clients.”
The ban on stamping fees for LICs and LITs for all advisers is therefore black and white. Some advisers have speculated that FASEA’s code might only apply to retail, not wholesale, clients, thereby allowing them to still capture conflicted sales commissions when recommending products to wholesale customers. This column has confirmed that all registered advisers must comply with the code’s standards irrespective of whether they deal with wholesale or retail customers.
This means FASEA’s code extends well beyond FOFA’s reach, which only protects retail investors.
Under the Corporations Act, an individual can be classified as a wholesale client if the adviser can obtain an accountant’s certificate showing they have net assets of at least $2.5 million, or a gross income for each of the past two financial years of at least $250,000. The problem is that many individuals who earn more than $250,000 a year, or have a home worth $2.5 million, know absolutely nothing about finance, investing or markets. This includes scores of retirees who have seen their homes appreciate beyond $2.5 million.
Since roughly 80 per cent of all LICs and LITs are trading below their net tangible assets, with many inflicting large 10 per cent to 20 per cent losses on clients who bought them in the original IPO, advisers open themselves up to catastrophic compensation claims for losses incurred by any clients other than the most sophisticated institutional-style investors.
It would be straightforward for many normal wholesale clients to argue that they do not fully understand hedge funds or leveraged junk bond funds, and relied on their adviser’s recommendation with or without a formal statement of advice.
It would also be easy for them to make the case that the adviser’s recommendation was being influenced by the large conflicted sales commission they received for pushing the product.
Here the guidance note explains that a key legal test is whether “a disinterested person, in possession of all the facts, might reasonably conclude that the form of variable income (eg, brokerage fees, asset-based fees or commissions) could induce an adviser to act in a manner inconsistent with the best interests of the client or the other provisions of the code”.