Preserve the Code: The case for avoiding all conflicts

Pared-down to the bone, the regulation of financial advisers in Australia has been based on one simple word: Disclosure.

The principle of disclosure has been the backbone of the industry and consumer protection regulation for decades, having been strongly endorsed by the Wallis Inquiry way back in 1997.

Disclosure relies on financially capable, informed and responsible consumers being able to understand the meaning and consequences of what they are being told by advisers, thereby enabling them to make rational financial decisions in their best interests. This is sometimes called giving ‘informed consent’.

Sadly, ‘disclosure’ has failed badly.

In Australia, its shortcomings were questioned by the Murray Inquiry in 2014 and more recently in the Hayne Royal Commission. The failure of disclosure has resulted in the increasingly complex, costly, compromised and ineffective ‘box ticking’ regulation that financial advisers and their clients love to hate. It has also enabled and even encouraged bad behaviour by the industry, a point not lost by the authors of an excellent paper (“Disclosure: Why it shouldn’t be the Default”) published in October 2019 by the Australian Securities and Investments Commission and the Dutch Authority for Financial Markets.

In summary, the reliance on disclosure as the principal regulatory tool has done no favours at all to anyone. To use the parlance of economists, it has created a ‘failed market’ for financial advice in which only a small number of Australians use the service because it is expensive, unintelligible and untrusted.

Thankfully, all of this is about to change for the better for advisers and clients with the advent of the Financial Adviser Standards and Ethics Authority’s Code of Ethics which commences on 1 January 2020. Yes, I know that the Code (especially Standard 3) has caused anxiety and uncertainty. Change always does, especially this change which (building on the Future of Financial Advice laws) effectively removes all forms of conflicted remuneration, including brokerage, asset fees, life insurance commissions and profit shares on ‘white label’ or ‘in-house’ products and platforms from that date.

The Code achieves this in a subtle way, requiring serious thought by individual financial advisers about their values and ethics. Importantly, Standard 3 doesn’t specifically “ban” anything, except acting or advising with a conflict of interest. In that context, professional advisers must ask themselves whether receiving any of the above forms of remuneration (called in the Code, ’variable income’) is acceptable. Add to that the “disinterested person” test in FASEA’s Guidance document attached to the Code and one must conclude that any adviser seeking to mount an argument that any of these forms of remuneration are not in conflict with standard 3 would be in for an uphill battle, to say the very least. The industry’s leaders know this, which is why there has been so much push-back to the Code and especially to Standard 3.

At this point I can hear some advisers crying foul, claiming “all forms of remuneration are conflicted”. I do understand that this opinion is sincerely held. In fact, I would always concede that charging fees based on an hourly rate may lead to inefficiency and even overcharging. Furthermore, for many advisers, the hourly rate methodology is not always the simplest or most comfortable one to use (I know from personal experience as both an adviser and a client). Where appropriate, these problems can be overcome by the adoption of flat or fixed fees. However, the overarching point is that a genuine ‘fee for service’ is clearly not a form of ‘variable income’ anticipated in the Code and is not conflicted in the sense that it does not lead to the inappropriate selling of products or the unnecessary accumulation of funds under management which is the misbehaviour that decades of disclosure-based regulation has unsuccessfully sought to curtail.

So what happens next? The reality for the industry is that from 1 January 2020, the Code of Ethics is compulsory. Advisers will choose to comply with its clear intention or not. If they choose not to do so, they will be breaking the law and they may have to account to their clients, to their PI insurer, to their AFSL holder, to the regulator or to a court as to why they made that choice.

As for AFSL holders, while they are not quite directly in the firing line, they will nevertheless need to give serious consideration to the practices and methodologies that they are willing to accept from their licensed representatives from 1 January 2020 (assuming they wish to retain their licences). Perhaps, there may be some scope for “light touch” regulation and “understanding” and there may even be some practical refinements to the operational details, but the ethical principles in the Code are clear and the law is the law. Advisers are expected to comply with it from that date.

My hope is that the industry will embrace the clear meaning and spirit of the new Code of Ethics. Any plans to lobby government and FASEA to amend its plain words or to dilute its principles or interpretation should be dropped. It is simply not in the interests of the new profession of financial advice to return to a conflicted past that will become history in literally a few weeks’ time.

Instead, the profession’s leaders should support a vision in which the box-ticking complexities and conflicts of the old disclosure based regime will surely recede into a distant memory and advisers in the industry will be accepted by the public (and themselves) as the true professionals that the Code of Ethics will allow them to become. Of course, there are already many financial advisers who have successfully adopted these principles years ago. They will be exemplary role models for the rest. A new profession is about to emerge. We should embrace that development with enthusiasm and a sense of opportunity, not with negativity and doubt.