Adviser liability

— 1 minute read

A number of significant issues have arisen in the past few years in terms of adviser liability. Halsey Legal Services' Mark Halsey examines five of those key issues.

The past three years have been a very busy and sometimes stressful time for compliance risk managers, professional indemnity insurers, advisers and lawyers.

These years have seen:

  • the introduction of a new consumer compensation scheme, involving mandatory professional indemnity insurance, in 2007;
  • a wave of consumer compensation claims and complaints arising from the global financial crisis in 2008;
  • a series of government reviews (such as the Ripoll review) and the announcement of reforms relating to the provision of financial services in 2009 and 2010; and
  • the restructure of ASIC-approved external dispute resolution schemes, with new and expanded terms of reference, commencing from 1 January 2010.

Each of the matters referred to above has generated a large number of significant issues in the context of adviser liability.

This article will highlight and provide some practical commentary in relation to five of those significant issues. In terms of significance, my firm Halsey Legal Services provides legal services to over 40 Australian financial services licensees throughout Australia, and these five issues currently seem to be the hot topics. The issues are:

  1. the proposed introduction of a statutory fiduciary obligation owed by financial advisers to clients;
  2. the advisers' know your product obligations;
  3. matching the products in the client's portfolio to the client's risk profile;
  4. the Financial Ombudsman Service's (FOS) approach to differentiating disputes and claims; and
  5. situations where the client contributes to their own losses.


The proposed statutory fiduciary obligation

On 26 April 2010, Financial Services Minister Chris Bowen announced a number of key reform measures, referred to as the Future of Financial Advice, which are intended to apply from 1 July 2012. One of those reform measures is the introduction of a statutory fiduciary duty for financial advisers requiring them to act in the best interests of their clients and to place the interests of their clients ahead of their own when providing personal advice to retail clients. This reform was recommendation one from the Ripoll report.

Since the publication of the Ripoll report, there has been a great deal of commentary in relation to the proposed statutory fiduciary obligation. While there is little doubt this will represent significant regulatory change, there is some debate about what this means in a practical context in terms of dispute resolution between advisers and their clients.

For example, ASIC, in its submission to the Ripoll inquiry, stated "a fiduciary relationship, requiring the adviser to act in the best interests of their clients, might exist between the adviser and client as a matter of general law".

This seemed like a somewhat surprising statement given the approach already adopted by the courts and FOS.

In litigation before the courts, the authority for the proposition that a fiduciary obligation already exists can be found in a decision of the full High Court dating back to 1986 - Daly v Sydney Stock Exchange Ltd [1986] HCA25. The High Court held: "Whenever a stockbroker or other person who holds himself out as having expertise in advising on investments is approached for advice . and undertakes to give it, in giving that advice the adviser stands in a fiduciary relationship to the person whom he advises."

ASIC-approved external dispute resolution schemes, such as FOS, are increasingly becoming the main jurisdiction for financial services disputes. The position at FOS appears to be that a fiduciary relationship is already considered to exist between advisers and clients. In FOS Determination 18959 (which has also been referred to as the Basis Capital case) FOS stated in paragraph 77: "The legal nature of the adviser-investor relationship, as in financial planning, is fiduciary."

Having noted this, it is also important to consider that adviser liability may also arise from an adviser breaching their regulatory obligations and being pursued by ASIC in terms of some form of enforcement action. In this context, I see the proposed statutory fiduciary obligation as representing significant change. The current Corporations Act benchmark for adviser conduct is that the adviser has a reasonable basis for their advice and conduct (section 945A of the Corporations Act 2001).

In Regulatory Guide RG 175, ASIC describes how it currently interprets and applies the financial services laws. At paragraph RG 175.110, it states: "To comply with the Corporations Act, personal advice does not need to be ideal, perfect or best, but it must satisfy each of the three elements set out in RG 175.106."

RG 175.106 refers to the suitability test and the fact the advice has a reasonable basis.

An exception to this rule is where an adviser provides managed discretionary account services to a client. In those circumstances, the current benchmark is that the adviser must act in the best interests of the client, which is part of the fiduciary obligation benchmark (see Regulatory Guide 179 at paragraph RG 179.38(b)).

In summary, a statutory fiduciary obligation may not in practical terms significantly change dispute resolution and litigation between advisers and clients - although it may serve to remove any confusion introduced by the wording of the Corporations Act 2001. However, the higher duty imposed by a statutory fiduciary obligation will represent significant change in the ASIC regulatory action context. It will make it easier for ASIC to take enforcement actions against advisers, including processes such as the banning of advisers. Adviser conduct will face a much higher test. Adviser conduct will need to be not merely on a reasonable basis, but will have to be in the best interests of the client.


Advisers' know your product obligations

There is usually relatively little emphasis on the advisers' know your product obligations, as compared to the advisers' know your client obligations.

Perhaps it is taken as a given that advisers know their products and that this benchmark can be readily achieved by a number of external facilities and processes, such as purchased external research and licensee group training sessions.

However, such understandings of the obligation were put to the test and found wanting in a series of adviser banning hearings between 2006 and 2008.

The advisers' know your product obligations arguably arise under the provisions of section 945A(1)(b) of the Corporations Act 2001. This provides that, having regard to information obtained from the client in relation to those personal circumstances (presumably in the form of a fact finder), the adviser has given such consideration to and conducted such investigation of the subject matter of the advice (including the relevant financial products to be recommended) as is reasonable in all of the circumstances.

The key questions are what and how much consideration is reasonable in all of the circumstances.

Between 2006 and 2008, ASIC conducted a series of hearings in relation to whether advisers who recommended Westpoint products should be banned for breaching their obligations to their clients under the financial services laws. One of the key allegations ASIC made in this respect was that the advisers failed in their obligation to adequately know and understand the products they were recommending.

The position taken by many of the advisers was that:

  • the Westpoint products had been researched by external researchers and the advisers had relied on the external research; and
  • the products were on the licensees' approved product list and, in some instances, the advisers had been required to undertake product-specific training conducted by the licensee and had been accredited by the licensee to promote the products.

The advisers sought to rely on a statutory defence under section 945A(2) of the Corporations Act 2001, which provides that an adviser who is a representative has a defence to a proceeding for a breach of section 945A(1) (which includes the know your product obligations), where the licensee had provided the adviser with information and instructions about the requirements to be complied with in giving advice to clients. The defence is meant to apply where the adviser's failure to comply with section 945A(1) occurred because the adviser was acting in reliance on that information or those instructions from the licensee, and the adviser's reliance was reasonable.

That defence was typically not accepted by both the ASIC delegate at the banning hearings and the Administrative Appeals Tribunal.

For its part, ASIC argued the principles in paragraph RG 175.130, which states: "The obligation rests on the providing entity (adviser where they are an authorised representative) to investigate the subject matter of the advice. Depending on the circumstances, it may be reasonable for the providing entity to rely on information supplied by external research houses. A providing entity relying on such information should take reasonable steps to ensure that the research is accurate, complete, reliable and up-to-date."

In the hearings and appeals I attended it appeared ASIC intended that the reasonable steps that advisers should take included (in relation to Westpoint) whether the advisers knew the specific contents of provisions in the products' information memorandum and prospectuses, the methodology of arriving at pre-sales to support valuations of underlying property assets financed by the promissory notes, the nature and strength of inter-company guarantees referred to in the disclosure documents and other elements relating to the products' security.

A significant amount of misunderstanding and misinformation has been published on this point in relation to the Westpoint matter as it relates to advisers. This was not merely an issue as to whether a particular product on the licensee's approved product list was appropriate for a particular client with a particular risk profile (although that was also an issue raised by ASIC). This was an issue as to whether the adviser was expected to take reasonable steps to ensure the information provided in the product research was "accurate, complete, reliable and up-to-date".

It is my view the Westpoint banning hearings set a new high point in terms of prospective adviser know your product obligations. While it is not expected that this will necessarily become the norm in dealing with claims and administrative actions against advisers, it would be unwise to ignore the fact that actual hearings have taken place on this basis, and advisers have lost their livelihoods through banning orders (albeit temporarily in most cases).

Advisers would be well advised to think carefully before expanding their product offerings to include recommending non-standard, boutique or complex products to clients - particularly retail clients - regardless of the position taken by the licensee. The fact that a product has been included in an approved product list does not create an obligation for the adviser to promote it.


The averaging of risk view

There are a number of schools of thought in terms of risk management in portfolio design. One school of thought provides that speculative or high-risk investments may form a small part of any investment portfolio provided the risk profile of the investment portfolio as a whole on average is consistent with the client risk profile - the so-called averaging of risk view.

While this may remain the source of considerable legitimate debate from the perspective of fund managers and 'financial engineers', where FOS is involved, this may not be acceptable for a retail client.

The position that seems to have been taken by FOS is that the averaging of risk view can only be acceptable in very limited and specific circumstances. In FOS Determination 18959, FOS held that: "The member's [adviser's] strategy had the tendency to blend 'higher than risk profile' products with 'lower than risk profile' products in order to achieve a weighted average approximating the client's risk profile. This can only be undertaken where the additional risks and the potential consequences of those added risks are fully disclosed. It would be impossible to achieve an informed consent without such disclosure.

"It is not a question of whether the Basis Yield Fund exposure was only 5 per cent or 6 per cent of the portfolio. It is whether the product selected had all the elements necessary to qualify for this portfolio and the complainant in the first place."

The effect of this determination seems to be that each product must be seen to be appropriate for a client's requirements and risk profile, and the averaging of risk between products in the portfolio is not acceptable. Where this approach is followed and applied, the client may be able to cherry-pick losses from inappropriate investments products instead of having the overall portfolio considered as a whole.

Some may argue this contradicts some of the principles of modern portfolio theory. However, as most advisers know, a licensee has no rights of appeal against a FOS determination, so serious consideration and attention must be paid to FOS's positions.


FOS's approach to differentiating disputes and claims

Under the FOS terms of reference (TOR) that came into effect on 1 January 2010, there have been significant changes to FOS's monetary limit jurisdiction. Under Rule 5.1(o) of the TOR, FOS may consider a dispute where the value of the applicant's claim in the dispute does not exceed $500,000. However, schedule one of the TOR provides that the value of the award in relation to a claim is capped at $150,000 for claims arising out of managed investments, stockbroking and financial planning (other than life insurance products).

In recent months I have noticed an increasing trend for FOS to unbundle a client dispute into a number of separate claims, and have those unbundled claims dealt with together under a single dispute number for administrative purposes.

The unbundling process stems from a procedural change that occurred under FOS's forerunner, the Financial Industry Complaints Service (FICS). The procedural change was advised to members under FICS Bulletin 46, issued on 2 April 2007.

In essence, FICS advised that it had changed its approach and would apply the monetary limit to each claim or cause of action raised by complainants, even if those claims all arose out of a single ongoing working relationship between the financial services provider and the client. However, FICS appeared to indicate that it would be likely to do so where it appeared that the claims arose as a consequence of essentially separate items of advice over a period of time, and provided a worked example in the bulletin to illustrate its reasoning.

FICS confirmed that the change in approach may result in complaints being accepted in the future that would previously have been excluded because the aggregate value of the claims exceeded the FICS monetary limit. In other words, each unbundled claim would represent a separate matter for the calculation of monetary limits and monetary caps.

As a consequence of the unbundling process, I have seen disputes where the aggregate value of the claims that are capable of giving rise to an actual financial award has exceeded $600,000. In other words, advice on different statements of advice and records of advice relating to different products at different times have triggered different monetary caps for each claim in respect of the same client and same adviser.

This unbundling process has the potential to have a very detrimental impact on advisers and licensees, because the wording and process of FOS are becoming increasingly inconsistent with the wording and processes of the advisers' and licensees' professional indemnity (PI) insurers. Prior to FICS Bulletin 46 and FICS's changed approach, both FICS and the PI insurers had the same approach to claims and adopted essentially the same terminology.

The inconsistent approach between FOS and PI insurers can occur because some PI insurance policies provide coverage for FOS claims as endorsements to the insurance policy and provide for a maximum amount payable under such a claim to be capped to the current FOS monetary cap of $150,000. Since FOS's typical administrative procedure is to treat all claims arising under a single client dispute together for administrative purposes (that is, a single dispute number), there can be a real danger that the PI insurer will treat the dispute as a single claim under the insurer's definition.

Using the example I have referred to in my earlier paragraph of the aggregate value of a client's claims being $600,000, such an approach would leave both the adviser and licensee with an uninsured gap of $450,000. Obviously, this is a very undesirable outcome.

It is important for advisers and licensees to quickly identify client disputes and claims that are likely to give rise to the unbundling process referred to above and to enter into discussions with FOS.

I understand the reason FOS treats multiple claims scenarios as a single dispute (with a single dispute number) is to limit administrative costs in relation to client disputes. This is a worthy motive, but it does not make sense if the adviser and licensees are left uninsured and in a position where they are unable to meet a FOS award granted to a client.

I have found FOS is prepared to be flexible and to treat unbundled claims as separate disputes in these situations. That tends to remove the advisers' and licensees' PI insurance coverage problems. However, from the advisers' and licensees' perspective, it is also important to balance this approach against the fact that unbundling claims as separate matters for insurance purposes must result in them facing multiple excess payments.


Situations where the client contributes to their own loss

The position of the courts and bodies such as FOS on the proposition that clients have contributed to their own losses is an uncertain one. However, there appears to be recent anecdotal evidence that they have not typically been sympathetic to those arguments used by advisers and licensees against clients (particularly retail clients).

An example of this can be seen in the high-profile Delmenico case in Queensland Delmenico v Brannelly & Ors [2007] QDC 165 and the subsequent appeal to the Supreme Court, Delmenico v Brannelly & Anor [2008] QCA 74), which was a case relating to an investor who was recommended Westpoint products by their adviser.

In the Delmenico case, the adviser stated that the covering letter provided by the adviser to the client contained incorrect information and was inconsistent with the information contained in the product's information memorandum document that was provided to the client at the same time.

The adviser argued that the client may have been careless as to the discrepancy between the two documents. Alternatively, the client failed to make proper enquiries about the discrepancy or his possible lack of understanding of the matter. In that sense, it was suggested the client may have contributed to his own losses, and any damages awarded should reflect the extent to which the client contributed to his own losses.

The courts specifically rejected this position. The judgment in the District Court stated that: "The fact that the [client] has been careless or could have discovered the misrepresentation had he made proper enquires of the [adviser] does not allow the latter to avoid liability for such misrepresentations.

"It will commonly be the case that a person who is induced by a misleading or deceptive representation to undertake a cause of action will have acted carelessly, or will have been otherwise at fault, in responding to the inducement.

"The purpose of the legislation is not restricted to the protection of the careful or the astute.

"Negligence on the part of a victim of a contravention is not a bar to an action unless the conduct of the victim is such as to destroy the causal connection between contravention and loss or damage."

The Court of Appeal also stated: "It is also well-established by decisions of the High Court, of which the most recent is I & L Securities Pty Ltd v HTW Valuers (Brisbane) Pty Ltd, that the circumstance that a consumer, who is in fact induced to rely upon a statement which is objectively misleading, could have avoided the loss consequent upon that reliance by the exercise of reasonable care does not mean that the consumer did not act in reliance upon it so as to be entitled to recover damages by way of compensation for that loss."

It should be noted in the Delmenico case that the adviser did not appear to have pleaded the provisions of section 12GF of the ASIC Act to allege contributory negligence on the part of the client to allow a just and equitable assessment of damages.

In summary, the courts and FOS seem particularly forgiving towards retail clients whose actions, or omissions, contribute to their own losses.

While client contribution to their own losses should always be argued (where it has occurred), it is not a factor that is certain to mitigate the adviser's or licensee's liability. In fact, the evidence is to the contrary.

It would be prudent for compliance risk managers and responsible managers to consider the five significant issues regarding adviser liability outlined above and consider how these issues relate to their businesses.

Naturally, there are many other important issues, but these are issues of particular current concern.

Mark Halsey is a principal of Halsey Legal Services, a Perth-based law firm specialising in financial services.


Adviser liability
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