The end of vertically integrated businesses
"The reports of my death are greatly exaggerated" - Mark Twain.
Those of us who recently sat, transfixed and unblinking, captivated by the Royal Commission have now had time to reflect. The Commission offered us "incidents arousing pity and fear, [and the spectacle] with which to accomplish...catharsis of such emotions."
Aristotle may have understood tragedy, but his prescription fails to account for the abiding anger that's endured beyond the admissions of corruption, contempt and concealment made to the Commission.
Fees for no service. Self-interest disguised as expertise. Illegality.
It is inconceivable that significant changes will not occur. In fact, significant changes are required.
We should all demand a consistent, predictable and courageous regulator.
We should insist on stronger penalties, more aggressively pursued, against corrupt gatekeepers.
We should expect our Institutions, of whom are all shareholders, not to exploit us as customers to satisfy us as shareholders.
What we should not expect is the prohibition of vertical-integration.
"I appreciate that some commentators are predicting the death of vertically-integrated businesses. They highlight the inevitability of change and cleave to ASIC's observation that "there is inherently a conflict between manufacturing a product and supplying a product but then having advice network or advisers who are supposed to be providing advice in the best interests of the clients" - ASIC deputy chair, Peter Kell.
Let's start with the basics. According to ASIC, a "vertically-integrated model occurs where the institution engages in both the provision of financial advice and the manufacture of financial products."
It's a practical definition notwithstanding lawyer Michelle Levy's technically correct view that "financial institutions don't extract, grow, make, produce or build anything" (they instead enter into legal relationships with their customers).
I think the Royal Commission has demonstrated the imprudence of relying, too heavily, on technically correct legal advice, so let's presume that 'structuring' legal relationships for the purpose of providing financial services is "manufacturing products".
So, is there a problem with both manufacturing and distributing financial products?
Not necessarily.
I'll concede that there's an inherent conflict of interests, but the position only becomes untenable when the providers' prioritise their interests before those of their clients.
Vertical integration, as ASIC acknowledge in REP562, can provide significant benefits to clients - convenience, efficiency and consistency of experience.
Vertical integration only becomes toxic and problematic when self and self-interest become the raison d'etre for these arrangements.
In my opinion, vertical integration is not the cause of the misconduct identified by the Royal Commission. Mismanagement, misaligned incentives and successive ethical failures (both personal and institutional) are the root causes of the exposed misconduct. Vertical integration magnified, concealed and normalised the misconduct, but it didn't cause it.
Remember that conflicts of interests exist in all commercial relationships; 'sustainability' depends on our ability to manage or avoid these conflicts and give priority to the interests of those who depend on our advice and services.
It's also important to remember that the big banks don't have a monopoly on vertically integrated models. Many licensees, in pursuit of efficiencies and benefits for their clients, have implemented similar strategies. (It's also important to acknowledge that even non-integrated businesses can be riven with conflicts).
Rather than obsess over the perils of 'vertical integration' we could, instead, try to manage the recurrence of systemic conduct risks by limiting the nature, scale and complexity of the advice businesses themselves.
"It's a tough one, and I don't think it's as simple as saying who owns the business. It's about how do you design a business system that overwhelmingly will get it right for customers" - Westpac chief executive, Brian Hartzer.
Fragmentation and fear
Many of the large vertically-integrated financial institutions are de-risking their businesses in anticipation of the Commissioner's findings.
ANZ led from the front and CBA and MLC are closely following their lead.
Despite my view on vertically-integrated businesses, I'm not concerned by these moves. In fact, I think they're essential to the emergence of an advice profession.
I appreciate ASIC's view of the competence and culture of vertically integrated businesses (REP 515) but - in my view - the problem is that their institutional structure allows them to treat their customers as abstractions (rather than people) and their size insulates them from the consequences of their misconduct.
They may not have been too big to fail, but they were certainly too big to be held to account for their failures. Enforceable Undertakings, the best option for under-resourced regulator, are ineffective deterrents.
Worse still, because they seldom had any lasting impact, they became (like compliance) simply the 'cost of business'.
Some commentators observe that "If the banks do leave the sector ... it will revert to being a very fragmented sector populated by a host of relatively small businesses. Most, if not all of them, would be incapable of writing the kind of cheques the banks have been writing routinely in recent years."
The commentator, Stephen Bartholomeusz, is correct but, in a fragmented industry, small businesses would not need to "write the kind of cheques the banks have been writing routinely in recent years" precisely because the systemic failures that are now being remediated are unlikely to occur at anything approaching the current scale.
Failure and misconduct may still occur, consumers may still receive inappropriate advice, but not at anything like the current position.
FRAGMENTATION IS NOT THE WORST POSSIBLE OUTCOME OF THE ROYAL COMMISSION. PRESERVING THE STATUS QUO, AND FAILING TO PREVENT THE MISCONDUCT RECURRING, ARE FAR WORSE OUTCOMES.
The flight to safety
"He that hath [a licensee] has given hostages to fortune; for they are impediments to great enterprises, either of virtue or mischief."- Francis Bacon.
For all their natural advantages, the vertically integrated licensees have hardly showered themselves in glory.
AMP licensees made the provision of ongoing service both more efficient and more profitable by divorcing ongoing service fees from the obligation to provide ongoing service. CBA trumped them by holding deceased clients to their ongoing service contracts (without providing ongoing service). ANZ highlighted mandatory supervisory arrangements that required advisers to 'opt in' on an ongoing basis (but couldn't tell if they had or not). Westpac admitted that it would be difficult to unwind the inherent conflict between sales and advice and Dover presented an "Orwellian" Client Protection Policy that didn't protect clients as much as "exclude Dover's liability for the acts of its authorised representatives."
In the current environment, it's understandable that advisers are looking for alternatives to institutional models.
We've previously observed that sometimes your licensee is your greatest source of risk. We think the Royal Commission is driving that point home.
While we'd encourage all professional advisers to consider their options it's critical that you don't simply trade one bad option with another equally bad one. A non-institutional licensee isn't necessarily better than an institutional licensee. Quite often, they lack the capability and competency of their institutional competitors and these deficiencies, with their need to scale, can lead to equally poor outcomes.
Consider AZ Next Generation's acquisition of Henderson Maxwell on the eve of Henderson's appearance before the Royal Commission to explain his 'risible' advice, alleged misrepresentation and 'questionable' business practices. Despite the FPA's determined, and ongoing, efforts to protect Henderson from scrutiny, what the media described as his "lies and fakery" were easily exposed.
The ease with which Henderson was exposed raises, in my mind, serious concerns about the capability and competence of the licensee that acquired his business.
If their due diligence process failed to uncover the conduct and advice issues identified at the Royal Commission, what does that say about their capability and competence? How can they protect themselves, and their advisers, from regulatory, legislative and conduct risks?
AZ Next Generation's failure is simply the most dramatic example of the risks of some licensees. Every licensee has the same challenges to face.
Dover's recent collapse highlights that a brutal reality for many advisers: when you join a licensee you are giving hostages to fortune. You're tying your reputation, your livelihood and the sustainability of your business both to the license and the other business that comprise it.
Choose well.
In my opinion, you can no longer base your decision on generous remuneration structures or the back-slapping bonhomie of the chief executive.
You need to do your own due diligence and, appreciating the risk the licensee poses to you, you need to interrogate the licensee, consider its management team and review their governance framework.
The risk your licensee poses to you is too important for you to ignore.
If you're doing your own due diligence, I recommend judge each prospective licensee on three distinct criteria:
- Capability (processes, tools, skills, resources and behaviour),
- Competence (knowledge, skills, behaviour and attitude) and
- Character (ethics, conscientiousness, cultural alignment and compliance with social, cultural and emotional norms)
Good luck.
