I've always enjoyed irony, so the irony wasn't lost on me when I first read Standard 3 of the FASEA Code of Ethics (Standard 3). It's ironic because Standard 3 purported to eliminate conflicts, but at the same time it brought into existence a brand new one. I'm referring to the conflict between Standard 3 and established law and regulatory policy.
Let's get the details out of the way. Standard 3 reads: " You must not advise, refer or act in any other manner where you have a conflict of interest or duty." It's drafted in a rather absolute, black-and-white manner, which understandably has given rise to a great deal of confusion among financial advisers who use managed accounts. However all is not lost. Despite the confusion and fear that Standard 3 might signal the end of managed accounts as we know them, I firmly believe that managed accounts still have an important role to play as an investment solution for many clients.
Managed accounts have the potential to benefit both clients and advisers. The client benefits by having an investment account managed on a discretionary basis by a professional investment manager. The portfolio can be rebalanced without requiring a Statement of Advice or Record of Advice every time. Managed accounts also offer transparency and the ability to hold assets in the client's own name, which means they can managed to create after-tax benefits.
Many, but certainly not all, managed accounts are considered in-house or related party products because they are branded and operated by an advice firm that recommends its own suite of managed accounts to clients. In some way, shape or form, the advisers and principals of the advice firm will receive a financial benefit when an adviser recommends a related party managed account to a client. This creates a conflict of interest.
To manage or avoid? That is the question
AFS licensees already have an obligation under the Corporations Act to have adequate arrangements in place for the management of conflicts of interest. Conflicts can and do arise between the interests of financial services providers and their clients, and the law and regulatory guidance does not require financial services providers to avoid all such conflicts.
ASIC Regulatory Guide 181 "Managing Conflicts of Interest" states that adequate conflict management arrangements help to minimise the potential impact on clients. This ASIC guidance states that there are three mechanisms for managing conflicts (depending on the circumstances) - controlling the conflict, disclosing the conflict and avoiding the conflict. It states that financial services providers will generally use all the three mechanisms, which clearly indicates that not all conflicts must be avoided.
In contrast, at first blush, Standard 3 appears to impose a blanket ban on servicing a client if a conflict exists. It fails to recognise that an adviser can adequately manage many conflicts that arise in the provision of their services. Standard 3 also seems to go beyond the recommendations of the Banking Royal Commission. In his final report, Commissioner Hayne posed the question: "Is there more that could be done to manage those conflicts better?"
A matter of semantics
This is where things get interesting. My newly-formed contention is that the stakeholders may actually in broad agreement with one another without realising it.
In the consultation sessions held in December 2019, and the guidance released subsequent to those sessions, FASEA stressed that Standard 3 only prohibits advisers acting in the face of actual conflicts, as opposed to potential or perceived conflicts. The explanation was that by managing a potential conflict so that it does not influence your advice, you ensure that it does not become an actual conflict. The guidance also put forward a 'disinterested person test' - an adviser should consider whether a disinterested or unbiased person would reasonably conclude that the potential conflict could induce the adviser to act other than in their client's best interests. An arrangement that passes this test should be permitted - irrespective of the specific form or features of the arrangement.
Lamentably, the Code itself contains no such language or explanation, hence the confusion remains.
It pays to stop for a second to think about what we mean by a conflict. At its core, a conflict is a divergence of interests between the adviser and their client. If a client pays a fee to an adviser and the adviser provides appropriate advice that this in the client's best interests, is there really a conflict? Without attempting to speak for FASEA, I believe their position is that, in that situation, the answer is no.
At the other end of the spectrum, RG 181 provides two examples of genuine conflicts i.e. where the adviser's interests are directly opposed to the client's interests:
Example 1: An adviser has an interest in recommending higher risk product to the client in order to receive a higher commission. This is inconsistent with the client's desire to obtain a lower risk product.
Example 2: An adviser has an interest in maximising trading volume by the client in order to increase brokerage revenue, which is inconsistent with the client's objective of minimising investment costs.
These days, when I hear an adviser say "every time you charge a fee there's a conflict" or "this will shut down the whole industry" I take pause, because I'm no longer convinced it's true. While it's not articulated in the Code, FAESA's subsequent guidance and commentary has stressed importance of advisers managing any potential conflicts by ensuring that the advice is in the client's best interests (thus avoiding an actual conflict).
Acting in the client's best interests
Advisers cannot have a one-size fits all approach to recommending managed accounts. They need to look at each client individually to determine whether a managed account is appropriate for that client, having regard to the relative costs, taxation implications and the client's preference for certain product features.
If an adviser is considering recommending a managed account to a client, the adviser should consider:
- How the managed account is likely to satisfy the client's needs, objectives and preferences; and
- Whether the client is likely to be in a better position if they follow the recommendation.
Advisers must be able to demonstrate that their advice is clearly in the best interests of the client and that it represents value for money for the client. If the adviser cannot do this, they should reassess the advice.
As outlined above, many advisers that use managed accounts have some form of ownership interest in the business that operates the managed account. The FASEA guidance states that an adviser will not breach Standard 3 if they share in profits generated by the provision of ancillary products and services (e.g. managed accounts) to clients, providing that:
- The ancillary products and services are merely incidental to the adviser's dominant purpose in providing advice; and
- The ancillary products and services recommended are in the best interests of clients.
However, FASEA states that an adviser will breach Standard 3 if the dominant purpose of providing advice is to derive profits from the ancillary products or services.
A robust advice process
Pulling it all together, based on current law, guidance and the Code, advisers can recommend related party managed accounts provided they follow a robust advice process. See below:
- Identify the client's needs and objectives. Ask questions to draw out the client's preferences and priorities. Find out which product features and benefits (if any) are important to them;
- Research investment solutions that are capable of satisfying the client's needs, objectives and preferences. Learn about the benefits, risks and costs of each option;
- If the client has an existing investment solution, investigate that investment solution and conduct a detailed comparison of the existing solution vs the managed account;
- If you are considering recommending a managed account, ensure that the fees and costs of the managed account are reasonable and represent value for money for the client (e.g. by benchmarking against the broader market);
- Tailor the advice to the client's circumstances. Link each recommendation back to the client's needs, objectives and preferences;
- If you do recommend a managed amount, explain how it satisfies the client's needs and objectives and why it is likely to leave the client in a better position; and
- Take steps to ensure that the client understands the benefits, costs and risks of each recommendation.
There is no doubt that advisers who recommend related-party managed accounts will, and probably should, attract more regulatory scrutiny going forward. However it would be a bridge too far so suggest that Standard 3 is the death knell for managed accounts. There will always be a place for quality advice and investment solutions that are in the client's best interests.