Michael Arnold Ombudsman and Panel Chair, Investments, Life Insurance and Superannuation, FOS

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1 Financial Advice Presenters Michael Arnold Ombudsman and Panel Chair, Investments, Life Insurance and Premjeet Gill Panel Case Manager, Investments, Life Insurance and Dick Viney Ombudsman and Panel Chair, Investments, Life Insurance and Alex Knipping Panel Industry Representative, Investments, Life Insurance and Gavin Wright Panel Industry Representative, Investments, Life Insurance and Case Study 1 Mr. L worked as a sales consultant for N Group (a corporate authorised representative of the member) from August 2007 to March As part of his employment, he was involved in the sale of a product colloquially known as the Bolt (so called because it was said to be bolted onto a client s existing mortgage). Mr. L had prior experience selling mortgages, investment properties and financial products and was suitably qualified. The Bolt was issued by C Co. and operated akin to a Managed Discretionary Account insofar as it was an Individual Managed Account structured in the form of a registered managed investment scheme managed by a manager selected by C Co. but was not pooled with the interests of other investors. Investors could either invest cash or transfer existing securities into the facility and had the option to gear their investment in the case of cash investments the Bolt s manager would acquire shares on behalf of investors. The Bolt was listed on the member s Approved Product s List and was given a Recommended rating by the member s research committee. The member also conducted the following in relation to its due diligence into the Bolt: Reviewed a copy of the Bolt s PDS (the PDS); Conducted a company search of C Co. as well as searches of C Co s. directors, share structure and shareholders; Financial Advice Case Studies 1 of 8

2 Conducted Google searches of C Co., its directors, its shareholders, the Bolt, the Bolt s manager, its brokers and any other products issued by C Co.; Mr. DL (an authorised representative and director of the member as well as part of the member s research committee) attended C Co s. head office and also spoke with a director of the Bolt s manager. The PDS contained references to securities lending including the risks associated with such practice and disclosure that the Bolt s constitution sets out the terms and conditions under which it operates including the right of its Responsible Entity to enter into securities lending arrangements on behalf of investors (amongst other things). The terms of such lending arrangement would be based on the Australian Master Securities Lending Agreement (AMSLA). The member did not review a copy of the Bolt s constitution and relied on disclosure contained in the PDS instead. The member also did not review a copy of the Bolt s AMSLA as it did not believe it related directly to investments in the Bolt or the securities lending agreement referred to in the PDS. The AMSLA relevantly states that an investor s securities are transferred to a borrower (P Securities, (a company within the C Co. group of companies that provided the margin lending facility for the Bolt)), with P Securities being contractually obliged to redeliver to the investor at a later time, securities that are equivalent in number and type. The P Securities pays a fee for the use of the securities and pays collateral to the investor. It further provides the parties must execute and deliver all documents necessary to pass title of securities from the lender to the borrower. This effectively means that if title of the loaned securities passes from the investor to P Securities, it (P Securities) is free to enjoy all the benefits of ownership of the securities including the right to sell or on-lend. Mr. L met with Mr. PL (an authorised representative of the member) several times in late 2007 to discuss the Bolt as well as his financial situation. At one such meeting, Mr. L told Mr. PL that he would increase his mortgage by $150,000 to invest in the Bolt. Mr. PL advised Mr. L that 75% gearing would increase the value of the $150,000 to $450,000. At another meeting, Mr. PL confirmed that Mr. L would retain ownership and control of the shares purchased via the Bolt. Mr. L explained that it was important that the ownership of the shares was retained because he had no control over a previous investment which resulted in the loss of his home. Mr. PL also gave Mr. L a Financial Services Guide issued by the member. Mr. L was not asked to complete a client questionnaire. Mr. L made an application to invest $150,000 in the Bolt in February 2008 and during a meeting with Mr. DL he signed a Limited Advice Client Questionnaire and notably an Execution Only request Authorisation. Mr. L elected to leverage his investment up to 50%. No SOA was prepared for Mr. L. Financial Advice Case Studies 2 of 8

3 Mr. L, in June 2008 contacted C Co. to discuss his upcoming July 2008 dividend payment and was informed that such payment was not likely to be made. This was because P Securities was experiencing financial difficulties with its lender at the time. This was the first time Mr. L had been made aware of P Securities and its role in the Bolt. C Co., in December 2008 wrote to Mr. L informing him that when he chose the geared investment option, the shares in his Bolt portfolio were loaned to P Securities and Mr. L s entitlements to have his shares re-delivered was for practical purposes extinguished in July 2008 when P Securities lender appointed receivers to P Securities because the securities lending agreement with P Securities was closed out by C Co. in September Discussion questions Without limiting the questions arising from the case studies, the following should be considered for the purposes of discussion: 1. Did Messrs. PL and DL undertake sufficient enquiries into Mr. L s circumstances, goals and objectives? If not, what could they have done differently? 2. What weight (if any) ought to be placed on the Limited Advice Client Questionnaire and the Execution Only request Authorisation signed by Mr. L? 3. Did the member take sufficient steps to satisfy its know your product obligations in respect of the Bolt? If not, what could the member have done differently? 4. What weight (if any) ought to be placed on Mr. L s previous professional experience, in particular his role in selling the Bolt? Should Mr. L have been expected to have a better understanding of the Bolt compared to an average investor? 5. To what extent (if any) does Mr. L s professional involvement with the Bolt place a greater responsibility on him to have made independent enquiries as to the nature and characteristics of the Bolt? Would this in turn have reduced the member s liability (if so, to what extent)? Financial Advice Case Studies 3 of 8

4 Case Study 2 Mr. and Mrs. D were inexperienced investors, who, June 2007, were married with four dependent children under eight years of age. Mr. D was employed as an electrical technician and was in receipt of gross income of $65,000 per annum. Mrs. D was not employed at the time and had no plans to return to work for another five years. The family received some Centrelink entitlements and they owned their own home with an outstanding mortgage of approximately $210,000 over it. Besides the house, they also jointly had savings of $15,000 in a bank account and two cars (worth $20,000 collectively). Mr. and Mrs. D were fairly risk averse. Mr. and Mrs. D met with Mr. S (an authorised representative of the member) in June 2007 to ascertain how they could begin to establish an investment portfolio. Mr. and Mrs. D generally spoke with Mr. S about their circumstances as well as their investment goals and objectives no formal fact find was conducted. There were also no discussions of substance relating to the correlation between investment risk and reward. Mr. S made the following recommendations to Mr. and Mrs. D: Obtain a home loan from B Bank of $150,000 using the available equity in their home. Obtain a margin loan from M Bank of $100,000; Obtain a margin loan from C Bank of $210,000; and Establish a Cash Management Trust Account with M Bank. With the above monies, Mr. S recommended: Using the M Bank margin loan, purchase $100,000 of shares in ANZ, Wesfarmers Limited and Macquarie Bank Limited; Using the C Bank margin loan and $105,000 from the B Bank loan, purchase $315,000 of units in various managed funds managed under the Navigator Personal Investment Plan (predominantly growth/high growth funds); Purchase $45,000 of units in the M Bank Cash Management Trust (CMT). Mr. S recommendations focussed on informing Mr. and Mrs. D that in 10 years they would have paid off their house and have a large share portfolio. Mr. S advised Mr. and Mrs. D that he would actively manage their investment portfolio for them so that if the market was to drop in value, he would move their investment portfolio to cash until the market improved. He also advised them that the market was strong and it was highly unlikely to fall substantially. He further advised Financial Advice Case Studies 4 of 8

5 them that all interest payments would be managed entirely through the investment and there would be no changes to their financial commitments or current lifestyle. Mr. and Mrs. D adopted Mr. S recommendations in August In February 2008, they received notification from B Bank that the equity loan interest payments were in arrears as the automatic payment facility established by Mr. S did not cover such interest payments they subsequently increased the amount of such payments. In the mean time however, volatility in world investment markets started to increase, leading to a decline in the value of their investment portfolio. Mr. S recommended securing additional funds (between $30,000 and $50,000) in order to tide the investments over until investment markets settled. Mr. and Mrs. D declined to do so. Mr. and Mrs. D redeemed their investments in January 2009, realising a net loss of approximately $127,000. In all that time, Mr. S did not move Mr. and Mrs. D s investments to cash. Discussion questions Without limiting the questions arising from the case studies, the following should be considered for the purposes of discussion: 1. Did Mr. S discharge his know your client obligations in respect of Mr. and Mrs. D, effectively? If not, what should he have done differently? 2. Were Mr. S recommendations appropriate to Mr. and Mrs. D (in light of their circumstances, goals and objectives) insofar as they related to: a) The financial products recommended; and b) The gearing strategies recommended. If not, what should he have done differently? 3. Would your response to 2) above be different if Mr. and Mrs. D s primary investment objective was to achieve a 15% - 20% annual rate of return? 4. Were direct share investments (albeit blue chip shares ) a suitable investment strategy for inexperienced investors such as Mr. and Mrs. D? Why? 5. Under the circumstances, what steps should Mr. S have taken to effectively discharge his know your product obligations? Financial Advice Case Studies 5 of 8

6 Case Study 3 Ms. A inherited a share portfolio worth approximately $1.1 million in value from her late father in October It was subsequently valued at approximately $1.4 million in August The solicitors for Ms. A s father s estate referred her to the member in May 2005 to organise the transfer of shares into her name. As a consequence, Ms. A met Ms. C, a stockbroker and authorised representative of the member. On 1 June 2005, Ms. C sent Ms. A an proposing the tidying up of the portfolio and commented on the Capital Gains Tax (CGT) implications of the inherited shares however noted that she was not qualified to provide taxation advice to Ms. A and recommended that Ms. A obtain independent taxation advice on this matter. The member s Financial Services Guide also mirrors Ms. C s recommendation insofar as the member is not authorised to provide taxation advice. Ms. C subsequently sent Ms. A another on 4 June 2005 suggesting that transactions on the portfolio would be CGT neutral as the cost of brokerage and GST could be offset against the net CGT (i.e. no CGT at all). Ms. A had no experience in handling shares and Ms. C became her adviser on the portfolio. Ms. A signed an account opening form with the member in July 2005 in which the following information was recorded: Her Investment Objective was income ; Her Risk Profile was Conservative ; Her Investment Experience was Australian Equities ; Her Investment Time Horizon was Long Term (over two years) ; Her Trading Policy was Opportunistic and Passive ; and Her Initial Investment Amount was $100,001 - $500,000. The form further recorded the following: Her Annual Gross Income was in the range of $50,000 - $100,000 ; Her Total Net Asset Position was greater than $1 million ; Her Approximate Tax Rate was in the range of 20% - 40% ; and There was 0 Gearing on her securities portfolio. Ms. C managed and conducted share trading on Ms. A s portfolio between August 2005 and June Besides the information supplied by Ms. A in the account opening form, there was no other written agreement between Ms. C/the member and Ms. A in respect of the parameters of such share trading however Ms. A approved Financial Advice Case Studies 6 of 8

7 each trade that occurred on the portfolio including the sale (in 2005/2006) of a portion of the shares she inherited as part of the portfolio. Ms. C also provided Ms. A with numerous income projections relating to her investments and generally based her trading of Ms. A s portfolio on such projections. Ms. C adopted the following strategy in the management of Ms. A s portfolio: An initial sale of shares that formed part of the inherited portfolio; A dividend capture strategy stocks of the major Australian banks and other ASX 200 leaders; and A buy and hold strategy. The member s dividend capture strategy entailed maximizing the amount of income that can be earned by an investor and involves buying shares and holding them for at least 45 days over the ex dividend period to enable an investor to receive the dividends. In the case of bank and other stocks, it involved buying another bank and other stock that was due to pay dividends. Over the course of Ms. A s relationship with the member, Ms. C conducted $10,122,028 of Buy/Sell trades on the portfolio, generating $109,035 in brokerage fees and around $10,000 in GST, as follows: 2005/2006: $3,252,568 contracts; $34,591 brokerage; 2006/2007: $5,333,237 contracts; $54,123 brokerage; and 2007/2008: $1,539,422 contracts; $20,321 brokerage. To put this in perspective, Ms. C conducted a total of 138 transactions on Ms. A s portfolio in a period of two years and 10 months; an average of 48.7 trades per annum or about 4 trades per month. 60% of Ms. A s holdings in her portfolio were never traded. Ms. A s income and capital gains during the time Ms. C was managing and trading on Ms. A s portfolio was as follows: Tax Returns 2005/ / /2008 Salary etc $21,730 $20,430 $21,390 Dividends $48,946 $83,702 $65,775 Franking Credits $19,814 $34,407 $27,368 Capital Gains $195,101 $65,614 $-6,715 Total Income $292,697 $204,688 $114,533 Tax Paid $101,020 $38,037 $6,653 Financial Advice Case Studies 7 of 8

8 Ms. A subsequently discovered that the reason her Capital Gains liability in 2005/2006 was so high was because she inherited the cost base of her late father s shares. Ms. A claims that Ms. C s recommended initial sale of shares from the portfolio was ill advised as such recommendation failed to consider the CGT implications on Ms. A. Ms. A also disputes the number of trades conducted on her portfolio as excessive, believing that Ms. C s purposely traded her portfolio to generate brokerage (i.e. churning ). Discussion questions Without limiting the questions arising from the case studies, the following should be considered for the purposes of discussion: 1. What steps should Ms. C/the member have taken to effectively discharge the member s know your client obligations in respect of Ms. A? Should there have been any consideration given to the appropriate structure of Ms. A s account to meet her aims and objectives? 2. Do you agree with Ms. A s claim that Ms. C s recommended initial sale of shares from Ms. A s portfolio was ill advised? a) How would your response to (1) be different if Ms. C s recommended initial sale of shares from Ms. A s portfolio related only to speculative shares due to Ms. A s wish not to hold any such shares? b) What weight (if any) should be attached to the fact that Ms. C warned Ms. A that she was not qualified to provide tax advice? 3. Given the conservative nature of Ms. A s risk profile, were investments wholly in shares suitable to Ms. A s circumstances (i.e. did Ms. A s asset allocation accurately reflect her tolerance to risk)? 4. Given the information disclosed by Ms. A in the account opening form, what are your thoughts on the number of trades conducted by Ms. C on Ms. A s portfolio? What factors do you believe ought to be taken into account when considering such matters? 5. What steps could the member/ms. C have taken to avoid a dispute with Ms. A in respect of the trading parameters on Ms. A s portfolio? 6. What weight (if any) ought to be placed on the fact that Ms. A approved each trade made by Ms. C? 7. What are your thoughts on Ms. C s use of income projections in respect of planning Ms. A s future investment strategy (i.e. were this sufficient in place of a formal plan)? What could Ms. C have done differently in this respect? Financial Advice Case Studies 8 of 8